Inventories Don't Kill Growth — People Kill Growth
The most destructive ideas in academia are those that are technically defensible but nonetheless encourage erroneous intuitions. In economic science, a prime example of such a destructive idea is GDP accounting. As the recent punditry on the "inventory blip" of the fourth-quarter growth figures perfectly illustrates, the mainstream macro framework leads us into absolute absurdity.
The GDP Hall of Shame
In previous articles, I have pointed out that the familiar GDP accounting tautology, Y = C + I + G + X, is technically correct, but leads many economists to abuse the equation and in the process make horrible policy recommendations.
For example, it is this typical macro framework that leads our financial press to assume that saving is bad because consumer spending "is responsible for" so much of the economy. The national-income tautology also recently led Paul Krugman — who won the Nobel for his work on international trade theory — to (apparently) commit a basic mercantilist fallacy in a quick blog post.
GDP and Inventory Adjustments
Before we dive into the latest confusion, let's review the theoretical relevance of changes in inventories when it comes to calculating GDP. First of all, remember that Gross Domestic Product tries to measure the total amount of finished goods and services produced during a particular period (typically three months or a year).
In practice, the Bureau of Economic Analysis (BEA) estimates how much consumers, businesses, government, and foreigners spent on finished goods and services (made in the country) during the period in question. Let's say it was $10 trillion. Then, the BEA looks at the change in the value of inventories during the period. So if inventories started out at $500 billion and ended up at $400 billion, then inventories fell $100 billion.
Now the last step is to adjust the "final demand" figure by the change in inventories. In our case, the $10 trillion in total purchases must be adjusted to only $9.9 trillion in new production during the period, because $100 billion of those purchases were fulfilled by drawing down inventories.
So yes, those goods were produced within the country and contributed to GDP, but they did so in a previous period and were already counted in an earlier GDP figure. It would be double counting the same production if we included $100 billion of output
- when a business "invested" by buying the newly produced output and throwing it in the warehouse and then again
- when the retailers moved the goods from the warehouse and into consumers' houses.
So far, so good. Setting aside the severe conceptual and data problems for GDP estimation, it is an obvious refinement to look at changes in inventories to better isolate how much "stuff" was actually produced in a certain period, as opposed to how much stuff was purchased.
The Economists Make a Mess of Things
Even though technically the inventory adjustment makes sense, in practice economists botch things horribly. (We do this a lot.) Recently, when the GDP estimates for the fourth quarter of 2009 came out, many cynics dismissed the 5.7 percent "headline figure" as being mostly an "inventory blip" or an "inventory bounce." Although he was not alone, AEI economist Kevin Hassett was the most forceful I saw on the topic, so it's worth quoting from his Bloomberg article:
When is quarterly gross domestic product growth of almost 6 percent bad news? When it looks like what was reported last week.
US GDP increased 5.7 percent at the end of last year, with more than half of that growth — 3.4 percent — attributable to changes in inventories. This astonishing impact of inventory has ample historical precedent, and the bottom line has terrible implications for 2010.
Inventories are a remarkable corner of the economy. They are the goods and materials that companies keep on hand to make sure that their operations run smoothly. They are the boxes of food on shelves at the grocery store and the bins of metal parts sitting next to the assembly line in a manufacturing plant.…
Inventories are even more important during recessions. In [a] paper, co-authored with Louis Maccini in 1991, [Alan] Blinder found that 87 percent of the decline in GDP from the peak to the trough of the recession was attributable to inventories.…
Since 1970, there have been nine quarters, like the last one, when GDP grew by at least 3 percent and inventories accounted for at least half of that growth. The history of those quarters is hardly a favorable sign of what is in store. (emphasis added)
First, let us note the familiar problem with relying on conventional GDP calculations. Hassett talks as if inventories themselves have some power to steer the economy, as opposed to the human choices underlying changes in inventories. It's a bit like saying 87 percent of fevers can be attributed to thermometers.
But when it comes to the discussion of last quarter's GDP figures, the focus on inventory changes is particularly perverse. I bet those readers who don't already know the answer would have been quite confident after reading Hassett's article that inventories rose in the fourth quarter.
After all, it would make sense for someone to say, "Sure, production was up 5.7 percent in the 4th quarter of 2009 compared to its level in the 3rd quarter. But that spike in output is unsustainable, because 3.4 percentage points of the growth went right into warehouses. It's not as if the final consumers picked up their spending by the full 5.7 percent."
As I say, the above reasoning would be problematic because it presumes that spending green pieces of paper is the ultimate source of prosperity, but besides that, it would make a certain sort of sense.
Yet that's not what happened in the fourth quarter of 2009. No, inventories fell, as the BEA's press release makes clear:
Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 5.7 percent in the fourth quarter of 2009.…
The increase in real GDP in the fourth quarter primarily reflected positive contributions from private inventory investment, exports, and personal consumption expenditures (PCE). Imports, which are a subtraction in the calculation of GDP, increased.
The acceleration in real GDP in the fourth quarter primarily reflected an acceleration in private inventory investment, a deceleration in imports, and an upturn in nonresidential fixed investment that were partly offset by decelerations in federal government spending and in PCE.…
The change in real private inventories added 3.39 percentage points to the fourth-quarter change in real GDP after adding 0.69 percentage point to the third-quarter change. Private businesses decreased inventories $33.5 billion in the fourth quarter, following decreases of $139.2 billion in the third quarter and $160.2 billion in the second. (emphasis added)
The BEA's press release is a testament to the Orwellian nature of GDP accounting. An innocent person would have every reason to assume that phrases such as "positive contributions from private inventory investment" and "an acceleration in private inventory investment" meant that inventories rose in the fourth quarter. But, as the press release says, inventories actually fell by $33.5 billion.
What's really strange is that the change in inventories was fairly small. So the real "contribution" was not even the change in inventories, but the change in the change. In other words, we have moved the analysis one more step into absurdity by explaining the creation of real goods and services by referring to the second derivative of something (inventories) that does not have the power to create goods and services.
A Numerical Illustration of the Absurdity
I have tried to spell out my frustration with the typical handling of GDP inventory accounting to my colleagues, and yet the sharpest of them were nonplussed to say the least. But I hope that the following numerical example will show quite convincingly just how crazy the techniques that I've described above are.
Suppose we have an economy with the following characteristics:
|Year||Starting Inventories||Ending Inventories||Final Purchases||GDP||GDP Growth|
|2010||$1 trillion||$1 trillion||$2 trillion||$2 trillion||N/A|
|2011||$1 trillion||$0||$2 trillion||$1 trillion||−50%|
|2012||$0||$0||$2 trillion||$2 trillion||+100%|
Of course, the numbers above are completely unrealistic, but they can illustrate the knots we tie ourselves in when worrying about inventories.
First, let's make sure we understand the cells in the table. In 2010, inventories didn't change, and so the only way people could consume $2 trillion in purchases of finished goods and services is if that output were actually produced during 2010. Hence GDP is also $2 trillion.
Things are different in 2011. People still bought $2 trillion worth of total stuff. However, only half of that was newly produced in 2011, because the other $1 trillion was taken from the inventory stockpile. That's why GDP fell in half, down to $1 trillion.
In 2012, people once again spent a total of $2 trillion on finished goods and services. Since inventories didn't change during the year, obviously these purchases were consummated through entirely new production during the period. Hence, GDP rose back up to $2 trillion for the year, a 100-percent increase over the previous year's level of output.
Now in this context, look at what someone like Hassett would be forced to say after the 2012 number came out: "Sure, the BEA and the press are running around celebrating the ostensible doubling of real output in 2012. But if you dig into the numbers, you see that fully 100 percent of the growth is attributed to the $1 trillion acceleration in private inventory investment. If we net out the contribution of inventories to GDP growth in 2012, we see that growth was zero. We should be prepared for a double dip in 2013, after this one-time blip of statistical GDP growth."
I hope the reader sees just how nonsensical this type of analysis would be for the table above. In what possible sense did inventories "contribute" to GDP in the year 2012? Inventories didn't even exist at any point in 2012. They were $0 at the beginning of the year, and $0 at the end of the year.
What happened is that people spent $2 trillion buying stuff, and workers took raw materials and other inputs and transformed them into $2 trillion of real output. This was twice as much as the same workers physically produced in 2011. So how in the world does an "inventory adjustment" — from $0 to $0 — cancel out that doubling of physical production?
Furthermore, is it really true that we need to worry about real GDP falling off a cliff after such a huge "inventory bounce"? After all, final demand has been steady at $2 trillion for three years straight. And even if entrepreneurs got spooked again and wanted to draw down inventories to satisfy their demand in 2013, they can't — there are no inventories to draw down.
It's true that someone like Hassett could point out that the growth of GDP was bound to collapse, but so what? There would have presumably been huge unemployment in the year 2011, as half of the economy's productive resources sat idle. Yet in 2012, all those resources would be back in normal operations. Those workers, tractors, drill presses, etc., wouldn't have any reason to see their usage dwindle in 2013, despite the massive "inventory contribution" to GDP growth in 2012.
In fact, to the extent that businesses want to rebuild their inventories in 2013 to give themselves a buffer greater than $0, workers will need to put in extra shifts. Under any reasonable standard, the situation of inventories in 2012 would lead us to expect GDP and employment growth in 2013. It's true, there would be a drop in the growth rate of GDP, but workers care more about their hours than they do about second derivatives of arbitrary magnitudes.
The textbook GDP equation is not false; it is a tautology and so of course it is true. Nonetheless, it is a destructive framework for thinking about macroeconomic events. Abuse of the equation leads economists and pundits to blame savings and praise reckless consumption, to hate imports and love exports, and (in principle) to attribute a doubling in the flow of goods coming out of factories to a nonchange in the level of a nonexistent stock of inventory.
Hassett and others are right to doubt the strength of our alleged "recovery." I think that the economy is currently held together by bubble gum and Ben Bernanke's charm. But to explain our economy's fragility, I would analyze the government and the Fed's policies. A slowdown in the fall of inventories per se is not a warning sign at all. If anything, it is a signal that businesses are becoming more optimistic.