Aggregate Demand and Aggregate Supply
In September, Eurostat waved a magic wand and increased the GDP in the European Union by 3.53 percent overnight. That is a full year's worth of very solid growth. But it didn't make Europeans any wealthier because it was actually just due to a new definition of the way GDP is counted. Eurostat (the economic statistics office of the European Commission) redefined GDP to include many transactions that were previously uncounted and are actually illegal across much of the Eurozone.
The new GDP definition includes illegal drug deals, prostitution, and even sales of stolen goods. Specifically, it includes illegal transactions as long as both parties agree to the transaction.
Ostensibly, Eurostat is trying to capture part of the shadow economy that is typically not measured in GDP. This makes sense, right? GDP is supposed to measure the output of final goods and services, so shouldn't we include all final goods and services even if the service is illegal? In addition, this is complicated when the legality of goods and services varies across nations. For example, the map to the right (from Wikimedia Commons) shows how cannabis laws vary across Europe - cannabis is essentially legal in some nations like the Netherlands but strictly illegal in others like France.
So, normalizing the accounting standards across nations makes sense. But these illegal activities are difficult to measure. In addition, if the illegal activities are a relatively stable portion of GDP, then there is really no bias when they are not included. In fact, the new estimates, in an attempt to provide a more complete measure, may actually introduce more error into GDP measurement due to the difficulty of estimating illegal trade.
So why the change in definition? There is another, perhaps insincere rationale: the new GDP measurements are a bit of an accounting trick to help nations lower their deficit to GDP ratios. Many European nations are dealing with high deficit (and debt) to GDP ratios. The European Commission has explicit rules regarding these budget measures: a nation's deficit in a given fiscal year is not to exceed 3% of their GDP, and the national debt is not to exceed 60% of GDP. When nations exceed these bounds, the Council is directed to bring coercive measures called Excessive Deficit Procedures (EDRs). The Council has certainly been lax in enforcing these EDRs in recent years. However, increasing GDP by simply redefining how it is measured automatically lowers deficit and debt ratios and helps nations with higher government debt levels.
The figure below shows the effect of the new GDP definition on the GDP level each nation in 2013 (along with the overall EU and Euroarea). The countries are ordered according to their GDP gains from the ESA 2010.
As you can see, GDP for Cyprus jumped 9.8% exclusively due to this accounting change. This re-definition of GDP then shrank the debt-to-GDP ratio in Cyprus by a full half of a percentage point in 2013 - reducing it from 5.4% to 4.9%. Therefore, this accounting rule change exaggerates any debt reduction in Cyprus, as they (hopefully) move closer to the EU goal of 3 percent.
So while new GDP accounting rules in Europe may normalize national income accounting across the continent, they are particularly helpful to those nations that already have high government debt levels.
This morning, the BLS released the Employment Situation report for October and the news is very good. The unemployment rate is now back to 5.8% for the first time since July 2008.
In addition, there were 214,000 new jobs added in October. The economy has added more thatn 200,000 jobs per month for nine straight months now. In 2014, we are averaging 229,000 new jobs per month. That is real recovery.
Real GDP grew 3.5% in the third quarter, according to the advance estimate released by the BEA.
A big piece of the growth came from net exports (exports minus imports). Exports rose by 7.8% and imports fell by 2.4%. Since net exports makes up a very small piece of total GDP, this contributed 1.3% to real GDP growth, but this is more than a third of the total growth in the third quarter.
Here is a complete breakdown in the growth contribution from each of the four major components:
Overall, 3.5% is a solid growth rate, assuming this estimate holds up through revisions over the next three months. However, it is slower that the growth experienced in the second quarter, which was 4.6 percent. One big difference between the last two quarters is in investment which contributed just 0.2% to third quarter growth but contributed 2.9% in the second quarter.
The BEA now estimates that real GDP grew by 4.6% in the second quarter. This revision means that the most recent quarter saw the fastest real GDP growth since 2006. That's a long time. Before we get too excited, let's remember that this comes on the heels of negative growth in the first quarter.
The growth was driven largely by changes in investment, which grew by $115.5 billion, or 19.1 percent on an annual basis.
Those who follow me on Twitter may recall that, back on July 3, I predicted that second quarter growth would come in at "something like 5 percent." My rationale was that the negative first quarter growth was likely due to short run supply factors associated with the polar vortex. After all, the unemployment rate fell consistently throughout the spring. Even a blind squirrel finds a nut once in a while.
I'll post more on this later, but I wanted to point out that the new GDP report is available. It shows that the first quarter of 2014 was particularly weak, with growth of just 0.1%.
Remember, this is the first estimate and these have recently been adjusted upward. Even so, nobody expected such a weak report.
Today's jobs report brought mixed news. On the one hand, 113,000 new jobs were added to the economy in January. On the other hand, the unemployment rate continued its decline, falling to 6.6 percent. For perspective, note that just one year ago the unemployment rate was 7.9 percent.
One other piece of good news - the labor force participation rate rose slightly to 63 percent. Perhaps this rate has stopped its decline.
In sum, the labor force grew while the unemployment rate declined. We need more months like that.
Real GDP grew at 3.2% in the fourth quarter of 2013, according to the first estimate released by the BEA this week. This news is decidedly... not terrible. You could spin it to be good news or just mediocre news. But, assuming the estimate doesn't change much in subsequent revisions, we've now had two solid quarters of growth.
The first graphic shows real GDP growth since 2003, by quarter. Recession periods are shaded and the dashed line shows the long-run average of 3%. For the year 2013, real GDP grew at 1.9%. Though this isn't too impressive, it's understandably driven by poor performance in the first quarter.
The second graphic shows the long-run path of real GDP, going back 50 years.
Finally, we can zoom in on real GDP over the past twenty years along with a trend line. This graphic clarifies the mediocre nature of growth in the wake of the Great Recession. At some point, we hope that growth can restore GDP to the long-run trend line. There just hasn't been any bounce coming out of that last recession.
Keep in mind, this is just the first estimate for 2013 GDP and subsequent revisions can be significant.
Ben Bernanke is serving his last week as the Chair of the Federal Reserve and will be replaced by Janet Yellen on February 1st, which makes this a good time to consider his track record.
I agree with Kevin Grier (aka Angus), who praises Bernanke for avoiding both financial catastrophe and inflation. Ben considers the monetary authority to be limited in its ability to manage the macroeconomy. He sees the Fed's power as limited to two functions:
- Controlling inflation
- Providing ample money in times of crisis
The data shows that Bernanke was successful in both endeavors.
First, inflation averaged just 2.2% during Bernanke's tenure (see figure below), lower than any of his predecessors since the 1970s. Ben is probably not unhappy with this result.
Second, Bernanke made sure there was plenty of liquidity in markets during the darkest days of the Great Recession and the recovery, even when this involved creating a new tool (quantitative easing) and figuring out how to use it, all without causing inflation. Tough job.
The third (and final) GDP estimate for the third quarter revised growth up yet again, this time to 4.1%. This figure indicates that growth was stronger in the third quarter than at any time since the end of 2011. The graph below shows quarterly growth rates since 2003.
Notice that 4.1% is larger than all but one quarter since before the Great Recession. These are the kinds of growth rates we need if the economy is to truly recover from the Great Recession. Finally, the revisions indicate that more of the growth came from consumption than previously thought. The table below shows how each of the four categories of GDP spending contributed to overall growth.
- GDP growth in the third quarter was higher than all but one quarter since 2006.
- The new data shows greater growth in consumption.
Japan is simultaneously implementing both expansionary and contractionary fiscal policy. According to The Wall Street Journal, the massive government debt has necessitated an increase in the national sales tax:
Prime Minister Shinzo Abe took a long-awaited decision to raise Japan's sales tax by 3 percentage points (LC: up to 8% total), placing the need to cut the nation's towering debt ahead of any risk to recent economic growth...
In order to offset this increase in taxes, Abe also promised an additional fiscal stimulus:
The stimulus measures total around ¥5 trillion ($51 billion), including cash-handouts to low-income families, Mr. Abe said. On top of that, there will be tax breaks valued at ¥1 trillion for companies making capital investments and wage increases.
Both of these policies are focused firmly on aggregate demand.