Why 5.6% GDP Burst in 2009 Is Not Sustainable

Gross Domestic Product grew by 5.6% in the last three months of 2009. That's a small revision downward from the advance estimate earlier this year, but it's still an enormous increase over the last three months of 2008, when GDP fell by 6.3%. GDP is a dubiously useful measure, as Megan explained in the magazine, but this report still tells us important things about the health of the economy. In short: we're still sick, but getting better.

Roughly two-thirds of this 5.6% burst did not come from consumers. It came from the slowdown in inventory liquidation, which contributed 3.79 percentage points to fourth-quarter GDP. The Wall Street Journal has a wonderful explainer interactive about how inventories contribute to GDP figures. The confusing thing for most people is: how does a small increase in demand create a huge increase in output (GDP)? Here's a simple way to think about it:

Imagine that you're a kid at a lemonade stand. At first, business is good and you start filling a few cups every minute. Suddenly, the streets thin out and you find yourself with a lot of extra filled lemonade cups. Uh oh, inventory glut! As walkers trickle back into the street, you hand them already-filled lemonade cups rather than pour more, because you don't want to waste lemonade mix if fewer people are buying lemonade. But when crowds start to pick up you think: I haven't been filling lemonade cups for a while, I'd better start restocking because it looks like the crowds are coming back. Crucially this will require you to make even more lemonade than you were making at the beginning of this story, because you need to satisfy current demand and stock for future crowds by building back a normal inventory. And that's how small increases in demand can produce huge increases in output, which is GDP.

Like lemonade itself, this story is sweet and sour. High GDP growth is sweet. The sour is that we shouldn't expect the first three months of 2010 to experience similar growth. Factories went into overdrive to restock businesses after employers dipped into inventories to save money. Without growing consumer spending, that burst is unsustainable. Analysts expect something closer to 3% growth in Q1 2010, according to the AP.

And how is consumer spending? This useful graph from Calculated Risk tracing the GDP estimates finds personal consumption and residential investments, two key factors of sustainable growth, trending down across revisions.

	Advance	Second Estimate	Third Estimate
GDP	5.7%	5.9%	5.6%
PCE	2.0%	1.7%	1.6%
Residential Investment	5.7%	5.0%	3.8%
Structures	-15.4%	-13.9%	-18.0%
Equipment & Software	13.3%	18.2%	19.0%

Lastly, how's inflation doing? It's still pretty subdued. From the WSJ

The government's price index for personal consumption increased 2.5% October through December, compared to the previously estimated 2.3% climb, reflecting upward revisions to the price of financial services, insurance and health care. The core PCE gauge, which excludes volatile food and energy prices, rose 1.8%, compared to the previously estimated 1.6% increase.