First quarter GDP contraction

For today’s second post, I absolutely have to say something about the surprising first quarter Gross Domestic Product (GDP) figure. In case you have not heard, the first stab (i.e. unrevised) at 1st quarter GDP says the economy contracted at an annualized rate of 6.1%! I have to confess that number is shockingly high. The consensus expectation by economists had been a contraction of 4.6%.

Just so that we are all on the same page, the 6.1% contraction represents an annualized number – it does not mean that the economy actually shrank 6.1% total in the first quarter.

Instead it means that if the same sort of contraction continued it would result in a shrinking of 6.1% over the course of an entire year.

The only positive aspect of the big contraction is that consumer spending was up. Consumer spending makes up 65-70% of total GDP.

GDP is calculated as: GDP = C + I + G + X

Where C is consumer spending; I is investment; G is government spending; and X is net exports.

We know that G, government spending, is up massively because of the BIG bailout, yes?  Exports, X, have also been improving. So that means that the culprit for the big drop has to be I, or investment spending.

The “I” category is typically dominated by businesses, and sure enough businesses dramatically cut back on their spending and investing in inventories. Thus, while the GDP drop was large, businesses are actually rapidly slimming their budgets down and holding cash. This is indicated by their cutting of capital expenditures (business investment) and the fact that they no longer are investing as much of their cash in other illiquid assets such as excess inventory.

Recall that fourth quarter GDP contracted at 6.3%, but that the majority of that decline was centered on consumers.

It appears that in the first quarter businesses did their adjusting to the sentiment of consumers during the fourth quarter. Also recall that the source of real economic growth is efficiencies developing in the economy.

When businesses slash inventories to match reduced buying by consumers, this is a way of gaining efficiency. I am not trying to put a bonnet on a pig, its just that had GDP shrunk by 6.1% and the attribution was consumers then I would truly be worried.

Instead, we have businesses responding quickly to a new economic reality. Additionally, this means that businesses can begin manufacturing new goods as well. And as we all know, when we go to the store we like to see new merchandise.

Another point that needs mentioning is that economists have been fearing deflation (see the earlier blog posting on deflation) since the only way for businesses to induce spending has been to drastically cut prices, yes? The problem is that if the consumer comes to expect prices will fall tomorrow, they won’t spend today. That can lead to a downward spiral (just ask the 1990s Japanese) where people don’t buy, so businesses cut prices more, leading to even less buying, leading to…ugliness.

But in the first quarter figures we can see that the price index rose 1.5% if you exclude energy (fuel, natural gas, heating oil, etc.) and food.

Lastly, this marks the third consecutive quarter where the economy has contracted. In the third quarter of 2008 the economy had shrunk at 0.5%. This marks the longest contraction since 1974.

Given that the U.S. consumer has started buying again, it will be interesting to see what happens to the “I” component in the 2nd quarter. I can say that low interest rates are leading many people to refinance their mortgages. The additional buying capacity gained by refinancing will ultimately result in increased consumer spending…and this is a new one…consumer SAVING. All of this bodes well for the economy.

Jason