What is dragging down the U.S. economy?
More than three years after the recovery began — in name, at least — the economy is still in a giant hole. But what, precisely, is still dragging it down? What sectors are the culprits? A simple model delivers some answers.
We can start by looking at the difference between what the U.S. economy is capable of producing and what it is actually producing, known as the “output gap.”
If almost all of the workers who wanted a job had one, factories were working at full speed and office buildings were full, economic activity would be $973 billion higher (at an annual rate) than it actually was in the third quarter.
That, in other words, is the value of what we are not producing every year because of idle factories and wouldbe workers on the jobless rolls. To see what parts of the economy are responsible for that lost activity, we can look at what proportion of GDP each sector is historically responsible for, and then see how their performance actually is in 2012 compared to what it would be expected in a world of full employment. (I used the average from 1985 to 2005, but these numbers are fairly stable over time so the exact years used doesn’t make much difference). The result is a simple model that tells us what sectors are underperforming and by how much.
The biggest single sector responsible for the weak economy won’t surprise anyone. Residential investment is a startling 49 percent below what would be expected historically, accounting for $370 billion in “missing” economic activity. This is exactly what one would expect given the prime role of housing in causing the economic downturn, and even offers a bit of hope; if housing just returns to its normal role in the economy, 38 percent of the output gap would disappear.
The next major driver of economic weakness similarly makes sense. Spending on durable goods — think automobiles, furniture, and large appliances — is 18 percent below what it would be in a healthy economy, accounting for another $267 billion of the output gap. This is likely tied to U.S. citizens dealing with an overhang of debt and tighter credit; it is harder to get a car loan, for example, and people are more cautious about big-ticket spending because they are fearful about their job prospects and still paying down debts racked up in years past. The hole in spending on nondurable goods is substantial as well, at $127 billion. Consumers holding on to their wallets are clearly a major part of the story for the economic weakness.
That said, new data out Monday suggest trends are pointing the right direction for consumer spending. Personal consumption expenditures rose 0.8 percent in September, the Commerce Department said, as personal income rose 0.4 percent.
The third major contributor to the weak economy is less investment spending by businesses. Corporate America is spending 13 percent less on equipment and software than they would in a healthy economy, accounting for $174 billion in missing economic activity. Less investment in structures — think office buildings, factories, and stores — accounts for another $69 billion. One of the most worrisome signs in Friday’s GDP report was that business spending on equipment and software, which had been growing nicely for the last two years, stopped growing in the third quarter. That, combined with recent data on factory orders, mean there is some risk that this part of the economy’s gap is poised to widen rather than narrow.
There are other drags on growth, but they just aren’t as big a deal as these big three of housing, consumption, and business investment. Trade is more of a drag on the economy than history would suggest, though the overall role of trade masks an interesting story. Exports are much, much higher than the historical numbers would suggest, overshooting that predicted by our model by $551 billion. But imports, which subtract from GDP, overshoot by even more, $670 billion.
Those increases can be partly explained by the longer-term shift toward trade as a larger share of economic activity. But it also reflects the steep run-up in prices for commodities since 2005: Both the oil that the United States imports and the agricultural and mined products that we export have increased in price, and are therefore larger relative to the overall economy than the past would predict.
State and local government spending has been falling over the past three years, one of the ongoing drags on the job market. But in the scheme of things, it’s not that big a deal. State and local government spending is only 4.7 percent below where it would be expected in a healthy economy, accounting for $92 billion in lost activity, or about 9 percent of the output gap.
Federal nondefense spending is actually 7 percent above the level that would be expected, contributing an extra $28 billion to economic activity. National defense spending, however, is down 6 percent against forecasts, meaning that overall federal spending is contributing $28 billion to the output gap.
There is only one major sector that is outperforming what our model predicts. While spending on physical goods is well below the forecast, spending on services is actually 4 percent above what might be expected, contributing an extra $290 billion to the economy.
Part of this is likely due to longer-term secular shifts in the economy, such as people eating more restaurant meals and buying fewer groceries. Part is probably due to the fact that many service sector expenditures can’t be postponed the way the purchase of an automobile can. And part of it is likely due to the fact that many big-ticket services, namely healthcare and education, have become steadily more expensive relative to physical goods like cars and computers, and therefore take up a bigger portion of U.S. citizens’ spending.
In a way, understanding the nation’s output gap through the different components offer reasons for hope. Housing and personal consumption seem to be recovering more quickly, and if that trend continues, most of the nation’s economic problem will be solved.