April 28, 2011
Economy still growing and still disappointing
The Bureau of Economic Analysis reported today that U.S. real GDP grew at an annual rate of 1.8% during the first quarter of 2011. Not exactly what the doctor ordered for a still very sick patient.
If we were back to a tolerable unemployment rate, an annual GDP growth rate of 1.8% would be a little disappointing but not that unusual for an expansion. The problem is, growth this slow would often mean a rising unemployment rate, the last thing we need at the moment. Still, our Econbrowser Recession Indicator Index remains about where it was, with a reading of 5.2% for 2010:Q4, leaving no doubt that as of then, the economy had not yet entered a contraction phase of the business cycle. Note that we wait a quarter for data revisions and trend recognition before calculating the index, so it is always looking one quarter back from the most recent release.
Real consumption spending increased at a 2.7% annual rate during 2011:Q1, contributing 1.9% to the GDP total and essentially accounting for all the economic growth by itself. Bill McBride notes this means that consumption spending must have picked up in March from the slow consumption spending reported in January and February. Consumers are obviously burdened by higher energy prices, but that's not the core problem with GDP at the moment.
Inventory rebuilding and a gain in exports made positive contributions, but these were essentially undone by increases in imports and decreases in government spending. Perhaps the most disappointing detail was investment spending by businesses, which had been making solid contributions to growth the previous three quarters, but was essentially flat for Q1. Housing remains stuck at very low levels, but at least it's no longer a significant factor dragging the level of GDP down.
But until housing and business investment start making a positive contribution, we're likely to be disappointed by the employment and GDP reports.
Posted by James Hamilton at April 28, 2011 08:26 AMdigg this | reddit
It seems like more excuses keep coming up for the mortgage mess, and rather than clear the markets and take the bitter medicine, the can keeps getting kicked down the (Wall) street. I doubt you'll see much housing and business investment until Fannie and Freddie are disciplined.
We also had the fortune of having, for at least the last half-century or so, cheap energy grease the skids of previous recoveries. While the economy did experience a reduction in oil prices after the 2008 meltdown, by the time the economy was ready to gather steam the energy to heat the steam was getting more expensive. It's continuing to rise as I type.
These are the first few years of a new US economy. Effective leadership would have had us clear the markets, bring the lawbreakers(bankers) to justice and reduce federal debt. Instead the opposite has happened and we're stuck treading water, watching quite a few of our friends go under.
Posted by: Spud at April 28, 2011 10:13 AM
Who is running the USA, FED or government?
Now, with these numbers:
Jobless claims up (real unemployment up)
Everyone will be looking at the FED -unelected body- how it will solve the problem of dual mandate? As if there is no president, no congress responsible for the country.
Strange system. Not sustainable, not democratic.
Posted by: Ivars at April 28, 2011 10:22 AM
Posted by: edgolb at April 28, 2011 11:47 AM
Be VERY careful with this number. It didn't catch the export surge in March and that will have to be revised in. The BEA has been behind the curve and its sizeable revisions to the 2nd half of last year are noticeable. Why they even release this number, is frankly a waste of time.
Release it at the end of June if you must, when you have a better idea. Even then, you may be far off. I have long considered this 'GDP' report stuff shouldn't even be released. The market doesn't follow it and has its own internal contributions toward growth. Which is much closer to the front lines and a much better indicator.
Posted by: The Rage at April 28, 2011 01:13 PM
This is especially puzzling considering we have one of the most business-friendly, economically savvy administrations since Coolidge. I guess the ability of George Bush to undermine the economy was really long lasting - I can understand President Obama's frustration in trying to clean up the mess. Keeping the sea level from rising probably used up most of his energy.
Posted by: Rich Berger at April 28, 2011 01:37 PM
Spud, if it were that simple Econbrowser would have no reason to exist. Market economies would hum along, crash, quickly clean up the mess, and then hum along again. There's no history, or basis in fact to support your point of view, but it must feel good to think that way.
Posted by: edgolb at April 28, 2011 02:52 PM
Better than Britain. Maybe that could be our motto.
Posted by: Jonathan at April 28, 2011 03:16 PM
Looks like the Macroeconomic Advisors forecast got it about right. Kudos to Larry Meyer. Wonder what the Heritage version of the IHS Global Insight model predicted?
Posted by: 2slugbaits at April 28, 2011 03:49 PM
Investment in equipment and software increased 11.6 in Q1 2011 so according to the Heritage version of the IHS Global Insight model real GDP grew 5%, unemployment fell to 3% and tax revenues set a new record.
Posted by: joe at April 28, 2011 07:02 PM
If March made up for the lost consumer spending from terrible winter weather earlier in Q1, then we should see a nice rebound in consumer spending for Q2. Weather probably explains some of the change in imports as well.
Posted by: tj at April 28, 2011 07:54 PM
As usual with these bogus numbers, we'd like to unpack the creative accounting and take a look at what's really going on.
 How much of the alleged "economic growth" involves Ponzi scheme casino activity like Goldman Sachs?
Bear in mind that quite a few trillions of dollars of alleged GDP growth went on in the years immediately preceding the global economic meltdown. Turns out none of that was actual economic growth, just garbage numbers from fraudulent and/or delusional transactions.
How much of today's so-called 'economic growth' comes from fraud or self-delusion?
 How much of the so-called "economic growth" results from worthless military expenditures? I.e., pallets full of hundred dollar bills shipped to Iraq only to mysteriously vanish?
 How much of the so-called "economic growth" experienced by nominally American corporations actually results from accounting games involving payments by foreign subsidiaries which are actually wholly owned by the American corporation itself/ I.e., accounting games to zero out corporate tax liabilities, without any actual meaningful economic production of goods or services? One might enquire how GE managed to zero taxes last year: answering this question might go a long ways toward solving that riddle...
Posted by: mclaren at April 28, 2011 08:28 PM
edgolb: not really. The UK grew faster than the US in 2011Q1, actually.
Posted by: Cempazúchitl at April 28, 2011 08:33 PM
"Better than Britain. Maybe that could be our motto."
Except that the 0.5% Q1 growth figure for the UK is a quarterly number -- Britain is growing faster than the US.
Posted by: Anonymous at April 29, 2011 01:15 AM
Anonymous: Except that the 0.5% Q1 growth figure for the UK is a quarterly number -- Britain is growing faster than the US.
Because UK have chosen austerity over spending their way into deeper hole. That is the only way, should have started in the USA before QE2.
Posted by: Anonymous at April 29, 2011 04:08 AM
For those old enough to remember, Reagan did a much better job than the Bumbler-
Posted by: Rich Berger at April 29, 2011 05:43 AM
Posted by: Ricardo at April 29, 2011 06:18 AM
We also had the fortune of having, for at least the last half-century or so, cheap energy grease the skids of previous recoveries.
Spud, don't get sucked in by the anti-business/anti-oil rhetoric. When gasoline was "cheap" at $0.25/gal you could buy 140 gal. with an ounce of gold. Sounds like a lot doesn't it. Today with gasoline at $4.00/gal you could buy 375 gallons with an ounce of gold. If gasoline was as "cheap" as it was in the 1960s it would cost you over $10.00/gal.
Posted by: Ricardo at April 29, 2011 06:55 AM
The dollar index DROPPED 10% in the first quarter of 2011.... The FED continues dollar dilution via QE2, and the Federal Government continues deficits to the tune of $200B/qtr . Only a rube would believe that real GDP expanded by 1.8%.
We'll all jump for joy when US GDP reaches $20 Trillion in 2020 and the dollar is worth 20 cents.
Posted by: MarkS at April 29, 2011 07:15 AM
Sometimes you cynicism makes me laugh out loud.
The IBD article you linked is what makes me shout and cry at the same time. The solution to our problem is so easy and there is ample and very strong evidence to prove it. But these idiots in Washington, both Democrats and Republicans just don't get it. Reagan and his supply siders got it.
Why is the simplest solution the hardest?
Obama should have the economy booming by now in his administration. Instead he is still blaming Bush. Someone needs to tell him that Bush is no longer president and that he needs to stop channeling FDR and start acting like Grover Cleveland, or Calvin Coolidge, or John Kennedy, or Ronald Reagan, or all of them together.
Posted by: Ricardo at April 29, 2011 07:17 AM
I found the graph on Real GDP Growth interesting. Notice that in all of the other recessions indicated on the chart GDP began to decline before the recession. In our recent recession GDP was relatively stable even increasing slightly.
The primary difference between our current recession and the other recessions is that interest rates were not almost zero and massive amounts of money were not being forced into the economy to "stimulate" activity in earlier recessions. That meant that the GDP was much more reflective of the decline in the productive economy.
I see two interpretations of this. One the economy was actually doing okay until Bush/Paulson/Bernanke hosed it up with TARP and bad monetary policy.
The other is the nature of GDP. Those of us who have studied GDP realize that it is a Keynesian indicator especially the G component. Here we can see that we were actually in a recession prior to the actual mathematical recognition of recession as the private sector was declining but government spending masked the decline. Not until the decline in the private sector overwhelmed the pumping of the government sector did the real conditions become manifest in the GDP.
I actually believe it is a combination of both.
Posted by: Ricardo at April 29, 2011 07:31 AM
While the identity of the GDP requires the component of exports-imports we should not find pleasure in this component of increase in GDP. We live in a global economy. That means that many of our factors of production are imported. As we saw with the consequences of the earthquake in Japan, many manufacturers in the US (particularly auto manufacturers) had to cut back or even suspend production because of the shortage of critical parts. Now it is doubtful that these parts were a significant part of the total cost of the end item but the loss of the import did significant damage to domestic production.
It is a mistake to see the net of exports - imports as either good or bad. It is simply a part of the identity and a postive number could actually signal a very bad situation.
Just one more flaw in using GDP as an indicator of growth.
Posted by: Ricardo at April 29, 2011 07:41 AM
Ivars, JPMorgan is.
Talk about having balls: "If you don't borrow more from us, we'll raise rates on what you owe."
Posted by: aaron at April 29, 2011 07:46 AM
Some interesting superlatives from the latest GDP report:
This is the first time 7 quarters into a recovery:
1) since the 1948-49 recession that real residential investment is down.
2) since the the 1969-70 recession that real (total) government consumption expenditures is down.
3) that real state and local government consumption expenditures has ever fallen.
Sort of gives lie to the Tea Party's "gut feeling" that government spending is exploding, doesn't it?
P.S. We don't have the full income figures yet for the first quarter but looking at the Gross Domestic Income report from the 4th quarter of 2010 reveals another superlative:
66.0% of all real GDI growth this recovery has gone into corporate profits. Needless to say this completely unprecedented.
Posted by: Mark A. Sadowski at April 29, 2011 08:45 AM
Reagan wrote hot checks for 8 years and started with less debt, government and private.
Posted by: Anonymous at April 29, 2011 09:37 AM
See how nicely USA stimulating effects on DJIA pattern follows those of Greek government on Athens index in 2009. The USA seems to be very close to Greece in some financial behaviour aspects. Hence the future may also be the same:
Posted by: Ivars at April 29, 2011 09:46 AM
We're still negative for real private final sales per capita since '06-'07.
We will have borrowed and spent at the federal level an equivalent of 50% of private GDP since '08 just to get back to no growth for the past 4-5 years.
US deficits/private GDP and deficits/receipts are at the levels of WW II and the worst of the Great Depression and FDR's New Deal giveaways.
Real private GDP per capita did not exceed the 1929 high until 1946-47, and did not double from 1929 until 1955. In the meantime, it took a 40% devaluation of the US$ against gold, a gov't takeover of half the output of the US economy for war mobilization, and the utter destruction of Japan, parts of coastal China, a large share of the European continent, and tens of millions of human lives to bring to an end the debt-deflationary depression of the 1930s-40s.
What do the US gov't and Bernanke Fed do for an encore without enabling $200+ oil and the worsening of the Greatest Depression?
Posted by: Nemesis at April 29, 2011 11:59 AM
Anonymous The 1Q2011 UK figure is virtually unchanged from the 3Q2010 figure. The only reason the latest number showed a bump from the previous quarter is that the 4th qtr GDP numbers were extraordinarily low because of the loverly English weather. The UK economy is essentially flatlining and getting worse as the govt cuts start to bite.
Rich Berger Those who are old enough to remember but not yet old enough to have forgotten will know that it was Paul Volcker's lowering of the interest rate that pulled us out of that recession. The 81-82 recession was a Fed engineered recession to squeeze out inflation and it was a Fed engineered recovery. The last time I checked the Federal Funds Rate is currently hovering around zero. Let's see...how high were interest rates back in the early 80s? I'm gonna say a good bit above zero.
Posted by: 2slugbaits at April 29, 2011 02:49 PM
You always get it wrong.
Posted by: Rich Berger at April 29, 2011 03:57 PM
Rich Berger: I am curious. What exactly is factually wrong with what 2slugbaits stated?
Posted by: Menzie Chinn at April 29, 2011 04:39 PM
Ronald Reagan was president, not Paul Volcker. Reagan supported Volcker's policies and took the political heat. Falling interest rates were the result of falling inflation. Furthermore, Reagan's focus was on the health of the private sector, not growth of the government, as is the current misadministration. Shall I go on?
Posted by: Rich Berger at April 29, 2011 05:07 PM
How are these numbers calculated? Are they dollar amounts deflated, or actual volumes? For example, if the price of oil goes up and import volumes stay the same, have imports gone up or not?
Also, what is that trend in non-residential fixed investment? Any interpretations?
Posted by: Steven Kopits at April 29, 2011 06:54 PM
Rich Berger Furthermore, Reagan's focus was on the health of the private sector, not growth of the government
More fact free analysis. FYI, there were more federal workers during Reagan's tenure than now:
Falling interest rates were the result of falling inflation.
I think you've got it backwards. Falling inflation was the result of higher interest rates, and the ensuing reduction in the rate of inflation allowed the Fed to lower the interest rates.
And like Menzie, I'm also curious. Where did you learn your economics? You see, my daughter is starting to look around for colleges and I'd like to know which schools I should definitely scratch off the list. Thanks.
Posted by: 2slugbaits at April 29, 2011 08:07 PM
Volcker actually cared little about "real" inflation. People don't understand that at all. Simply don't. To Volcker, US inflation was actually, in some respects..........to low. It was the "expectations" that were the problem and had been since the 73 embargo. Driving up unneeded cost of business and consumption.
He had to get "expectations" out of the market for inflation. Hence, the "inflation" that was being created, was in fact, fantasy. There was no reason for it. Volcker at first tried to tame the money supply, which he has admitted, was a mistake, it created quick, painfull Carter recession and cost Jimmy the election.
So comes in Burger's Ronald Reagan. Volcker hated Reagan. He hated his fiscal policies and freaked out when Reagan was talking up huge tax cuts and defense spending. Volcker drove 1 year interest rates so high because of Reagan. If Carter had been reelected, those rates would have never went so high.
What Volcker didn't expect was the credit boom would create a new economic era and economic boom. Hence, he failed to get Reagan out of there in 1984 and quit shortly thereafter when his term was finished. The myth of Volcker never ceases to amaze me. The whole problem with the US economy in the 70's was poor business confidence and stupid inflation expectations. The economy grew strongly, 3.6% for the decade. But not quite enough to satisfy the Boomer demand surge. Alot of the poor business confidence had to do with satisfying monster demand fwiw and alot of people don't follow that well either. In many respects the US economy should have peaked in the 1970's but we flubbed it up.
Hence the US struggles to 1983 which coincided with the credit inflation boom of 83-07. You could argue, that in many respects the 1970's was a paradise compared to the problems of today. We are in a oasis right now. The desert is still there.
Posted by: The Rage at April 29, 2011 08:17 PM
Nemesis: Real private GDP per capita did not exceed the 1929 high until 1946-47, and did not double from 1929 until 1955. In the meantime, it took a 40% devaluation of the US$ against gold, a gov't takeover of half the output of the US economy for war mobilization, and the utter destruction of Japan, parts of coastal China, a large share of the European continent, and tens of millions of human lives to bring to an end the debt-deflationary depression of the 1930s-40s.
This time it will be longer and not so deep. First second crash (minimum) of USA stock market happened 6 months after the initial one. This time, it will be around 3 years. And it will not drop so deep, DJIA somewhere around 5000 with 6 times deflated USD (vs. gold) being the minimum.
This time its more deflation, less contraction, so it will take longer before enmities arise. Also, the increased openness ( before its taken under state control) of INTERNET information flows DELAY, demotivate hidden destructive action.
But in general I see the outcome as formation of 2 blocks, neo-stalinism (core: China) vs. neo-fascism ( core: the USA) and their increasing confrontation over decades. First smaller ( comparable to Japanese occupation of Manchuria in 1931) military acts involving these players in areas of mutual interest are just 5-8 years away.
What I am interested in, is there a way to avoid this outcome? Difficult way, but one that will open the eyes of all that politics as usual will bring in never seen amounts of destruction. Of course, it is a very complex question, since deco operation and lowering of living standards are necessary after bubbles,which everyone should share, but how to avoid going into outright wars?
Posted by: Ivars at April 29, 2011 10:56 PM
2slugbaits The reason there were more federal employees during Reagan’s tenure than now is due to the dramatic runoff in defense employees since the end of the Cold War. Furthermore the government workforce he inherited from Carter was a high one, and presidents can accomplish only so much during their limited time in office. Historic context is always important. Upon taking office, Reagan immediately began ramping up the defense program for the specific objective of bringing the Cold War to an end. That objective was attained with the fall of the Berlin Wall in 1989, at which time defense began to shrink dramatically. Similar defense buildups occurred during other wars. When talking about growth of government, defense must be looked at separately and in historic context. More meaningful for the purpose of analyzing size of government is the number of civilian federal employees. And in looking at a specific presidency, what’s important is what happens over the span of office. Over his 8-year term, Reagan reduced the number of civilian federal employees by 2.4 percent. (Thanks for linking the table.) He was the only president in the postwar era to do so! Moreover he did it constrained by a Democratic-controlled House all 8 years, and in the face of a 14 percent growth of the labor force.
Posted by: JBH at April 30, 2011 06:27 AM
So the measure of the size of government is the size of the federal work force? I guess I should ignore the growth in spending, taxation, regulation and the plan to take over the health care sector and realize my worries are unfounded.
If you examine the FRED data, looking at corporate bond rates, interest rates in the 1980s were still high well after inflation had come down, as a result of the Fed sharply curtailing the growth in the money supply. You have the causation backward.
Posted by: Rich Berger at April 30, 2011 06:36 AM
Seventies was not a paradise. Tax rates were very high. We were either in a serious war or had just lost it. (Boy, was the nightly news depressing.) It looked as though communism would be ascendant. Everything was a bit run down; crime was pretty high and rising. And we had two oil shocks in six years, with a lot of inflation, and three recessions between '73 and '83 (admittedly, two the way I count it).
Today we have a transportation fuels crisis and an aging population. The latter requires re-setting expectations and getting more efficiency out of associated expenditures. The former, for the moment, is pretty thorny.
But all the problems we have today are the result of prosperity--as it turns out, China's prosperity. Yes, it may be somewhat harder for us, but for literally billions of people--Chinese, Indian, Middle Eastern, Eastern European, Russian, Southeast Asian, South Korean, Indonesian, and some Latin American--life is much better than it was in the seventies.
Posted by: Steven Kopits at April 30, 2011 07:01 AM
JBH The reason there were more federal employees during Reagan’s tenure than now is due to the dramatic runoff in defense employees since the end of the Cold War.
Partly true, but take a closer look at the numbers. The increase in non-DoD employees is due entirely to Homeland Security. I haven't heard the GOP calling for reductions in Homeland Security, have you?
Furthermore the government workforce he inherited from Carter was a high one,
Sounds like you're making excuses.
When talking about growth of government, defense must be looked at separately and in historic context.
And we shouldn't look at growth in other areas "in historic context"? That seems rather arbitrary, doesn't it? If global warming becomes a bigger concern, shouldn't that justify increased growth in NOAA? If the economy is in recession, shouldn't that justify increased infrastructure spending and a bigger safety net? If crime goes up, shouldn't that justify higher justice department budgets? If the population gets older, larger and less healthy, shouldn't that justify increased growth in government healthcare? Why aren't you willing to extend the logic of your position to other sectors?
Over his 8-year term, Reagan reduced the number of civilian federal employees by 2.4 percent.
You might want to recheck your math. Civilian employment increased 4.4% between 1981 and 1989. And if Americans have weak math skills, shouldn't that justify increased growth in government education budget?
Posted by: 2slugbaits at April 30, 2011 11:31 AM
"Real private GDP per capita did not exceed the 1929 high until 1946-47, and did not double from 1929 until 1955."
This sounds like one of those bizarre claims from Catoland.
First of all, define "private GDP". Is that GDP less government consumption and investment (which makes sense, if only mildly) or is it GDP less all government spending (which is inconsistent since a good part of that is government transfers which is then spent privately)?
Even if one uses the second, less lucid definition, it's not true.
Population increased by 8.5% from 1929 (121.8 million) to 1940 (132.1 million). Real GDP increased by 19.4% from 1929 ($977.0 billion in 2005 dollars) to 1940 ($1166.9 billion). Total government spending went from roughly 12% of GDP in 1929 to 20% of GDP in 1940. By this definition of "private GDP", real private GDP per capita surpassed the 1929 level (just barely) by 1940.
A slightly more rational calculation based on subtracting total government consumption and investment from GDP yields an increase in real "private GDP" of 11.0% for an increase in real private GDP per capita of 2.3%.
In any case, why anyone would think government GDP doesn't count as GDP is beyond me. Government GDP seemed to do pretty well for the Soviet Union through at least the 1970s (the first man in orbit and the Tsar Bomba come to mind). And if it didn't then why all the fuss about Reagan bringing down the Berlin Wall through an arms race? He should have just huffed and puffed.
Other measures such as the unemployment rate (6.0% in 1940, counting Federal Emergency Relief Workers as employed, as is consistent with modern BLS definitions of "employed") suggest that the economy had laregly recovered from the Great Depression before US entry into WW II.
Posted by: Mark A. Sadowski at April 30, 2011 11:35 AM
Rich Berger So the measure of the size of government is the size of the federal work force? I guess I should ignore the growth in spending, taxation, regulation and the plan to take over the health care sector and realize my worries are unfounded.
Well, you're the guy who's always complaining about all of those government workers. But let's do it your way and look at some of the other items on your list. I'll use the OMB historical tables. Growth in taxes. Hmmm...during Reagan income taxes averaged 8.4% of GDP. Under Obama, 6.35%. Well, let's try something else. How about total receipts, including corporate taxes, FICA taxes, income taxes, etc.? Oops. Reagan: 18.2% and Obama: 14.9%. Okay, let's look at on-budget expenditures because those are things that the President can control. Reagan: 18.1% and Obama: 20.6%. Yeah!!!! We finally found a metric that shows bigger government. Uh-oh...looks like a lot of that is due to a gap in GDP. Correct for that and it looks like we're down to 18.6%. So basically your argument is that the government is becoming oppressive because long run on-budget spending is running about a half-percent higher than under St. Ronnie even though taxes are lower, total receipts are lower and employment is lower. Pardon me, but that's a very bizarre argument.
As to interest rates, yes they were still high midway through Reagan's reign, but there's high and then again there's really high. 10yr Treasury rates of 7.5% are high, but not compared to 15% Treasury rates, which is what we had during the 81-82 recession. Interest rates were headed down. So your comment seems disconnected from reality.
Posted by: 2slugbaits at April 30, 2011 11:57 AM
Rich Berger and 2slugbaits Let’s dissect this frog, OK? By this I mean lay the process open with a scalpel. Because a dynamic process is involved here the initial condition is important. The initial condition going into Reagan’s first year was high inflation. That had been caused in the years before and during the Carter administration by too-easy money. Said another way, the real rate of interest was kept too low over many years and that eventually drove inflation up into double-digit territory. Now let’s start with the high inflation Reagan inherited. Volcker correctly hiked the funds rate to break the money inflation dynamic. Volcker’s tight money policy meant a high real rate. Money and interest rates are two sides of a coin. You cannot have one without the other, otherwise there’s simply no coin. When real rates are sufficiently high, it is tight money that induces nominal money supply growth to slow. When real rates are too low, it is easy money. Inflation will rise dynamically over time if real rates are held too low for too long, and vice versa. The core point of the Taylor rule.
The tightening (or easing) impulse has two effects on market rates. Each effect has a different time path. We here start with an initial level of rates and compare it with a future level after some time has transpired. The initial level of rates has an effect on the future level(s). The impulse decomposes into a liquidity effect and an inflation effect. When Volcker tightened in late-1980 and early-1981, the liquidity effect immediately took market rates much higher. During that short time interval, demand for credit was roughly constant, but the supply of credit was seriously shut down at its source. The ensuing illiquidity quickly manifest itself in extremely high market rates. Then time transpired with the funds rate and market rates remaining high during this interval, while contemporaneously on a separate track aggregate demand was being brought to its knees resulting in recession. As overall demand fell, the strong upward momentum of prices dissipated in the normal way via supply and demand. And inflation began falling. At the point where inflation (expectations) started falling the second effect – the inflation effect – began kicking in. The liquidity effect was still holding the yield curve high, but out at the long end slowly at first, and then more rapidly, the inflation effect gained more and more traction as inflation itself was now falling in this tight-money high-rate environment.
Contemporaneous with the fall in inflation, and slowly gathering steam over the course of 1981 and 1982, the impulse from falling inflation created higher and higher real returns that worked their inevitable magic of attracting liquid funds into longer-term securities. With the supply of notes and bonds relatively fixed over any short interval measured in months, this influx of demand took bond and note prices higher and yields, of course, down. The inflation effect of the initial hike in the funds rate was virtually nonexistent at first, was completely swamped by the liquidity effect, but now came into its own and began to dominate. Remember, all of this is happening dynamically over time. Of course there are expectations involved in this process, in particular the expectations of longer-term investors regarding the future course of inflation. When the funds rate peaked in summer 1981, we can say that was roughly when the center of gravity on the teeter-totter tilted away from the liquidity effect toward the inflation effect. All this while, Volcker watched the money supply relative to its target and as money growth began to collapse that summer he brought the funds rate down. Now both effects took the yield curve lower! The inflation effect then probably dominated until 1983 when Volcker reversed course and hiked the funds rate as the economy boomed up from its trough taking money growth once again above target. Quickly the liquidity effect once again dominated and another cycle – this one with a lower interest rate peak because inflation was now lower relative to its earlier watershed peak – transpired over the course of 1983-84.
Hence the Berger contention that “Falling interest rates were the result of falling inflation” is a perfectly correct slice out of what actually happened. It is simply not the whole story. The 2slugsbait statement that: “Falling inflation was the result of higher interest rates, and the ensuing reduction in the rate of inflation allowed the Fed to lower the interest rates” is also correct, and as well more complete. Both statements are a correct description of what happened. A more detailed story that leaves out no important particular is that of the above. With greater precision I would say it this way: It was not the ensuing reduction in the rate of inflation per se that allowed Volcker to lower the funds rate. It was that money supply growth had dropped back into the target cone and then quickly fell below it as a consequence of the recessionary nosedive in aggregate demand. Inflation was already falling on trend coming into 1981 and throughout the year. The funds rate timing is perfectly in sync with money growth and somewhat out of sync with inflation, because the operative policy target was money growth not inflation. Volcker followed money growth up and down with the funds rate since this was the rule he created in 1979, and he knew it would work. Note that market rates tracked the funds rate much more closely than they tracked inflation during the first half of 1981 as the liquidity effect still dominated.
As for the larger argument. Volcker policy carved out the broad contour of the 1982 recession with massive monetary tightening at first and then somewhat less tightness until the full-blown easing in August 1982. The economy troughed 3 months later and this easing (low rates and new liquidity flowing everywhere) powerfully drove the 1983 recovery. During 1981-82, Reagan’s policies only modulated the shape of that contour. Without his tax cuts and pro-growth oratory, the recession would have lasted somewhat longer, been deeper, and had a shallower recovery. But then as the recovery grabbed hold, Volcker policy faded somewhat in importance while Reagan’s no-nonsense pro-growth plank came into its own with a sustained impact on entrepreneurial and investor risk-taking and business decision-making. Of course, inflation was now lower and Volcker’s strong hand until 1987 also helped mitigate the uncertainty (both fiscal and monetary) that had plagued the economy until the two joined forces in January 1981 and people started seeing benign results on both stagflation fronts as soon as recession gave way to recovery.
Posted by: JBH at April 30, 2011 12:33 PM
JBH Because a dynamic process is involved here the initial condition is important.
Hmmmm....When I took differential equations we were always taught that in a dynamic process the initial condition was largely irrelevant. An afterthought. The part of the solution you did for extra credit. What counts is the stationary part (assuming the process is convergent).
In any event, I've never quite understood what people meant when they talked about the "Reagan economy." The part about breaking the back of inflation is really due to Volcker, so he gets the credit...or in some cases the blame. Reagan's contribution in the first half of his Presidency was to create a huge structural deficit that eventually crowded out private sector investment after the economy recovered. And he had two radically different tax policies. His first round of tax changes in 1981 were intellectually confused and bad economics. That was all the Laffer silliness, the insane depreciation allowances that contributed to empty office buildings and Silverado, etc. But Reagan also gave us the quite sensible 1986 tax reform, which probably went a long way towards making the economy more efficient. But what a lot of people don't get is that the 1986 tax reform was a complete reversal of the 1981 bill. The 1981 bill was all about increasing the number of tax shelters and deductions along with lowering the top marginal rate. The 1986 law also lowered the top rate, but it abolished a lot of the tax shelters and deductions. Gee...it's almost as though someone else wrote the 1986 tax reform bill and managed to sneak it past a napping Reagan by promising a lower top rate.
Posted by: 2slugbaits at April 30, 2011 03:39 PM
2slugbaits Two eminently reasonable criteria to judge Reagan by are what the data show and how he performed relative to his promises. In overview terms, economic performance as measured by GDP growth was above-average. This is part of why he got reelected and part of why Bush was able to succeed him. Reagan did not leave the economy weaker for his successor like many other presidents have. It is conventional – and I see no reason to violate that – to start with the year before taking office as the base year and then go 8 years out for a 2-term president to calculate growth rates. That’s a cell of 9 years from which to calculate 8 years of growth. So the comparison of Reagan with today’s president is not about the entire multi-decade period. It is about what Reagan did while in office versus what Bush II or Obama or FDR did during their terms. My point about inheritance is an important one. If a president inherits a trend situation that started well before and went on long after that is one thing; if he inherited a trend situation and then muscled that trend in a new direction that is entirely another. As are the implications of inheriting a mess like Obama, Reagan, FDR, and Lincoln all did. It’s what a president does with the material he has to work with in the context of that era, and how well desirable goals like growing the economy are met, that I focus on. Homeland Security is a moot point in the Reagan era. On the criterion of growth of government employees, the total needs to be split into defense and civilian because two very different things were going on that Reagan made promises about. You already have my analysis of that. That analysis stands.
In saying that “when talking about growth of government, defense must be looked at in historic context” I did not mean to imply that other things should not also be looked at that way. Of course they should be depending on their significance. But there is a strong argument that is so transparently obvious it should not have to be made that wars and their expenditures create such anomalies in the long flow of data series that is imperative to take special cognizance of them. The greater the exogeneity (and magnitude) of the variable in question, the more imperative it is to examine it separately. Next would be oil shocks, and then perhaps natural disasters. None of these nor any of the other things you mention apply with any gravitas to the Reagan era.
My math is correct as it stands using 1980 as the base year; 1172 over 1201 is a 2.4 percent reduction in the relevant category. This choice of base year is the gold standard for looking across an octad of years just as fourth-quarter to fourth-quarter is the most revealing for showing GDP growth over the course of a year, and for the same reasons. Regards …
Posted by: JBH at April 30, 2011 05:59 PM
Mark, transfer payments are gov't spending, of course. Private economic activity is taxed to transfer spending elsewhere, including pay gov't employees to manage the process.
When the private sector is growing at a sufficient rate to support overall gov't spending plus transfers, everything "appears" to be "working" from a Keynesian aggregate spending perspective (irrespective of the source of spending and its rate of growth to other sectors).
However, when real per capita gov't spending plus transfers grows at three times the rate of real per capita private spending for 10-11 years or more, and the prospects are that the trend continues indefinitely, this is not "working"; that is, unless one assumes that total gov't spending (including transfers) of 56-57% of private GDP today can grow to 60%, 70%, 80%, 90%, and 100% over the next 20 years.
This is where Keynesianism (and all "isms", in fact) breaks down in a debt-deflationary, slow-motion depression with Peak Oil, peak oil exports, and population/ecological overshoot on a finite planet with net energy decline.
Growth of anything in this larger planetary context is no longer possible, especially real per capita GDP, but we don't yet know it; therefore, we are not prepared for the consequences of a no-growth world with liquid fossil fuel and net energy peak and eventual depletion.
Posted by: Nemesis at April 30, 2011 06:01 PM
One thing I keep wondering: is it time to change the "real GDP" calculations, or perhaps to start working with nominal values so everyone can correct them depending on what they want to look at?
The problem I see with real GDP is twofold. First, external trade is no longer a peripheral matter for GDP, so what a nation produces and what it consumes can be very different. This has always been the case for smaller nations, but in the second half of the 20th century it has become true of the US as well. Secondly, the GDP deflator has been running well below CPI since the mid to late eighties. So even when "real GDP" increases, it may still mean that there is less consumption. While one may still want to focus on what the US produces, i.e. real GDP, it makes a lot of sense to look at CPI-adjusted nominal GDP as well.
Posted by: endorendil at May 2, 2011 01:44 AM
Yes, there are myriad problems with the national income accounting and price deflators, including what we measure, why, and what we report and do not report.
That economics, rather than a science, is political propaganda based upon one's ideological persuasion, and war is politics by other means (von Clausewitz), war and economics are inextricably linked today via the peak-Oil Age, Anglo-American imperial trade regime (successor to the British Empire).
Further, that economists perceive the ecological system as a sub-set of "the economy", rather than the obvious converse, and that such a belief system assumes that perpetual growth of population and resource consumption is possible on a finite, spherical planet, it is self-evident that our economic thinking is fundamentally flawed.
Were we accurately to account for natural resources as we would other scarce resources, the "actual" costs of perpetual growth would be seen clearly as manifestly prohibitive to further growth per capita.
That we "externalize" so many ecological costs (and devalue the commons as "free", wrongly assuming perpetual abundance) reflects more our desire not to account accurately for the costs (to encourage increasing extraction, consumption, production, profits, and capital accumulation), not that we do not know how.
Posted by: Nemesis at May 2, 2011 07:39 AM
Slug has problems with his timeline. Volker actually caused the 1981-82 recession because he did not supply sufficient liquidity to support the increase in economic activity created by the Reagan policy changes. Certianly Volker stopped inflation by sending the economy into a tailspin by creating a real deflationary contraction. Not until the Mexican peso crisis did Volker break with his monetarist policies and provide sufficient liquidity to allow the economy to grow at greater than 5%. I would encourage you to read the recently released minutes from the FOMC during this time and you can see Volker's various incarnations.
Posted by: Ricardo at May 2, 2011 12:22 PM
I did go back and read the Fed minutes from 1981 and 1982 and found that their primary concern was with the growth in the money supply and inflation. It seemed that interest rates were a secondary concern although there was language indicating that the Fed Funds rate would be above their targeted range. I think policy makers are overly optimistic about their ability to manage the economy. Maybe one of the video game makers could come out with a Fed "driving the economy" game. With the lags and uncertainties it would be like piloting a funhouse car while inebriated.
Posted by: Rich Berger at May 2, 2011 01:49 PM
Ricardo Volker actually caused the 1981-82 recession because he did not supply sufficient liquidity to support the increase in economic activity created by the Reagan policy changes.
The scary thing is that I think you actually believe this stuff. Scarier still, you probably vote. Unbelievable.
Rich Berger found that their primary concern was with the growth in the money supply and inflation. It seemed that interest rates were a secondary concern
Strictly speaking it's true that in the early 80s the Fed looked to monetary aggregates (e.g., M2) rather than interest rates. But in "modern-speak" we normally describe the early 80s in terms of the current regime approach of looking at interest rates. The language of the early 80s spoke in terms of monetary aggregates, but analytically you need to translate into interest rates.
Posted by: 2slugbaits at May 2, 2011 04:37 PM
JBH, when I was in undergrad, it was thought that presidents' policy effects on productivity went about 8 years out. I believe this has greatly shortened since then (mid 90s) due to improved forecasting and financial modeling. Markets now move before real productivity in anticipation.
Posted by: aaron at May 2, 2011 04:51 PM
Yes, Rich, you are exactly correct. Volker saw that the interest rate targets were not working so he ditched them and moved to a monetarist methodology. But that actually failed too and faced with a Mexican peso default the sent them a ton of money breaking his monetarist strangle hold.
I can tell you have read the minutes. You are as big a geek as I am.
Posted by: Ricardo at May 2, 2011 05:00 PM
Rich and Ricardo Let me add some perspective to the Volcker era. Volcker understood where his predecessors had gone wrong. They let the money supply grow too fast. At that time, there was a tight relationship between money as measured by M1 or M2 and the important objective variables of real GDP, unemployment rate, and inflation, as well as other variables. Parenthetically, that relationship went out of whack by the 90s with the advent of so many financial innovations whereby the banking system broadly defined was able to economize on reserve money, get more bang for the buck out of it. Nonetheless, at that time the money-inflation relationship was still a tight one. Understanding this, and determining that the primary goal of the Fed should be reversing inflation, Volcker adopted a new policy of monetary targeting. At the beginning of each calendar year, the Fed took the midpoint value of money supply in the prior year’s fourth quarter and set a target range for growth. This showed up quite clearly as a target cone emanating out of that fourth quarter point and fanning out over the subsequent four quarters. Each subsequent year the new cone was rebased per the fourth quarter actual money supply numbers, which resulted in a ratcheting down of the cones from year to year, and a commensurate drop in longer-trend money growth and finally the inflation rate itself.
If money growth went above the top (upper target growth rate) line of the cone, the funds rate was hiked dramatically to pinch off money growth at its source – monetary base growth. Then when recessionary conditions took hold and money supply dropped below the bottom line (lower growth target) of the cone, policy was eased massively and the funds rate dropped like a stone. These tightenings and easings were accompanied by wild gyrations in the funds rate, up and down in a big rolling whip in 1980, and then again up (even further) and down in 1981 until the eventual easing in August 1982 which was the catalyst that sparked the recovery (that of course was eventually going to happen anyway). Movement of the funds rate during this era was a consequence of the operation of monetary targeting (though of course it was part and parcel of that tightening and easing as well, since you cannot tighten effectively without moving the funds rate, abstracting from changes in reserve requirements which Volcker judged weren’t suitable for the job).
The strategy took nearly three years, resulted in back-to-back recessions, and brilliantly achieved its purpose. Volcker understood that by following a Friedman-like transparent rule he would (a) achieve the goal and (b) be able to stave off or shunt aside political heat, which assuredly was part of the Fed’s concern especially since they were turning a key variable around (inflation) in a watershed-like way. The election of Reagan eased the Fed’s way as Volcker’s monetary tightening policy was precisely one of the four planks of the Reagan plan. Of course there were unintended and undesirable consequences, there always are. But overriding those costs was the manifest benefit that inflation was broken, so that in the years following the economy no longer had that albatross around its neck.
Rich, your reading is correct. Interest rates were of secondary concern. They were the wildly swinging tail which Volcker was completely clear ahead of time would wag. This was a precision operation, a highly refined rule followed virtually to the letter, and it achieved the desired result brilliantly, though the final proof didn’t arrive until after the third rate cycle in 1983-4. The Fed then switched over to fed funds targeting which I opine John Taylor figured out and formalized in the rule which bear his name. Which by the way is remiss for not including an asset price variable, what I call an augmented Taylor rule, which I suspect is the exact direction the monetary policy guideline is going. Over-optimism about managing the economy, yes; over-optimism about knowing how to keep a target variable like inflation down close to the 2 percent range, no. Actually the Fed set up a controlled experiment with course corrections and feedback built in just like the program to put a man on the moon, and every bit as successful. However for the larger economy, economists are only now beginning with Behavioral Economics to take cognizance of how the narrow economy is embedded in the far broader society proper, and in propensities emanating out of our individual human psyches, for a good video game to be possible at this point. Sid Meier’s Civilization was brilliant, but did not even scratch the surface of the human element that makes economics so complex. As far as the early-80s era, this is the proper description of how it all happened: inflation as a target, money supply as the operating lever, the cones which vividly illustrate the rule that was followed, and the fed funds rate swinging as something of an appendage. Of course that was then. Today it is interest rate targeting.
The larger principle this story illustrates is that the path of the economy over time cannot be correctly described other than by piecewise understanding the historical elements intrinsic to each separate time segment. There are a few timeless concepts in economics, but these often are dominated for a time (measured in intervals as long as years) by other variables like Volcker’s unique monetary targeting policy. This leads to why macro models have such a hard time predicting. They statistically calculate beta-hats from time series of data that turn out to be homogeneous blendings of the universal and the particular, and therefore eventually will go awry in their predictive ability. The universe does not work on the average, it works on the margin.
Posted by: JBH at May 3, 2011 10:24 AM
Aaron In this world, the first thing to believe is what you see with your own eyes. The second is what the greats say in their original works. Darwin, Einstein, Keynes saw deeper into their subject matter because of their genius. So you want to be careful about what you learned as an undergraduate, much of it will not have been true. Ditto for the current time both undergrad and grad. I would say Carter's policies, to pick a president for which this is relatively clear, had an effect on productivity that dampened to nearly zero by around 1984. The weighted effect was of course much shorter in time. FDR's and Reagan's policies were far longer lasting. (Volcker's policies affect us to this day.) Regarding improved forecasting, that hasn't happened yet with regard to GDP. My assessment is only 5 percent or so of economic forecasters called the last recession ahead of time. Hence you want to be careful you don't build your belief on an incorrect premise. Though, of course, your supposition could still turn out to be right. As for markets moving before real productivity, that has always been the case since the market system came into being some centuries ago. Although on this point, economics may not have figured it out until "recently". More pointedly, I would say the lastingness of a president's policies are a function of (1st) how attuned they are to the underlying reality of how the world is evolving, something that is often hidden at the time, and (2nd) whether those policies sufficiently satisfied the electorate in the next election so that they voted in a new president (of same party) who perpetuated those policies or something reasonably close. Roosevelt’s policies gave the country hope, though they were for the most part counterproductive. An important part of the underlying reality was the country needed hope badly – at that historic juncture – and FDR had the articulateness and charisma to provide it. Then the war came and the game completely changed.
Posted by: JBH at May 3, 2011 11:01 AM
Regarding forecasting, what I meant was the financial movement mutes economic effects.
Posted by: aaron at May 3, 2011 02:53 PM
You are correct that Volker used a Friedman money supply dynamic but this static approach did not allow for changes in the needs based on economic activity. While the economy was still in the doldrums Volker's methodology seemed fine, but as the economy began to strengthen the fixed money supply began to put strains on the system. But Volker was wedded to his Friedman QTM methodology and would not listen to advice and unnecessarily drove the economy into recession.
On October 23, 1979 Jude Wanniski explained it well as he wrote concerning Volker:
The interest-rate school argues that high interest rates imply greater unemployment and thus lesser upward pressure on prices, i.e., less inflation, and that to get higher interest rates you extinguish money, and vice versa. The quantity school argues that interest rates are a poor guide to daily policy, that the Fed should decide on how much "M" it wants, and print or extinguish money in order to attain that quantity. Elaborate formulae have been worked out for various "M"s to instruct the Fed on what each will mean in terms of an inflation/unemployment mix.
On the surface, what Mr. Volcker seemed to be announcing on October 6 was that the Fed was abandoning the interest-rate school and embracing the quantity school. The gold/exchange rate crisis forced a change. In a classical model, the Fed should have been withdrawing reserves from the system, extinguishing dollars, in order to keep the dollar price of gold from soaring. Instead, it was raising the interest-rate target, yet finding that it was still printing money at higher rates in order to hit the target. It would switch to the "M" guide, the "monetary aggregates."
Unhappily, the various "M" guides have become embarrassingly unreliable to the Monetarist school in recent years; the formulae constantly break down as explanations of what is really happening in the world. The classicial economists argue this is bound to happen when you attempt to fix the supply of money, without any regard for the fluctuating demand for it. The quantity of money should be ignored, say the classicists. In today's world, fixing the purchasing power of the dollar would so increase the demand for dollars that a vastly greater "M" quantity of money still would be consistent with price stability.
At the moment, though, the Monetarist model is superior to the Keynesian model as a guide to monetary policy because it happens to overlap with the classical standard. In other words, at the moment, the monetarists and supply-siders would both be withdrawing reserves, extinguishing money, or at least standing aside and doing nothing — as opposed to pumping reserves into the banking system. Indeed, in the first weeks of the new policy, the Fed has mostly stood aside, and when it has intervened, it has been to drain reserves a bit.
The reason supply-side economists view this as being potentially bullish rests on the belief that inside Paul Volcker there is a classical economist struggling to get out. Having torn the Fed away from Keynesian philosophy, he at least has given himself a range of options. As the markets find him picking his way in a manner that suggests intellectual commitment to the classical school, they will rally. First, the bond markets, then the stock market. The markets have been jilted so often in the last dozen years it will take a while for Volcker to be trusted.
Then on December 8, 1982 Jude wrote:
...we can at least surmise that the Volcker Standard gives heavy weight to some price or prices as a guide to "tightening" or "easing," or he would not make so much of "price stability" as his primary objective. My advice to him a year ago was to heed the September 1981 advice of Jelle Zijlstra, then chairman of the Bank for International Settlements, and stabilize the price of gold at $425. If the Fed had been in a position then to ignore the Ms and do just that, the deflationary recession inflicted upon the global economy would have been avoided.
My most recent advice, which I discussed with Volcker on November 4, is the same as a year ago: Stabilize the gold price at $425. (At the exact time I spoke to him the London gold fix was at $424.75.)
Posted by: Ricardo at May 4, 2011 02:48 PM