The estimate is higher than my forecast by a fair amount actually, but in the grand scheme of forecasting, forecast errors, and the direction of change, I am reasonably happy. I had forecasted the increase in growth with trepidation because the economic fundamentals remain weak.

The fourth quarter data implies that the economy grew 1.7 percent in 2011, compared with 3.0 percent in 2010.

What were the drivers of the increase in fourth quarter growth? Consumption and Investment expenditures both rose, $50b and $80b respectively, trade was little changed, and government expenditures fell about $30b.

Investment expenditures are driven by a four main components, business structures, equipment and software, residential, and inventory investment. All of these components are volatile, but one of them, inventory expenditures, is super volatile. Sure enough, about $55b of the $80b investment expenditure increase was due to inventory investment. I hope that the shelf-stocking was not overdone for if it was, there would be a slowdown in inventory investment this quarter.

Another interesting movement within Investment was residential, up at an annualized growth rate of about 11 percent. While residential investment in states like Nevada, California, Florida remain at historic lows, it is booming in states like North Dakota, Oklahoma, and Texas. We can thank the middle part of the country for this source of growth.

The $30b pullback in government expenditure breaks down to a $20b decline in Federal and a $10b decline in State/local expenditures. The Federal change was due to a defense spending contraction, as non-defense expenditures rose slightly.

Inflation, as measured by the GDP deflator, fell dramatically from 2.6 percent in third quarter to 0.4 percent in fourth quarter. Subdued inflation in a time of relatively high unemployment is a good thing, as it helps those unemployment or partially-unemployed households manage expenses.

The BEA measure of the personal savings rate fell from 3.9 percent in third quarter to 3.7 percent in fourth quarter. This worries me, as household debt levels are still high. I have argued this before and will do it again: consumption in an era of high household debt does not help the economy. What is needed is savings and investment. Future growth depends on it.

The jump in consumption growth from second quarter’s rate, which was 0.7 percent, implied that the savings rate fell. The BEA measure of the savings rate fell a full percent, from 5.1 percent to 4.1 percent. The economic growth estimate of 2.5 percent, with the approximate job growth estimate of about one percent, implies that output per worker growth was positive again in third quarter. It was negative in the second quarter.

What does all this mean?

Turning to the output per worker first, this measure of gross labor productivity, which contracted in quarters 1 and 2, increased in third quarter. Increasing labor productivity is a key driver of per-capita income growth, and it is a feature of increased innovation in production. It appears likely now that the negative labor productivity of quarters 1 and 2 were just temporary, and that productivity is returning to trend. If true, economic growth will benefit.

I am pleased to see the investment in structures and equipment/software. Investment raises the productive capacity of the future economy, thereby providing greater choice for either investing or consuming in the future.

The rise in consumption and fall in savings worries me. While it benefits current growth, it is likely to prolong the balance sheet rebuilding that I feel is necessary to ensure healthy growth in the future.

The question of which way the savings rate will go is also one of the big macroeconomic forecasting challenges of the day. Some Economists argue that because of the Great Recession, households will see that they need to rebuild their balance sheet, in this case mostly by reducing liabilities. Some Economists argue that the baby boomer generation, still very influential on the economy, is culturally incapable of saving. Both arguments have merits, and it is a tough call.

From a forecasting perspective, it is hard for the econometrician to see the factors that might drive the decision wether or not to save. The relevant factors are likely to include: household structure (married or not, kids or not), age, employment history, wealth level, debt level, type of debt, education level, and skill level.

Our forecast for third quarter GDP, 0.6 percent, was really low, and much of the error stems from our consumption/savings forecast. Our forecast presumed a similar savings rate to second quarter, and thus a very slow consumption growth rate. Given that it is difficult for me as a forecaster to see the above-mentioned savings-decision factors, I am not sure if my forecast was based on what was more likely, or if it was simply what I hoped.

Most indicators of household debt indicate to me that debt levels are still too high. As a result I hold to my belief that long-run United States economic growth will rise if households save now, i.e. pay off their liabilities. However, I am not sure if or when this will happen.

The saga of the Great Recession continues. Over six million people have been unemployed for more than 27 weeks, and job growth may be slow enough in the next few months that the unemployment rate rises again. Major revisions to GDP, released in late July, show that from 2007 to early 2011 the United States economy was weaker than previously understood. The consensus forecasts for the United States and World economies have been revised down.

However, these aspects, negative as they are, are not currently as important to near-term growth as the impact from the probable reduction in the number of countries in the European Union. Bill Watkins discusses the European crisis earlier in this blogspace.

The economy grew much more slowly during the first half of 2011 than during 2010. One big reason is that consumption growth slowed. I think that consumption growth will remain relatively weak for at least the remainder of this year. This is in part because I think that wealth accumulation and income growth will be weak. At this point, low interest rates do not help much. But, there is more to the consumption story. Household debt levels, despite subsiding from their bubble highs, are still too high. If households continue to reduce their debt, consumption growth will remain muted. While near-term growth suffers a bit when households save more, the long-run health of the economy is improved. Economic recovery from major asset price deflation has never been quick or pleasant, and this time is no different. Indeed, real estate prices remain low and equities are down from the first half of this year.

We forecast growth in inventory investment and in equipment/software investment. However, we are bearish on commercial structures and housing.

We forecast that government expenditures growth, which includes state and local, will remain slightly negative for the remainder of this year. It appears that governments at all levels have bumped into their budget constraints.

We forecast that trade will produce a slight drag on growth, with the trade balance deteriorating slightly. This is due to slowing world growth.

What about the Fed? They have conducted the first of their two-day policy meeting today. I expect that the Fed will announce a policy change tomorrow which could include an attempt to push longer-dated Treasury rates down and, less likely, a reduction in the interest rate on excess reserves. The market has appears to have priced in a reduction in longer rates. Despite this boost, equities are not doing very well.

A reduction in the interest rate on excess reserves would provide greater incentive for banks to loan, and this is the better idea of the two. However, this policy may not provide much benefit. The problem is that many small businesses and households are reducing debt, not increasing it.

As a result of the above mentioned forecast of the major components of GDP, our GDP forecast is bearish, significantly under the Wall Street Journal consensus of 55 forecasters for the second half of 2011 and the first half of 2012.

With the recent and forecasted weak United States and World economic growth and with a slowdown in commodity price growth, our forecast indicates that inflation will not be a problem. The secular trend in rising inflation since March will likely be broken soon, probably as soon as the September data is released in mid-October.

Inflation will be the least of the Fed’s worries during the second half of 2011.

Productivity used to have a cyclical component. It fell early in a recession, and it rose early in the recovery. The early-recession fall resulted from falling sales and no employment change. The idea is that businesses see the sales decline, but don’t know if it is temporary. So, they don’t layoff for a while and productivity falls.

The early-recovery productivity growth is similar. A business sees increasing sales, but is unsure if it is permanent. So, they avoid adding to payroll until they are confident that the higher sales will be maintained.

All that went away with the past two recessions. In these recessions, productivity growth was relentless, increasing quarter after quarter. Consequently, our models cannot effectively use the new productivity information. (Don’t ask why. It is a statistical answer.)

Some, very few actually, are discounting the new jobs data, because it included the Verizon strike. We note that it also included the return of Minnesota’s government workers, significantly reducing the Verizon impact.

There are other reasons to be concerned about the new jobs data. A big one is that the previous two months were revised down. June was revised down 26,000 jobs (56 percent) to only 20,000, while July was revised down a whopping 32,000 jobs (27 percent) to 85,000. These revisions imply that the initial estimate is currently biased high, implying in turn that we actually lost jobs in August.

The combination of falling productivity and job losses is a powerful indicator that the second dip may be here or coming very soon.

Downward revisions to United States gross domestic product (GDP) have driven most of the revisions. For about two years, we had trouble with the original GDP estimates. Our jobs forecasts were pretty accurate, but we forecasted productivity growth and consumer spending growth below the initial estimates. This caused us enough grief that we’ve been reviewing our models. Well, the revised numbers are entirely consistent with our original models.

Downward revisions to productivity growth and consumer spending are what drove the downward GDP revisions.

Enough bragging. What is happening to the economy? We’re seeing a weak recovery.
Increasing numbers of forecasters, spooked by weak numbers and downward revisions, are now forecasting a double-dip in the near future. We don’t think that is the most likely case.

We’ve said all along that this would be a weak and inconsistent recession, and that appears to be what we are seeing. Some encouraging data might come in this week. The next week could see weak data. This is exactly what we expect to see in a recovery where financial institutions are wounded, real estate is weak, and consumers over extended.

So, we don’t expect a double-dip recession. We expect continued slow growth, accompanied by weak real estate markets, weak consumer spending, slow job growth, and persistent high unemployment.

That would be the good news and the bad news.

Another recession is in our future though, and not just because the business cycle has not been repealed. However, the timing of the next recession is really difficult to forecast, because in part, the timing will probably be politically driven.

I have become convinced that the culmination of Europe’s problems will be a partial breakup of the Eurozone. Perhaps it will be complete breakup. It really doesn’t matter.

Any breakup will almost surely be accompanied by financial and political crises. These crises will initiate a new recession, one that will be impacting an already weakened economy. It’s likely to be very painful.

It might seem like some quarters are up and some are down, in effect a wash. Despite that appearance, on net, the new measure implies that growth was slower during the 2007 through 2011 quarter 1 period.

The purple bars show the old measurement, and the blue line shows the new measure.

2011 quarter 2 economic growth was 1.3 percent. Some details include:

• Consumption growth was essentially zero
• The BEA savings measure rate rose a bit (from 4.9 to 5.1 percent)
• Investment was reasonably strong with a 0.9% contribution
• Government spending and investment was a drag on the economy (by 0.23 percent)
• Trade boosted GDP by a 0.6% contribution
• Motor vehicle output dropped
• The Core PCE price measure of inflation rose from 1.6 percent in quarter 1 to 2.1 percent in quarter 2

I do not mind seeing the consumption growth rate decline, and the savings rate rise. I have been arguing for a while that high debt levels and depressed housing prices should imply that households rebuild their assets to liabilities.

I note that the late 2009/early 2010 drop in the savings rate was during a period of time when the government was providing incentives for consumption: Cash-for-Clunkers and Home-buyer incentive programs. Balance sheet rebuilding is a hard and lengthy process. Perhaps policymakers should consider incentives to save rather than consume at this point.

It will be tough for the government to stimulate the economy in the near term. Witness what happened in quarter 2:

• Federal defense spending grew 7.3 percent
• Federal non-defense spending was shrank by 7.3 percent
• State and local spending also shrank by 3.4 percent

Despite vigorous defense spending, government sector growth was negative. State and local spending is about two-thirds of the total government spending level, and these governments will not be able to increase spending anytime soon. They have experienced a large drop in revenues, and they are constitutionally required to run balanced-budgets.

I note that export growth exceeded import growth by 470 basis points in quarter 2. This could easily swing the other way next quarter, i.e. the trade contribution could easily evaporate in 2011 quarter 3 or even become negative. Without trade in quarter 2, growth would have been less than 1 percent.

Our June forecast of quarter 2 economic growth was 2.0 percent, against the Wall Street Journal consensus of 2.3 percent. The new consensus will be out in about 2 weeks. I expect a large downward revision compared to the June consensus growth rate, 3.3 percent, for quarters 3 and 4. Despite that, our updated forecast will likely still be lower than this new, lower consensus.

Our relatively pessimistic forecast would be supported if savings increased yet again. In the near term, it would restrain growth, but in the long term it would bring debt down to healthier levels, paving the way for greater future economic growth.

The overall conclusions from this report are that:

• Economic growth was weaker than we thought during 2007 to 2010
• Inflation was higher than we thought during 2007 to 2010
• Consumption spending was weaker than we thought during 2007 to 2010
• Output per Worker was weaker than we thought during 2007 to 2010

I feel like the CERF forecasting, analysis, and blogging for the last year and a half or so has been vindicated. Ever since late 2008 our forecasts have been under consensus and we have written repeatedly about fundamental weaknesses in the United States economy. Our clients have pretty much stuck by our side despite our dour message.

I plan to publish a more granular analysis of today’s report early next week. For today, I provide quotes that I have written in the last couple of years or so, although the blogging and other essays by other CERFers have also contributed meaningfully to the message.

“I had hypothesized in 2009 that households would rebuild their balance sheets to pare down debt. However, this has not happened.” May 11, 2011

“The United States economy continues to surprise me. Fourth quarter real consumption growth of over four percent, the fastest growth rate in five years, seems anomalous in the face of many fundamentals. I remind myself and the reader that one quarter’s worth of data does not make a trend.” March 21, 2011

I blogged on February 3, 2011 that: “Consumption is too high and Investment is too low”, a title which is self explanatory.

“I note that virtually any measure of household debt is still extraordinarily high and these need to fall. For the long-term health of the American household sector and the economy, I am concerned about the fall in the savings rate. I hope that the increased consumption and falling savings rate do not forebode an extended period of weakness in the United States economy.” January 28, 2011

I blogged on December 15, 2010 that: “Spending is Still too High”, again a title that is self explanatory.

“I continue to be surprised by the strength of government expenditures. The preliminary estimates show federal spending growing with such strength to offset state and local weakness. I continue to expect that state and local expenditure weakness will be a greater drag on growth during the next few quarters than the previous couple of quarters.” October 28, 2010

“It confirms my suspicions that the economy does not yet have its own legs. Without government stimulus, this economy might not grow at all. This does not mean that we should re-instate the stimulus programs, as they have their own problems. Continued debt-funded consumption is simply unsustainable, and it does nothing for long-term growth.” August 27, 2010

“Total household consuming, which is imports plus consumption grew very rapidly (6 percent) in quarter 2. It is hard to imagine that households can continue to spend this rapidly given their debt levels and the unemployment rate.” July 30, 2010

“We here at CERF had been worried that, during the fourth quarter of 2009 and the first quarter of 2010, much of the observed growth transitory. We believed at that time that the household sector should have been rebuilding their balance sheets, reducing debt, and restraining consumption. It appeared as if government programs were inducing households away from balance sheet rebuilding with incentives to spend, to the long-term detriment to the economy. These programs included Cash-for-Clunkers, Home-buyer incentives, and attempts to save flagging mortgage payments.” July 14, 2010

“Our forecast is weaker than consensus because we believe that fundamental weaknesses still remain. The fundamental domestic weaknesses include: residential real estate, commercial real estate, banking, and household balance sheets.” June 4, 2010

“We released our new United States and California forecasts today. As we note in our publication, we are pessimistic relative to consensus, particularly for 2010 quarters 2, 3, and 4. It appears that we see the negatives continuing longer than our forecasting colleagues at UCLA and across the nation. These negatives include financial, real estate, and construction sectors.” March 24, 2010

Today’s report also shows that State and Local government expenditures have been rather weak for three quarters in a row. Back in late 2009 and 2010 I worried that ongoing state government budgetary problems would feed into the overall economy and prolong the weakness. Here, I was referring to jobs:

“We suspect the job-cuts that the State will have to perform to manage its current and future deficits will get substantially worse than they have been to date and that this will imply worse public sector job losses during the next year. Even if the private sector improves during the next few months, the worsening public sector job market could offset many of those gains. December 28, 2009

These quotes often refer to weak fundamentals. What are they? Here is a not too long version written March 21, 2011:

“The United States economic fundamentals include: a high revolving-credit debt level as a share of income, a high mortgage-debt level as a share of income, a high residential default rate and foreclosure rate, a high banking charge-off rate, a high long-term unemployment rate, a high home ownership rate, a low construction activity rate, a low small-business profit rate, a significant structural imbalance in the labor market (too many construction workers), and a low job creation rate. Some of these combine to the reality of a weak labor market, and some of these combine to the realization of a weak real estate market.” March 21, 2011

The preliminary estimate of U.S. real GDP growth during January through March is 1.8 percent. Our forecast was 2.8 percent. The recent Bloomberg consensus, which incorporated more recent high-frequency data, was 2.0 percent.

One thing that did not happen during the first quarter of this year was four percent consumption growth, which is what had occurred in the final quarter of 2010. Four percent consumption growth does not align with fundamental measures of the average household’s financial well-being. Mortgage and credit card debt are still too high. The preliminary estimate is 2.7 percent. This result is more in line with what is appropriate given the consumer’s financial situation.

Government expenditures fell 5.2 percent, down from a fall of 1.7 percent the previous quarter. This was driven by a dramatic fall in Federal expenditures, and a continuing deterioration in state & local spending. The Federal expenditure fall surprises us and was driven by a drop in defense spending. The state & local spending estimate is close to our forecast. We expect that the Federal expenditure weakness will be transitory and rebound in quarter 2.

Investment expenditures are roughly similar to our forecast with real estate investment relatively weak and inventory investment relatively strong.

Trade was close to our forecast with the unusual fall in imports of last quarter reversing itself and growth in exports was similar to growth in imports.

This new data release confirms what I have been thinking about the economy, that four percent consumption growth is unsustainable, that real estate investment expenditures will be weak, that state & local government expenditures will be weak, and that the trade impacts on GDP should be neutral. Based on this, a reasonable, (but not model-driven), forecast for next quarter is 2 percent.

If you are looking for a summary statistic on the United States economy, I recommend you consider bank charge-offs. These are the loans that banks have written off their books, because the probability of collecting them is so low. It doesn’t mean that the borrowers are off the hook, or that the bank will stop trying to collect the loan. It only means that a bank can’t consider a charged-off loan an asset.

Most people use GDP growth as a summary statistic for the economy, which leads to the current situation where policy makers and talking heads have declared a recovery while millions who have been unemployed for months or years continue to be unemployed. Indeed there were two recessions, based on GDP, in the 1960s where all of the job losses occurred after the recession was declared officially over.

OK, so why not use jobs as an indicator of prosperity? Actually, I’m sympathetic to that. It is certainly a better indicator of well being than is GDP. However, I think that charge-offs, particularly now, give us a little more information. Jobs tell us what businesses are doing. Charge-off data tell, at least in some sense, what business can do. That’s because banks don’t lend much when charge-offs are high, and without loans, businesses can’t grow.
So, what are bank charge-off data telling us?

They are telling us that a robust recovery is a ways off. Below is a history of real, inflation adjusted, bank charge-offs:

Prior to 2007, quarterly bank charge-offs had never exceeded $15 billion a quarter in today’s dollars. Then, they skyrocketed to almost $60 billion a quarter. Since then, bank charge-offs have fallen, but they remain well above $40 billion a quarter. You have to conclude that our banking system is still crippled.
This impacts small business much more than it impacts big business. Big businesses have direct access to capital markets and don’t need financial intermediation.

There are more reasons to be bearish on American small business growth. People who own small business own real estate, much more than the typical American. About 98 percent of all small business owners own their own home, but only about 66.5 percent of all American households own their own home. This means that small business was disproportionally hurt by the collapse in real estate values. Their balance sheet was suddenly over-leveraged, impairing their willingness and ability to borrow.

The inability of small business to use real estate equity to finance growth has impacts that are exacerbated by a banking sector that has forgotten how to lend to small business without the use of real estate as a secondary repayment source.

It used to be that small business had access to lines of credit secured by inventories or receivables. These were expensive loans, but they did not require real estate equity for the firm to grow, and in cyclical businesses they were self-liquidating, something that bankers just loved.

As real estate values climbed, banks lowered costs by moving away from these loans. Consequently, while some inventory and receivable financing remains, it is less important than it used to be. Perhaps worse, many bankers don’t know how to make and supervise inventory and receivable lines of credit. It was always a specialty. Today, asset-based lending, as this type of lending is referred to, is an almost forgotten specialty.

Still, those banks that are well enough capitalized to be aggressively seeking lending opportunities would be well advised to consider setting up asset-based lending units. It may be the only way for them to significantly increase loan volume in the near term. It would also be a service to small business and the economic well being of all of us.
The other alternative for small business expansion would be for real estate values to suddenly increase. That is not going to happen in this or next year. I go into the reasons more in the Real Estate Essay, but I have another summary statistic for you, Home Ownership Rates.

Home ownership in the United States is generally about 64 percent. That is about 64 percent of households own the home they live in. When the homeownership rate gets much above 64 percent, we have problems in our financial sector. Remember the Savings and Loan Crisis?

The United States homeownership rate climbed during the second half of the 1990s and the first half of the 2000s, until they peaked at over 69 percent. Since then, it has fallen, but not by enough. Until the United States home ownership ratio drops to below 65 percent, there will be no generalized upward pressure for home prices.

I think we have to conclude that this recovery is weak, because the normal drivers of a robust recovery, small business and real estate, can’t contribute.