The Skeptical Optimist

July 2006 GDP: Will the real growth rate please stand up?

The Bureau of Economic Analysis reported the following on July 28:

Real gross domestic product... increased at an annual rate of 2.5 percent in the second quarter of 2006... In the first quarter, real GDP increased 5.6 percent.

Ouch; sounds like the economy slowed down, doesn’t it?

Don’t believe it just yet.  In my view, real growth didn’t drop, it increased.  I’ll explain below, but for now, here’s how I would have reported the Q2 results:

Based on Q1&2 2006 results, real GDP increased at an annual rate of 4.0%.  That compares with the Q4&1 result of 3.6% reported last month.  The real GDP growth rate increased.

Explanation
To calculate the growth rate, the BEA annualizes the one-quarter change in GDP.  But an alternative way of calculating it is to annualize the two-quarter change.  I’ve been doing that calculation for a year, then posting the result here each month.  Here's the latest result:

[UPDATE: Click here for a brief, explicit summary of the math.]

Why do I calculate it two different ways?  Because the two-quarter method has been a better predictor than the one-quarter method has been.  I’ve back-tested both methods, quarter-by-quarter, from 1970 to now.  Result: The “annual growth rate” from the 2-qtr method is still a better predictor of GDP four quarters into the future.  It has won 58% of the time since 1970, 58% of the time since 1980, and 60% of the time since 1990.  (In an election, 60% would be a “landslide.”)

The 2-qtr method yields a growth rate that changes more smoothly quarter-to-quarter; the 1-qtr method is a lot jerkier.  [Important note: The BEA is not in the forecasting business; they are working hard to report what did happen, not what will happen, and they are doing an excellent job of it.  The 1-qtr method says the economy grew at an annual pace of 2.5% in Q2.  Although it’s also a fact that the 2-qtr method yields 4.0%, the BEA only reports the results of the 1-qtr method.] 

Below is a recap of the two methods, going back several quarters. 

If you’re interested in a more-detailed comparison, click on the thumbnail immediately below.  It’s the simplest way I could think of to show how accurate the two methods are, when used to forecast GDP four quarters into the future.  Email me if you have a question about it.

Click to enlarge:

Bottom line 
Contrary to conventional wisdom, real GDP growth appears (to me) to be accelerating.  If that upsets, or confirms, anyone’s political agenda... well, sorry, but it’s purely an accident.  I do have some private-sector forecasting experience, and I always prefer the method that yields the more reliable prediction, no matter whose pet theory is affected.  In this case, the 2-qtr method has been the more reliable predictor.  Real GDP is growing closer to a 4.0% rate than 2.5%. 

Debt Clock now ticking backwards

I recalibrated the debt clock, based on the latest growth rates for GDP and debt.  See top of right hand column. 

University of Glasgow

Last week I promised to post a picture of Adam Smith’s alma mater, the University of Glasgow in Scotland—if I could get a good shot.

Well, it isn’t perfect, but I decided to post it anyway.  I tried unsuccessfully to get a shot that was unmarred by graffiti, but the damn juvenile delinquents just won’t leave anything alone, anywhere, anytime.  Too bad; I guess vandalism is immortal. 

Anyway, this is the best I could do.  Click to enlarge.

FQ.06.30: Favorite Quote for This Week

We can indeed “cure” our trade deficit problems if we can create enough unemployment and hard times at home.
—Robert Eisner

I wish my taxes were higher

Every time I read an article that mentions the deficit or the debt, I can count on reading—one more time—the sob-story cliché about how our “children and grandchildren” will have to pay “higher taxes” because of those deficits we’re running today. 

Even Fed Chairman Ben Bernanke has joined the chorus.  According to Time/CNN, he said:

Deficits matter because they represent additions to debt that our children and grandchildren will either have to pay through higher taxes or reduced services.

I guess I’m supposed to feel guilty, or slip an intergenerational apology letter-to-my-granddaughter into my safe deposit box, or begin a self-flagellation program or something.  But I don’t, I won’t, and I won’t. 

No, I have long since retired my crying towel.  You see, I actually hope our kids pay higher taxes—much, much higher.  As a matter of fact, I wish I myself were paying higher taxes right now, this year.  I wish the same thing for my wife, and for you, and for all of my friends and neighbors.

Hold on, there.  Before you jump to the hasty conclusion that I’m off my rocker, take the following simple test.  Look at the two hypothetical paychecks, then decide which one you’d choose. 

I predict that Paycheck B, the one with the higher taxes, will win this contest by a comfortable margin of 100% to 0%.  (If you know anyone who would choose Paycheck A, please refer them to a psychiatrist; they’d be wasting their time reading this blog, not to mention messing up my survey.) 

And just so the main point isn’t overlooked…

That, by the way, is what “economic growth” means to the individual.  Higher pay, pretax and after-tax, with both numbers getting higher and higher at the same rate or more every year.  Under those conditions, who gives a hoot if “taxes are higher”?  Not me—and that’s one big reason why I traded in my crying towel for a political BS-detector a long time ago. 

Growth has been the underlying message at this blog ever since I started it more than a year ago.  I sure wish more politicians understood what "growth" means.  Maybe we should elect some different ones—some who do understand it—don’t you think?

================
End notes:
1 (...for nitpickers): Okay, a more-precise title would have been, “I wish my taxes were higher, but not my tax rates.”

2: The top-priority job of the Federal Reserve (Ben Bernanke and gang) is to maintain the value of their product, the Federal Reserve Note—such that “higher pay” always means “higher purchasing power.”  (For more on the money aspect of the economy, see my six-part series that starts here.) 

3: A top-priority job of Congress is to write and pass laws that foster economic growth.  (For more on how badly most of our Capitol Hill politicians are botching that aspect of their job, or how badly most journalists are botching the economic message, see just about any other article in this blog.  Try this one, for example.) 

4 (On the lighter side):  Just for fun every once in a while, go to Google News and type the following phrase into the search box (…yes, including the quote marks):

deficit debt “children and grandchildren” 

…then hit the “Search News” button.  A fraction of a second later, you’ll have a list of good chuckles to choose from—most of them from the Podunk Times and the Backwater Herald, but also some from major publications, too.  If you enjoy a good laugh as much as I do, you’ll add this activity to your weekly to-do list.

How to “improve” the trade deficit

Easy: Have a recession. 

On the other hand, here’s how to “worsen” the trade deficit: Have a prosperous, growing economy. 

Alan Reynolds explains it in detail here, in case you haven’t seen his June 22 article yet.

Inflation, free lunches, and Adam Smith

I'm still trying to get confirmation from a primary source regarding a key assumption in the doomsday-is-near article I mentioned last week.  If I'm reading things correctly, then I have a fundamental disagreement with it. 

In the meantime, I'm paying attention to a few other things of economic interest.  Here are three of them:

Inflation, yes or no?
The two economists at the very top of my tracking list illustrate why I am not in the interest rate forecasting business (...I'll just keep plotting the history, and let someone else forecast the future).  Alan Reynolds is not so sure we are in store for higher inflation; Brian Wesbury isn't so sure we're not. 

Both of these guys are experts, and the fact that they are reaching different prognostications based on their objective analyses of the data has been (for me) an education in itself.  They remain at the top of my daily rounds list.  Here's an excerpt from the recent Reynolds article that reminded me of a chart I posted a few months ago:

The Fed's key interest rate target was raised from a low 4.75 percent rate in June 1999 to a high 6.5 percent rate in May 2000, and kept that high through January 2001 while stock prices and industrial production collapsed. Three years later, long after that recession ended, the Fed decided to push the funds rate down to 1 percent. Was that trip necessary? Wouldn't a smoother, more-timely approach have been less tumultuous?

One of the things on my wish list is self-audits of past performance by the Fed (..fat chance, by the way).  Wouldn't it be refreshing to hear the Fed explain "Here's what we were thinking, here's why it did or didn't work, here's what we learned from it"?  Why should accountability for results apply only to private sector business managers?  Why not public sector economy managers, too?  Yeah, I know: Dream on, Steve. 

Free Lunch
I'm reading a book I will soon be recommending to everyone who's interested in plain-talk discussions of economics – growth economics, to be more specific.  The title of the article will be "Yes, there is a free lunch."  I'll finish reading the book before I write the article, but if you'd like to get a jump on it, the name of the book is Knowledge and the Wealth of Nations, by David Warsh (2006).  The first half is about economic history; the second half is about Paul Romer's shakeup of economic history, beginning in 1990, still under way.  (See "Now Reading" in the right-hand column of this blog.)

I'm looking forward to writing the free-lunch article, because it should raise the hackles of everyone (left, right, and center) fond of the bumpersticker-quality slogan "There's no such thing as a free lunch," and of everyone fond of attacking political opponents by labeling them "The Free Lunch Bunch."  By now, you should know how much I enjoy raising the hackles of anyone who uses economic buzzwords and  talking points as a convenient facade for a political agenda.

By the way, feel free to use a version of that label to describe me – although I would prefer a slight modification: instead of "Free Lunch Bunch" I prefer to be labeled a member of the "Endogenous Growth Bunch."  It's a far more accurate description (…but admittedly not as catchy-sounding for partisan, ad hominem attacks). 

Adam Smith
I plan to finish the book above on the plane back home from Scotland tomorrow.  Today, I'll get a shot or two of the place where Adam Smith went to work in 1751, Glasgow University.  Look for something about it later this week, assuming I can get a decent shot today.   

FQ.06.29: Favorite Quote for This Week

Growth is a form of change.  Change implies innovation; and the Western system of innovation has depended upon wide diffusion of the power to undertake and use innovations, coupled with ample rewards for success and penalties for failure. 
—Nathan Rosenberg

Another “USA is bankrupt” article

[This is the first of two articles.  I’ll write the second installment later this week, whether or not I get an answer to a question I asked the author of the article referenced below.]

[UPDATE:  The follow-up article is at this link.]

A scary article was just published a few days ago, titled Is the United States Bankrupt?  But it wasn’t the title that was scary to me; let’s face it, we see that title all the time, because it’s a sure-fire grabber that sells newspapers, magazines, and books, lickety-split.  As I recall, the last time I saw that title was six or seven weeks ago in the grocery store checkout line... but I just can’t remember if it was gracing the front page of the Globe, the Weekly World News, or the National Enquirer. 

In any case, it wasn’t the title that was scary this time.  No, what was scary was who published it: The Federal Reserve Bank of St. Louis Review (in the July/August 2006 issue). 

Its author, Laurence Kotlikoff, says the present value of our federal government’s future liabilities overwhelms the present value of future tax receipts.  Bad news for our grandkids, in other words.  Doomsday is right around the corner, just like all those books have been trying to tell us for at least the last forty years.

Having spent much of my career in corporate finance, consequently having become intimately familiar with discounted cash flow analysis (the key to which lies in the assumptions that lead to the end result), I went through the article carefully, looking for the key assumptions behind the present value calculations.  What was assumed about the future tax inflows from 401Ks and IRAs?  What was assumed about future economic growth, productivity growth, population growth?  What was assumed about the fixed/variable/semivariable costs of government programs?  Do they all really vary directly with GDP, or was that just a convenient way to simplify the financial model?  Was it assumed that the debt would eventually have to be paid off?  If so, when and why was it assumed that debt rollover would become impossible? 

[A while back, I took a shot at predicting some possible outcomes two generations down the road; it could no doubt be improved, but it did reveal some not-so-gloomy potential outcomes.]

Anyway, the assumptions have a significant impact on the outcome, and I’ve already emphasized how important the answer to that last question is.  All by itself, it could spell the difference between doomsday and dreamscape.  In one case, our kids would have to come up with sufficient taxes to pay not just the interest on their T-bonds, but also the principal to eliminate them; in the other case, all they’d have to come up with is enough taxes to pay themselves the interest—and keep rolling their T-bonds over and over, content with their financial assets (some of it money, some of it T-bonds) and a low-inflation environment, just like we’re doing today. 

Unfortunately, I couldn’t find the answers in the article.  So I asked the author.  Later this week, I’ll publish his response to my email, if I get one—along with a few of my comments, of course.  [Click on the thumbnail below to see the questions I asked.]

Until then, here’s something to think about, from the late father of management, Peter Drucker [emphasis mine]:

First-year accounting students are taught that the balance sheet portrays the liquidation value of the enterprise and provides creditors with worst-case information.  But enterprises are not normally run to be liquidated.  They have to be managed as going concerns, that is, for wealth creation. 

Guess what: Drucker's last two sentences also apply to nations, too.  But some people apparently think my country will need to stop everything and liquidate its assets against its liabilities—sometime in the next generation or two.  I disagree strongly, and I have some very serious questions for anyone who actually believes it. 

In any case, Drucker was being polite.  Here’s how I’d say it:

“Accountants count what’s easy to count—not what counts.” 

FQ.06.28: Favorite Quote for This Week

Unlike most forms of geometric expansion, there is no reason to believe that the expansion of knowledge has any inherent limits. 
—Nathan Rosenberg