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Worse Than It Sounds: Largest GDP contraction since 1982 actually understates economy’s weakness

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GDP Picture | January 30, 2009

Even Worse Than It Sounds: Largest GDP contraction since 1982 actually understates economy’s weaknesses

by Josh Bivens

The Commerce Department reported today that U.S. gross domestic product (GDP, the most comprehensive measure of economic activity) contracted at an annualized rate of 3.8% in the final quarter of 2008, following a 0.5% decline in the third quarter. This is the largest quarterly contraction since 1982, and GDP has now fallen in three of the last five quarters.  

Even worse, though, is that the headline number on GDP actually understates the current weakness of the U.S. economy. Changes to private inventories added 1.3% to the economy in the fourth quarter. However, inventory changes are quite volatile quarter to quarter, and accumulating inventories during sharp economic downturns may just reflect the inability of U.S. producers to find customers.

Final sales (a measure that strips out the influence of changing inventories) declined by 5.1% last quarter, after dropping by 1.3% in the third quarter.

Final sales to domestic purchasers, a measure of domestic demand growth that strips out exports and adds in imports, declined by 4.9% following a 2.3% decline in the third quarter.

The single largest contributor to last quarter’s contraction was falling exports—down 19.7% in the quarter. This is especially worrisome given that exports, on average, have boosted GDP by a full 1 percentage point over the past two years. In essence, the bottom has fallen out of a sector that was a source of recent strength. 

Consumption spending continues to decline rapidly, although actually at a slightly slower rate than previously, falling 3.5% in the fourth quarter compared to 3.8% in the third. This decline made consumption spending the second largest contributor to the fourth quarter’s contraction.

Falling consumption spending is related to one of the most striking changes in the past quarter—a rapid increase in the personal savings rate, which climbed to 2.9% from 1.2% in the third quarter (and from 0.4% from the same quarter a year ago). As households pull back their consumption and save more, this will require another economic sector to fill in this hole. Today’s report offers no evidence that this will happen absent a large public policy change, like passage of the stimulus package currently being debated by Congress.

Declines in equipment and software investment is the last of the major influences driving down GDP in the fourth quarter, falling 27.8% after a 7.5% fall in the third quarter.

Residential investment continues to crater, falling 23.6% in the fourth quarter after averaging quarterly declines of 17.3% since it began shrinking in 2006. At this point, however, the residential housing sector is such a small share of overall GDP that its large declines do not drag the overall economy down to the same degree they once did. Measured as a share of GDP, residential investment has fallen from a high of 6.3% in 2006 to 3.1% in the fourth quarter of 2008.

A bad harbinger of things to come was a 1.8% decline in non-residential structures. This sector tends to follow residential investment downturns with a lag. Before the fourth quarter, however, growth in this quarter held up well (it grew 9.7% in the third quarter). If this number’s contraction becomes a trend, it will constitute yet another component of GDP becoming yet another drag rather than a spur to growth.

Inflation continued to be tame in the fourth quarter. The market-based price index for consumption spending excluding food and energy (a so-called “core” measure of inflation) rose only 1.8% over the year. Overall prices (including food and energy) actually fell in the fourth quarter led by sharp drops in energy prices.

Federal government purchases grew by 5.8% in the quarter after rising by 13.8% in the third quarter. State and local government purchases contracted by 0.5% in the fourth quarter, and persistent shortfalls in state budgets will probably make this even worse in the future unless aid to states is included in any stimulus package that is enacted (it is in the version recently passed by the house).

The headline GDP number beat the consensus forecast of a 5.5% decline. However, the underlying weakness of the U.S. economy evidenced in this report provides no reason for cheer.


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