The fragility of GDP glee

It goes to show how fragile financial markets are when they greet news of US quarterly GDP growth of 2.0 per cent (annualised) with glee. Stocks in the US closed well off their lows after the September quarter GDP outcome exceed the uninspired expectations of market economists. In the June quarter, annualised GDP growth was a paltry 1.3 per cent, meaning the last six months in the US economy have been anemic.

To put the current growth momentum in some context, long-run annual trend GDP growth in the US is widely estimated to be close to 3 per cent. In fact in the last 30 years, GDP growth in the US has averaged 2.9 per cent, so near 3 per cent will do.

With the September quarter US GDP data, it has now been more than six years since annual GDP growth has been at 3 per cent or more. In other words, there has not been one quarter since June 2006 where annual (year on year) GDP growth has been above 3.0 per cent. While obviously the economic fall out from the 1930s Great Depression was more severe than the recent recession, at least in the four years starting in 1934 the US economy returned to strong growth after a three and a half year slump. It appears that the current six years of sub-trend GDP growth is the longest on record (data going back to the 1920s).

This highlights just how bad conditions are in the world's largest economy. It reinforces why the Fed has had zero interest rates in place for four years, why it has implemented trillions of dollars of quantitative easing and why the fiscal position in Washington is so dreadful, with net government debt currently at 84 per cent, rising to 89 per cent in 2016.

While there are some signs of stronger growth showing up in housing activity and the recent strength in the stock market points to better economic times ahead, the tepid expansion in consumer demand, business investment and most importantly, government demand, suggest that GDP growth is likely to remain nearer 2 to 2.5 per cent than lift to 3 to 3.5 per cent during 2013.

This is where the presidential election will be critical for the economy. While something needs to be done to move the budget towards balance, lifting the growth momentum of the economy is also vitally important. If fiscal policy is tightened too much – the fiscal cliff – the US economy will remain unimpressive.

From an economic growth perspective, it appears that fiscal policy has already been tightened too much and has been a vital factor behind the sub-par recovery.

The bottom line make-up of GDP over in the three years of recovery shows that private sector demand is expanding at a reasonable pace, no doubt aided by the record low level of interest rates. The problem for bottom line GDP growth has been, quite extraordinarily, the fact that government demand has cut GDP for eight of the last 10 quarters. Attempts to cut the budget deficit at the federal level and balance the budget at the state level is hurting economic growth and constraining job creation.

Ed Dolan from EconoMonitor points out that the September quarter GDP outcome was a rare example in recent times where government demand contributed to GDP growth. Indeed, government demand contributed a hefty 0.7 percentage points of the 2.0 per cent GDP growth rate, but at Dolan notes, that boost to GDP "turns out to be almost entirely due to a big jump in federal national defence consumption expenditures … the contribution to GDP growth from state and local government was a pathetic 0.01 per cent of GDP.”

It is unlikely that the US economic recovery can be sustained by defence consumption and if anything, as the Afghanistan involvement is wound back, it is reasonable to expect weaker defence spending in the years ahead.

Had the administration sustained its fiscal stance to the point where government demand made a zero contribution to GDP over the last three years rather than subtracting from GDP, the US economy would be around 4 per cent larger than it is now and would have recorded average GDP growth of around 3 per cent since the middle of 2010 rather than the sub-trend 2.1 per cent.

In other words, fiscal policy matters, even in the US.

This Friday, the US will publish its monthly jobs indicators and such are the low expectations for the US economy that the market would not doubt rejoice at an employment gain of 150,000 or more and would be delighted if the unemployment rate stayed at 7.8 per cent (the consensus forecasts are for a rise of 124,000 in non-farm payrolls and for the unemployment rate to tick up to 7.9 per cent).

It was only a few years ago that the US was creating close to 200,000 jobs a month and the unemployment rate was anchored below 5 per cent. A return to these dynamics seems a long way away, especially with fiscal policy acting as a handbrake on growth.