Among many economic indicators the Gross Domestic Production (abbreviated as GDP) is still the most popular and comprehensive indicator to gauge the economic performance of a society. We have discussed in detail how GDP is compiled in the second half of Comment 24 so we will not repeat the discussion here. The GDP data compiled is called the Nominal or Current Dollar GDP. Applying the inflation adjustment on Nominal GDP, we get Real GDP. In certain sense all the inflation adjusted numbers like Real GDP, real final sales and so on are measuring the quantities of production and consumption, not their monetary amount. The Real GDP of America for years 1929 to 2004, in logarithmic-10 (called the common logarithm) scale, are plotted as black dots in the figure at the right. In the logarithmic scale a straight line means a constant rate of changing Real GDP. It becomes easy to spot periods of economic slowdowns and contractions in this logarithmic scale; in the figure 12 economic slowdowns and contractions are visible and are numbered from 0 to 11 in black letters. The trough labeled "0" is the great depression, followed by the recovery attributed to the "New Deal". The trough labeled "1" is another economic contraction as the effectiveness of "New Deal" waned. The European war and the World War II boosted government's military spending enormously and thus the sharply higher Real GDP from 1939 to 1944. At the end of the war Real GDP fell along with the military spending, creating the troughs labeled "2" and "3" respectively. It is only from 1950 and on, America's economy has returned to its normal state.
We should note that in spite of eight economic slowdowns showing up as disturbances "4" to "11" to the over all rising trend of Real GDP since 1950, we may draw a straight line rising toward the right as a reasonable approximation to the Real GDP data for the recent 55 years. This implies that the Real GDP of America has risen persistently with an almost constant annual rate of 3.3% a year for the past 55 years. The first thing one will ask is what is the force driving this steadily rising Real GDP? Unfortunately there is not a single answer that will cover the whole range of this recent 55 years since beneath this seemingly uniform growth of Real GDP, there is a sharp structural change in America's economy that is induced by the "globalization". We can mark the first half of 1980's as the period of transition from pre-globalization to globalization. Let us first look at the productivity gains, the standard answer provided by the standard economic theory, called modern economics, for the rising Real GDP. In America productivity gain data are published quarterly. The quarterly productivity gain data are notoriously volatile; they oscillate violently along an economic cycle as is discussed in detail in article 5. In that article we took 8 year moving average of quarterly productivity gain data as representing the long-term productivity gain since 8 years are long enough to wipe out the short-term swings of most boom-bust cycles. When this 8-year moving average of productivity gain is plotted against similar 8 year moving average of the growth rate of Real GDP in a correlation graph, strong positive correlation is observed for the period of pre-globalization, confirming the common notion that the steady growth in Real GDP from 1950 to 1980 is due to the steady gain in productivity. However, in the globalization era, this positive correlation is diminishing rapidly. From the data point of year 2000 and later the correlation turns to negative. This means that higher long-term productivity gain is associated with lower long-term growth rate of Real GDP. This also means that the steady growth of Real GDP in the globalization era cannot be attributed to the productivity gain anymore. This naturally brings our attention to the root phenomena of the globalization, the explosive growth of imports and exports crossing national boundaries, as the driving force of continued steady rise of Real GDP in place of the productivity gain.
The advocates of the globalization scheme usually claim that it is the explosion of total trade that is powering the strong growth in Real GDP. Total trade of a country is the sum of its exports and imports. As can be seen from the red dots in the first figure, the inflation adjusted Real Total Trade of America, is also rising steadily since the nadir of the great depression. Actually the total trade of America is growing with a faster rate than Real GDP. Some will ask that if the growth of total trade is the answer, why it should not be the answer of the growth of Real GDP for all the time since the nadir of the great depression instead of just for the globalization era. Those advocates of the globalization scheme will point out that during the pre-globalization era, the amount of total trade is a relatively small fraction of the total GDP and is not likely to be the driving force boosting Real GDP steadily higher. At the dawn of the globalization era, total trade of America was 5% of the GDP, and today it is near 20% of the GDP. However, this seemingly elegant answer from the advocates fails miserably when is confronted with the hard facts of the reality. The most notable phenomena of this globalization era are the steady growth of Real GDP of America and the persistent stagnation of Real GDP of Japan in the last 15 years. The total trades of both countries have grown strongly during the period. If the expansion of the total trade is the force behind the growth, then why Japan is stagnating so badly when it's total trade is growing as strongly as that of America? In order to understand the distinctively different behavior of the economies of America and Japan, we must concentrate our attention on the factor that distinguish America and Japan in the globalization era, and that is the trade balance. As we all know America is running an explosive trade deficit since the dawn of the globalization era, whereas Japan is persistently the largest trade surplus country in the world. Thus we are induced into the idea that the explosive increase of trade deficit boosts economic growth (in America) and a large trade surplus hurts the economic performance (in Japan). The notion that trade deficits will boost economy and trade surpluses can hurt is completely in contradiction with the teaching of modern economics that says imports hurt GDP and exports are positive to GDP. The arguments against such naive claim from modern economists and financial analysts adhered to the dogma of modern economics have been advanced in numerous articles posted on this web site, see articles 1, 2, 4, 7 and 8, and numerous comments, especially Comment 24, so those arguments will not be repeated here. Instead we will consider some fictitious societies to illuminate this point.
We first consider an extreme case. Let us assume that Society AA does not have any manufacturing capability. It imports all the goods it consumes along with a substantial part of services from foreign countries. For simplicity we also assume that Society AA does not export anything. When the consumers of Society AA buy imported goods, they hand their money, say dollar, to foreign manufacturers of those goods. Since dollar is not the legal tender in foreign countries, those foreign manufacturers must sale their dollar for the currencies of their own countries to sustain their manufacturing operation. The dollar of Society AA is not backed by gold nor by its manufacturing capability, so naturally few foreign private parties are willing to buy them. If everything is bestowed on the free currency market, dollar will collapse against foreign currencies, and the wanton practice of Society AA to live on imports will be stopped. That is why foreign central governments step in to buy up the dollars from those foreign manufacturers to support the price of dollar so that consumers of Society AA can continue to buy their exports. However, the dollars in the hands of foreign central governments are completely useless papers unless they recycle the dollars back into Society AA to earn some interests; we should note that Society AA does not manufacture and export anything so those foreign central governments cannot find anything worth to buy from Society AA. In order to accommodate this manipulation of foreign central governments financial institutions and the government of Society AA sale dollar denominated debt instruments, commonly called IOU's, to foreign central governments in exchange for their dollars. The dollars flown into the hands of financial institutions will be lent out to consumers in various forms, and the dollars flown into the hand of the government of Society AA will also be recycled back to the consumers of the society in the forms of transfer payments or government expenditures. Thus consumers of Society AA will have fresh dollars to buy the next batch of foreign imports. We should note that the amount of dollar in circulation does not need to increase because same dollars can just recycle indefinitely, but the amount of dollar denominated IOU's held in the hands of foreign central governments must increase steadily to sustain this strange scheme. Society AA still has a healthy Real GDP. The final sales minus the amount of imports equals the value created by the imports when they go through the retail chain. There are private fixed asset investments powered by the recycled dollars. Also there will be government expenditures. Those factors all add up to form Real GDP of Society AA. Suppose a foreign government wants to increase its export to Society AA. It will manipulate the currency market more aggressively to boost the value of dollar against its own currency. This will induce a portion of its production originally ear-marked for its domestic consumption to be diverted as export to Society AA. As the import of Society AA increases, the value added on the increased import will boost Real GDP of Society AA. Also increased import means increased dollars in the hand of the foreign government, increased issuance of IOU's sold to the foreign government, increased dollar inflow and increased government expenditure that is also counted as the increase of Real GDP. Thus Real GDP of Society AA will increase as its trade deficit widens, and Real GDP shrinks as its trade deficit decreases. We refer readers who want to know more about such a strange society to the second half of Article 7 for a more detailed account about this matter.
The extreme case of Society AA can be made more realistic by modifying some of its conditions. Let us consider a society, say Society A, which imports a lot but still has manufacturing capabilities. When a $10 object is imported and is sold to a consumer for $50, this imported item contributes $40 to GDP; $50 in final sale minus $10 from the category of import. Suppose a similar item is produced domestically for $15. If this domestically produced item is also sold for $50 to a consumer, retailers can only gain $35, whereas they can gain $40 if the foreign made item is sold. Thus retailers will flock to the foreign made item and drive the domestic producer out of business. At this stage GDP will lose this $50 contribution from the domestic producer. However, the labor and the capital of the domestic producer displaced by the imported item will be redeployed to some other area that is not in competition with the imports. Let us be pessimistic and assume that redeployed labor and capital are able only to generate $30 contribution to GDP instead of its original $50 contribution. Now the gains of GDP by importing this $10 item is as follows; $40 gain directly from the import of this item, $50 loss from the phasing out of a similar domestically produced item and $30 gain from the redeployed labor and capital. Thus GDP will gain $20 by importing this $10 item. Therefore, even for the more realistic society A, more imports means larger GDP and vice versa. Only in a society that has lost all its economic flexibility and the displaced labor and capital cannot be redeployed in any new production, GDP will lose $10 by importing this $10 item.
The impact of exports on GDP is more complex than imports. Let us assume that Society J is in a steady state with all of its manufacturing capability employed, some for exports and some for the domestic consumption. Suppose the government of Society J wants to increase its export. It manipulates the currency market so its currency drops 20% versus dollar of Society A. Let us assume that before the currency market manipulation, a $10 item is produced and sold for $50 to a consumer in Society J. After the currency market manipulation the producer of the item can only fetch $8 and the final sale of this item can only fetch $40. Thus it is more profitable for the manufacturer to export this item to Society A for $10. What happens to GDP of Society J? GDP loses $40 from the loss of this domestic consumption of the item and gain $10 from the export of this item. In other words GDP of Society J will lose $30 and its final sale shrinks by $40 by exporting this $10 item to Society A. How about a society, say Society C, the manufacturing capability has not reached its maximum capacity? This happens when there is idled labor resource in Society C. Suppose the condition induces some new capital to employ some idled labor resource of Society C to manufacture a $10 item to be exported to Society A. Since this export is not depriving any domestic consumption of Society C, $10 exports enhances GDP of Society C by $10. Furthermore a part of this $10, say $5, is paid as wage to the labor force of Society C. Let us assume that the workers of Society C will save $2 and consume $3. Thus final sale of Society C will increase by $3. The gain of GDP of Society C is thus $13 by exporting this $10 item. If we equate Society A with America, Society J with Japan and Society C with China, we get a rough understanding why America is importing to its long economic prosperity, Japan is exporting to its stagnation and China is exporting to its explosive economic growth. We must note here that depending on the specific situation at a specific time period, a society can move from the status of Society J to Society C and vice versa. For example America can be in the situation of Society J at a certain time and in the situation of Society C at a different time for a certain sector of its industries, and so is Japan when a fraction of its labor force become idled or under employed due to some adverse economic conditions.
With the impacts of imports and exports illuminated by the consideration of fictitious societies AA, A, J and C, we are ready to confront the actual data of America and analyze the onset of two recessions in the globalization era. Only after this analysis we will equip ourselves with the means to answer the focal point of this comment, that is, is a recession looming? In the first figure inflation adjusted annual amount of imports is plotted as blue dots, and the corresponding annual amount of exports is plotted as green dots. We first focus our attention on the time period from 1983 to 1991. In this period, though the positive correlation between long-term productivity gain and the growth rate of Real GDP becomes weaker compared to the pre-globalization era, the positive correlation is not lost completely. The strong run up of imports in the period of 1983 to 1985 is responsible for the renewed rise of Real GDP in conjunction with long-term productivity gain. By the end of 1984 the pain of US industry from the rising foreign competition based on overly strong dollar became politically intolerable, and industrialized nations struck the Plaza accord to vastly devaluate US dollar against Japanese yen in early 1985. With the delayed effect of roughly two years, this massive devaluation of dollar started to curb the rapid rise of imports around 1987 as discussed in Article 2 and is visible from the blue curve of the first figure. At that time American export industry was still in phase 1, that is, the skilled labor and equipments were kept intact though idled from the foreign competition. As the value of dollar fell the export revived. Since those revived exports were not diverted from any domestic consumption, that is, the export industry was in the condition of Society C, the increased export contributed positively to GDP and cancelled the negative effect of slowing down of imports. Thus Real GDP had kept rising until the exports used up all the push from lower dollar and started to level off in 1990 whereas imports were still languishing due to the devaluation of dollar, and then a recession hit in 1990 to 1991. The recession of 2000 to 2001 was different from the one of 1990 to 1991. By 2000 US consumer goods industry has lost almost all its export capability so a lower dollar will not spur the increase of any export, though lower dollar will curb the import of consumer goods. This phase of the sorry state of an industry is called "phase 3" here. The capital goods industry has deteriorated from phase 1 of early 1980's to "phase 2", enduring near two decades of foreign competition. In this second phase capital goods industry has sent a substantial portion of manufacturing to foreign countries and re-imported those foreign made parts back to finish their products for domestic consumption or for export. On the other hand the industry also sends a large amount of parts to foreign soil to be used in capital goods that are exported back to America. Thus the export and import from the industry rise and fall together in this phase; the simple rule that lower dollar will curb import and spur export does not apply here. As the twin falls of dollar in the summers of 1998 and 1999 took effect in 2000 and the import of consumer goods started to decline by a modest amount, the trading partners that export to US heavily were hit hard and reduced the buying of American capital goods. Furthermore the shrinkage of trade deficit brought down the mighty market of information technology stocks, sharply lowering the private fixed investments of American businesses. These factors reduced the demand of capital goods, and that in turn sent both exports and imports of capital goods lower by a much larger fraction than imports of consumer goods. Both import and export shrank together as shown in the blue and green curves of the figure and a recession set in immediately, not waiting for more than 2 years after the turn of the trade deficit as in the case of 1990 recession.
To discuss the present condition quarterly data from year 2000 to the second quarter of 2005 are plotted in the second figure at the right. We should note that by year 2000 the correlation between the productivity gain and the growth rate of Real GDP has already turned negative. As explained in Article 5 this strange phenomenon is due to the massive off-shore outsourcing of labor intensive parts of manufacturing so that the most productivity inefficient parts of the production processes are not counted in the productivity statistics, and thus render the productivity gain more or less meaningless as a driving force to push Real GDP higher. Annualized nominal GDP for each quarter is plotted as black dots. Red dots are the quarterly sums of import of consumer goods and auto and auto parts that forms the major part of merchandise trade deficit. Blue and brown dots are the quarterly sums of export and import of capital goods except auto and auto parts respectively. Green dots at the bottom of the figure are the quarterly average of dollar's exchange rate with yen, but with time scale shifted toward the right hand side by 2 years and 1 quarter. The reason of this shift is, as discussed in Article 2, that the ups and downs of merchandise trade deficit are influenced by the value of dollar against the currencies of its trading partners with that America runs largest trade deficits, that is, Japanese yen. The movement of the exchange rate of dollar versus yen usually precedes the movement of the trade deficit by 2 to 3 years. The shift of Yen/Dollar graph to the right hand side by 2 years and 1 quarter is to match the peak of dollar vs. yen with the peak of the merchandise trade deficit in 2000 so that we can go on to discuss the events after that and project the future course of America's economic performance.
As discussed before, the sharp fall of dollar in the green curve at 1998 has triggered the fall of import of consumer goods and auto of the red curve in 2000; the deficit in the trades of consumer goods and auto accounts for 60% of the total deficit of goods trade. Along with the shrinkage of the total trade deficit, the amount of recycled dollar from foreign private parties and governments fell and caused the burst of the stock bubble of information technology. This in turn dried up the demand for capital goods related to the information technology, and triggered the sharp fall of both import and export of capital goods as manifested in the blue and the brown curves of the second figure. The import of consumer goods and auto bounced back strongly in 2002. By that time two new factors have emerged in the landscape of trades that cannot be accounted for by the value of dollar versus yen alone. The first factor is Euro. Though dollar has bounced against yen only by a modest amount in 2000, dollar has risen substantially against Euro during the year, causing America's trade deficit with Europe to expand strongly in the year of 2002. Another factor is the emergence of China. Since Chinese Yuan is pegged to dollar at a vastly undervalued level, the imports from China have started to surge starting from year 2002. Those two factors in conjunction have caused the import of consumer goods and auto to surge very strongly in 2002. Imports of consumer goods from China has continued to surge in 2003, but the weakness of Euro has bottomed out in 2001, causing the imports from Europe to sag in 2003, thus imports of consumer goods and auto temporarily stagnated in 2003. The strong rise of the imports of consumer goods and auto in 2002 is translated to the rapid rise of the total deficit of the goods trade and increased amount of recycled dollar from foreign hands. This recycled dollar makes long-term interest rates in America low and financial institutions desperate to push abundant funds into the hands of consumers. However, consumer enthusiasm has been tempered by the wind of the second Iraq war and then by SARS scare. Only after the war and the SARS scare American consumers, using plentiful funds pushed into their hands through mortgage refinancing and home equity loans, have started their spending spree and lifted GDP to a rapid rise in the latter half of 2003 compared to the measured rise in 2002. On the currency front both yen and Euro have turned around from their weakness against dollar in 2002, and in other words that dollar has started to fall precipitously against both of them starting from 2002. This event should have sagged the import of consumer goods in 2004, but has not. One important factor in this change is the ascend of China as the biggest trade deficit contributor and its currency has been pegged to dollar at 2002 so its exponentially rising exports have not been disturbed by the tumbling of dollar vs. yen and Euro. Another factor is again Europe. As America's trade deficit moves up strongly the amount of recycled dollar also jump in accordance. This dollar recycling activity has enriched financial markets of America and enhanced the gap between the rich and the poor. The newly riches are addicted to European made luxury goods from automobiles to fashion outfits, and certainly are not deterred from their spending spree by some strength of Euro. Thus America's trade deficit with Europe has continued to rise through 2004. This European factor and the Chinese factor have kept America's overall trade deficit continue to explode upward in 2004. To understand the performance of GDP we need also to consider the trades in capital goods. After the fall of both import and export of capital goods in 2000 to 2001 as discussed before, both export and import have crept along a bottom until well into 2003, lagging behind the import of consumer goods and auto. The import of capital goods is influenced by the desire of fixed asset investment on the part of American businesses. After the burst of information technology bubble, the appetite of American businesses to invest in new high tech equipments has crawled in the bottom for quite a while. Only after consumer spending smartly shot up and the second Iraq war was over, American businesses have picked up their capital goods investment and have lifted the import of capital goods. This increased import then stimulates exports of capital goods since the industry is still in phase 2 as discussed before. The import of capital goods directly adds to the fixed asset investments, but after subtracting from the category of import, it does not contribute directly to GDP. Only when the deployed imported capital goods generate consumer goods, then the import contributes indirectly to GDP. However, the export of capital goods, as long as it is not taking away from the domestic consumption, will directly add to GDP. Thus increased export of capital goods starting from the middle of 2003 in conjunction with the increase of import of consumer goods has been pushing up GDP. Though the capital goods industry is in phase 2, some genuine export of capital goods is still left in America. Since the major competitors of capital goods exporters are Japan and Europe, not China, the sharp drop of dollar against yen and Euro in the stretch from 2002 to 2004 should be boosting the genuine exporters of capital goods through 2006. Recently, in the second quarter of 2005 and beyond, there are signs that the export of capital goods is growing faster than the import. This phenomenon is offsetting the stagnation of the import of consumer goods in the second quarter of 2005 (probably feeling some effect of sharply lower dollar vs. yen and Euro finally) and is keeping GDP growth reasonably strong. In the months of July and August the import of consumer goods continue to stagnate but the export of capital goods continue to out pace the import of capital goods. Thus though the overall trade deficit seems to be stagnating in 2005, the positive effect on GDP is continuing. Considering the prolonged decline of dollar versus yen and Euro in the stretch from 2002 to 2004, the trend of stagnating imports of consumer goods and the escalating exports of capital goods can continue for a while, posing no threat to the growth of GDP.
In Comment 24 we have discussed the decoupling of the general price level from the energy price, as the society of America becomes more service oriented and less industry dependent. However, we have not considered the direct effect of the rising energy price on GDP. As the price of oil rises, the consumption of oil naturally drops. Though the nominal final sale of oil related products rises due to higher oil price, the real final sale of oil related products drops somewhat. Another more important factor of higher oil price is the shrinkage of the sale of gas guzzling automobiles, and that drop negatively impacts real final sale of GDP. Many analysts worry about the impact of higher oil price on retail sales in general, based on the argument that if money is diverted to pay for gasoline, less money will be available to purchase other items. However, the production of consumer goods has strong inertia and cannot be turned off and on in a moment's notice. If consumer demand for goods drops, retailers must discount the price and get rid of the inventories. Thus the real final sales from those goods may not drop very much. The factors discussed here are the natural market mechanism to regulate so that the economy will not run away without any constrain. Higher oil prices thus will act as the regulator to slow down the too rapid rise of Real GDP. As demand of oil decreases due to its high price, the price of oil will drop and the economy can sustain a faster growth. Considering the behavior of imports and exports, and this direct effect from higher oil price, we expect the growth rate of Real GDP to slow down somewhat, probably to 2 % annualized rate, as projected in "The Projection of USA" section, but an outright recession is not in the cards through 2006.
Many analysts still are possessed by the nightmare that the tightening by The Federal Reserve Board will automatically induce a recession, without realizing the changing economic fundamentals as discussed in Comment 23. Actually the persistent rise of short-term interest rates has arrested the fall of dollar in 2004 and dollar is edging up against yen and Euro in 2005. This will assure a renewed expansion of America's trade deficit in 2007 and somewhat faster growth rate of Real GDP. The small devaluation of Chinese Yuan at the end of July will only have a minimal effect on America's trade deficit with China. Even if Chinese Yuan is forced to upwardly revaluate by a significant amount during the remaining part of the year, the shrinkage of America's trade deficit with China will not occur until late 2007 or early 2008, so if an economic recession should come, it will be in 2008, not within the next 12 months, unless an unforeseen non-economic event, for example, a bird flu pandemic, suddenly emerges.