Episode 1: Unveiling the Mirage of Economic Robustness
As we venture into the final quarter of 2023, the persistent murmurs of a robust American economy echo through the crisp air of midwinter. Yet, beneath the veneer of prosperity, the foundation is increasingly fragile, and the illusion of economic vitality may soon dissipate.
Fundamentals
The month of October can be seen as a continuation of the 'September effect' we discussed in the previous report (Outlook and Report October 2023), potentially culminating in what may be an alarming zenith of policy missteps. The enthusiasm surrounding the release of America’s third-quarter GDP data was palpable, largely due to its interpretation as a sign of enduring economic strength within the US. This view, however, oversimplifies and possibly misleads, glossing over the nuanced reality of the situation.
The GDP Mirage
What is GDP?
Investopedia tells us that:-
“Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country’s economic health.”
Though GDP is typically calculated on an annual basis, it is sometimes calculated on a quarterly basis as well. In the U.S., for example, the government releases an annualized GDP estimate for each fiscal quarter and also for the calendar year. The individual data sets included in this report are given in real terms, so the data is adjusted for price changes and is, therefore, net of inflation.” [1]
Key points that are often misunderstood are.
1. Quarterly GDP releases are, like many financial data, only estimates and are subject to later revision.[2]
2 There is no single formula for calculating GDP.[3]
3 An even greater distinction is between Nominal GDP and Real GDP. Nominal GDP measures the total value at current market prices of all goods and services produced in a given economy within a given period. Based on current pricing, nominal GDP disregards inflation or deflation, distorting the true value of economic growth, whereas Real GDP, being adjusted for inflation or deflation, provides a more accurate measure of economic growth. Real GDP is calculated by dividing nominal GDP by an adjustment known as a GDP deflator. [4]
Table 1 on the following page highlights the main differences in the most commonly used measures of economic activity, GDP, GNP, and GNI.
Table 1 GDP vs GNP vs GNI
Apologies for using so many charts in the following analysis but if you wish to avoid ‘death by a surfeit of charts’, the key points are:
Policymakers remain wedded to their own favourite measures of economic performance but in doing so, they have made a number of major mistakes:
They continue to fail to distinguish between stock and flow (their use of inflation indices rather than rates is akin to a football manager whose team has lost the last 4 games but remains narrowly top of the league, claiming his team is in fine form and no changes are needed).
Conversely, when it suits them, policymakers have relied on misleading short term data points (such as quarterly GDP), which often is a ‘base effect’ reflection to prior data points.
Policymakers remain wedded to their own favourite measures of economic performance – this can sometimes blind them to broader measures – for instance their reliance on PCE masks the impact of housing (shelter) inflation changes whereas their preference for GDP as a measure of economic activity disguises inflection in GDP growth trends (i.e. hides the extent to which economic activity growth changes direction or velocity).
Policymakers have been inconsistent in their application of these measures – in the following charts, the extent to which the GDP deflator is also contributing to overstated GDP is apparent.
Table 2 US GDP growth rate 2017-2022
This table shows the US GDP growth rate from 2017 to 2022, setting the stage for our discussion on the recent economic performance.
Table 3 – Difference between Nominal GDP (blue line) and Real GDP (red) over 75 years
It illustrates the difference between Nominal GDP (blue line) and Real GDP (red) over the past 75 years, providing a long-term perspective on economic growth and inflation.
Table 4 – Difference between Nominal GDP (blue line) and Real GDP (red) since Y2K
This table offers a closer look at the Difference between Nominal GDP (blue line) and Real GDP (red) since the year 2000, highlighting how the two have diverged in the new millennium.
Table 5 – Last 5 years difference between Nominal GDP (green line) and Real GDP (blue)
This last table zeroes in on the Last 5 years difference between Nominal GDP (green line) and Real GDP (blue), showing the recent economic trends and the impact of inflation adjustments.
Conclusion: The Cost of Misread Data and Misguided Policies
In short, these data errors have combined to cause a number of serious policy mistakes, as evidenced by the trends depicted in Tables 2 to 5. Policymakers initially understated but subsequently overstated the rate of inflation (except when applying the ‘deflator’ to GDP) because of reliance on longer-term cumulative measures of inflation, a methodology that tends to minimize inflections. This is akin to using lump hammers to fine-tune a concert piano. Policymakers continue to overstate economic activity levels and economic activity growth due to bad methodology, an inconsistent inflation deflator, and the use of selective data points.
The effect has been that policy has been too tight for too long and the adverse consequences of this seem unavoidable in 2024. Such systemic missteps in policy formulation have led to an overly restrictive environment. As we face the threshold of 2024, it appears that the repercussions of these sustained policy errors may be inevitable, casting long shadows over the economic landscape. A recalibration is not just warranted; it is essential to mitigate the looming adverse consequences.
In Episode 1, we navigated the GDP Mirage. Now, brace for Episode 2: "Economic Currents and Policy Consequences," where we delve into the real impact of inflation adjustments and interest rates on our economy. A closer look awaits at the mechanisms that shape our financial reality and forecast the challenges of 2024.
Stay tuned for a pivotal exploration into the forces steering our economic destiny !!
[1] https://www.investopedia.com/terms/g/gdp.asp
[2] According to the Bureau of Economic Analysis (BEA), the advance estimate of GDP is based (to the extent of around 45% of input variables) largely on survey responses rather than ‘harder data’ that are subject to later revision for a variety of reasons, one of the most common being late respondents, whose answers are then incorporated into revised, updated estimates. Another 14% of GDP estimate inputs is based on historical trends. In other words, almost 60% of GDP estimate components are incomplete soft data or extrapolations of historic data. https://www.bea.gov/data/gdp/gross-domestic-product
[3] There are 3 primary methods for calculating GDP: the income approach, the expenditure method, and the production approach (https://www.investopedia.com/terms/g/gdp.asp)
[4] https://corporatefinanceinstitute.com/resources/economics/nominal-real-gdp