Note (March 21,2009) The massive downward revision of real personal consumption data on July 28, 2007 has made the first graph invalid and the discussion based on the data before the revision too rosy. For an updated graph of real personal consumption expenditure, please click here and then the link Real PCE from 2001 to 2009. For a more detailed discussion of the period entering into the current recession, please see article 10 and article 12. A "recession watch based on the July 28, 2007 downward revision has been issued on July 28, 2007 in USA_Update2007_07_28.
It is the time of the year to look at the prospects of 2007 and beyond. Before embarking on that task, we better consolidate our understanding about the present status of US economy, especially at the time of such diversified opinions among observers. Some experts are claiming that we are in the age of an unprecedented prosperity, whereas some think that we are plunging into a recession.
The best way to gauge present US economic condition is first to look at the real personal consumption expenditure that comprises 70% of real US GDP. Monthly data of real personal consumption expenditure from 1998 to November of 2006 are plotted in logarithmic scale in the graph at the right. It should be noted that the graph is designed to be updated as new data come in. If this comment is viewed substantially later than the date of posting, the graph may contain data points beyond the data of November of 2006, but this comment only covers the data up to November of 2006. On a graph of logarithmic scale a straight line implies a constant rate of change. This allows us to draw meaningful trend lines on the graph. The trend line AA represents the trend of real personal consumption expenditure from 1998 to the middle of 2000, and indicates the growth rate of +5.1% per year for the period. The trend line BB, covering the period of economic stagnation from the middle of 2000 to the beginning of 2003, indicates a growth rate of 2.5% per year for real personal consumption expenditure during the period. The first phase of the recovery period from the beginning of 2003 to the fall of 2005 is represented by the trend line CC that indicates a growth rate of 3.9% per year. Since the fall of 2005, a new trend line DD can be drawn and indicates a new phase of expansion of 3.4% per year. The November data shows a very strong growth in real personal consumption expenditure. Even if December growth turns out to be zero, real personal consumption expenditure would have grown about 4.0% per year in the fourth quarter of 2006. This means that the real personal consumption expenditure will contribute at least +2.8% to real GDP of the fourth quarter. Since real personal consumption expenditure does not subtract away imports that are not the values produced domestically, imports must be subtracted separately in GDP account to correct the defect of looking at the real personal consumption expenditure as a proxy of domestic production. Though the nominal dollar amount of imports has dropped substantially in recent months due to the sharply lower crude oil prices, the real amount of oil imports has risen as the consumption of gasoline increased as oil price drops. Thus the real import probably has increased in the fourth quarter, roughly canceling the increase of surplus in service. Thus the trade balance account will not contribute to GDP in any significant way in the fourth quarter. The housing sector seems to be bottoming out, and the sector of private fixed asset investment in GDP compilation probably will contribute near zero to the growth of fourth quarter GDP. In 2006 the spending of The Federal Government has been subdued. The local government spending has been noticeable due to the large outlays after the hurricane Katrina. However, this local government spending is tapering off, and we estimate that the total government spending will only contribute +0.2% to the fourth quarter real GDP. All in all we expect real GDP to grow like 3.0% or more in the fourth quarter, a substantial improvement over the reading of +2.0% in the third quarter. Though this picture does not imply an unprecedented economic boom, it is also far from the scenario that US economy is plunging into a recession.
To understand US economy in the globalization era the major character of the globalization, that is, the run away US trade deficit, must be incorporated into any analysis. Unfortunately “modern economics” either turns a blind eye toward the question how trade balances effect the economy, or propagate a completely erroneous view that trade deficit hurts economy and trade surplus boost economy. The superficial and misguided view about the effect of trade balances probably come from a superficial reading of the way of compilation of GDP in which imports are subtracted and exports are added to other components of GDP. GDP does not try to compile values added at each production stages, an almost impossible task. Instead it tabulates final sales to consumers as a proxy to the total production. However, this approach will mistakenly include all the imported final products, intermediate components and raw materials as domestically produced. That is why in GDP compilation all the imports are subtracted in a separate account. If imports increase, the subtraction from GDP will increase, but the same amount as the subtraction will be added in the portion of personal consumption expenditure. Thus the increase of imports are not negative nor positive for GDP. The effect of trade balance on an economy is much more complicated than the superficial view propagated on major financial media. We have discussed the issue in detail in articles 1, 2, 2A, and other comments on this website. In summary increased imports will generate greater added value as the imported products pass through the retail chain and thus help GDP. On the other hand increased imports will push out US manufacturers of competing products. If the workers and capitals idled by the increased imports can be redeployed to other fields not in competition with imports, even creating less value than the original products pushed away by the imports, the overall effects to the economy will be positive. If the idled workers and capitals cannot be redeployed, then the effect of increased imports will be negative to the whole economy. In a flexible economy like US the redeployment of idled labor and capital is still possible at the current status, so US economy has grown steadily riding on the run away trade deficit. In an extreme case when manufacturing industry is completely wiped out by imports, further imports will not cause any loss of jobs, and increased imports means higher GDP as discussed in article 7. Besides the above mentioned economy boosting effects of imports, trade deficits itself has another financial function to boost US economy. As US runs trade deficits, US dollars are handed over to foreigners as payments for the imports. Those trade deficit dollars eventually will end up in the hands of large foreign financial institutions and foreign central governments, and they will reinvest those trade deficit dollars in dollar denominated debt instruments and US equities. This should be compared with the case that equivalent amount of dollars are spent on domestic products. In the latter case those dollars will go through the hands of retailers, manufacturers, and their workers. Only at the end some portion of the dollars will trickle down to dollar denominated debt instruments and equities. Thus trade deficits become a super efficient way to convert circulating dollars into investment money that can be lent out. When those trade deficit money are lent out, the usual multiplying effect will work and one dollar of the original loan will balloon to like 10 dollars of new loans. With US trade deficit rising above 600 billion dollars a year, the impact on the amount of money ready to be lent is enormous. This is a potent force supporting the borrow-and-spend habits of not only US consumers but also US governments.
For readers who are still possessed by the idea that trade deficit is negative to the economy, our arguments and conclusions will appear to be weird. We would like to point out that if an investor really believes that trade deficit is negative to the economy, then he would have sold all his stocks around 1984 when US trade deficit started to expand rapidly and thus would have missed the stock market rally of Reagan era completely. The investor would have bought stocks at the middle of 1987 when US trade deficit peaked and started to decline, and thus suffered mightily at the stock market crash of late 1987. The investor would have sold all his stocks at the middle of 1997 when US trade deficit started to explode again, and thus missed the whole explosive stock market rally of late 1990's. The investor would have bought stocks at the first part of 2000 when US trade deficit started to stagnate and suffered again when the stock prices dropped substantially from the middle of 2000. The investor would have missed the current stock market rally too since US trade deficit is exploding upward again starting from the end of 2003. This series of arguments shows explicitly that data indicate clearly that US prosperities in the era of globalization always coincide with the explosion of trade deficits, and economic slowdowns are synchronized with retreating trade deficits.
The discussions in previous paragraphs show that in order to understand the economic prospects of USA in 2007 and beyond, we need to know the flows and ebbs of US trade deficit. US has a moderate positive trade balance in service and the picture is not going to change rapidly in near future. Our attention will be focused on deficits of goods trade. The trade balances of goods can be grouped into three categories. The first category consists of consumer goods and automobile. The second category is industrial materials and food. The third category covers capital goods. The capital goods category had a substantial trade surplus at early 1980's when the globalization process has started under strong push of Reagan administration. As US manufacturers have been continuously decimated under the pressure of foreign competition, the trade surplus in this category has all disappeared and the balance is hovering around zero at present. This situation of near zero trade balance of capital goods is not going to change rapidly in near future, so we can ignore this category from our consideration. Trade deficit of the category of industrial material and food comes mainly from crude oil imports. There may be slight tendency for oil price to rise when US Dollar is weak and to fall when US Dollar is strong, and thus creates weak correlations between expanding trade deficit in this category and weal dollar, and shrinking trade deficit in this second category and a strong dollar. However, major forces in shaping oil price and thus the trade deficit in this category come from the global supply and demand of oil, and from the greed and fear of oil market speculators. We will come back to discuss the trade deficit in this category later on, but will first analyze the first category of trade deficit, from consumer goods and autos.
Trade deficits of consumer goods and autos are very sensitive to the value of Dollar. Strong Dollar will boost the trade deficit enormously and weak Dollar will stagnate the trade deficit of this category. Before 2002 Japan was the major source of US trade deficit in consumer goods and autos, followed by Taiwan and South Korea. Thus the study of the exchange rate between US Dollar and Japanese Yen was suffice to measure the strength of US Dollar. However, in recent years, China has replaced Japan and Taiwan as the major source of US trade deficit in the category of consumer goods. Chinese Yuan underwent massive devaluations vs. US Dollar in the period from the end of 1989 to 1995, from 3.8 Yuan/Dollar to 8.3 Yuan/Dollar, and was then fixed at the rate of about 8.3 Yuan/Dollar for nearly a decade. Only from the middle of 2005 Yuan is allowed to appreciate against US Dollar slowly. The behavior of Yuan is thus very different from that of Yen against US Dollar. To measure how the value of Dollar influences US trade deficit in the category of consumer goods and autos at the era when China becomes the major source of US trade deficit, apparently we cannot rely on the exchange rate of Yen vs. Dollar anymore, but need to find some more effective measure to gauge the strength of Dollar. The trade weighted dollar index compiled by The Federal Reserve Board is skewed in favor of currencies of Canada and Mexico, two neighbors with large total trades with US but with substantially less trade surplus against US compared to that of China. We have compiled a trade balance weighted dollar index, based on the currencies of five trading partners, China, Japan, Euro region, Canada and Mexico, with each currency weighted by the relative trade deficit with US. The methodology and the results of this compilation of trade balance weighted dollar index are presented in article 9. A graph is borrowed from article 9 and is presented at the right. The red dots in the graph are the monthly values of trade balance weighted dollar index with the time scale indicated at the top of the graph. The green dots are the monthly values of trade deficit of consumer goods and autos plotted in logarithmic scale and its time scale is plotted at the bottom of the graph. The time scale of the dollar index is shifted by two years toward the right. From the graph we can see that the dollar index peaked at the beginning of 2002, whereas the trade deficit has started to rise more slowly and then flattens out from the middle of 2004. This indicates that the dollar index leads the trade deficit of consumer goods and autos by nearly 2.5 years. The dollar index has stopped its sharp fall and is leveling off from the beginning of 2004. That means that the trade deficit of consumer goods and autos will resume a moderate climb at the end of 2006 and will continue its slow rise through 2007 and into 2008.
Now we must return to the consideration of US trade deficit in the category of industrial materials and food. As mentioned before, trade deficits in this category is dominated by oil imports. As oil price rises, the trade deficit in this category expands quickly, and as oil price falls, the trade deficit falls with the oil price. There are two difficult issues related to this trade deficit confronting us. The first is what is the effect of this kind of trade deficit on the economy, and the second is how this category of trade deficit will behave in 2007 and beyond. Let us start with the first question, how the movement of trade deficit of industrial materials and food, or more directly oil price, will effect the economy.
When we talked about how increased imports will boost US economy, we are talking about the imports of consumer goods and autos, not about the crude oil. If we take an extreme case that the price of oil goes sky high, say like a few hundred dollars a barrel, without any doubt a severe global recession will befall coupled with very high inflation rates. The question to ask is whether there is a transition phase when the rise of oil price is moderate, and the expanding trade deficit will stimulate the economy through the financial effects as discussed before. Instead of setting up some non-solvable equations and argue in vacuum, we will look at the actual data in order to entangle this question. In the graph at the right the ratios of 12 month moving average of trade deficit of consumer goods plus autos over nominal personal consumption expenditure less food and energy are plotted as green dots. The ratios of 12 month moving average of total trade deficit in goods over the nominal personal consumption expenditure are plotted as red dots. The difference between the green curve and the red curve is due to the trade deficit in crude oil. The green curve leveled off from the beginning of 2005, whereas the red curve continue to rise, though with a little less vigor, until September of 2006. As discussed before, the real personal consumption expenditure has slowed down somewhat starting from the middle of 2005. This implies that there was a window of about 6 months, from the beginning of 2005 to the middle of 2005, that moderately high oil prices had boosted US trade deficit and that in turn held up US real personal consumption expenditure through the financial incentives as discussed before. Only when oil prices continued to rise beyond the level of the middle of 2005, inflation had heated up and the growth rate of real personal consumption expenditure shifted downward. The drop of oil price from September of 2006 has calmed down the inflation and real personal consumption expenditure has turned up strongly. In the last graph at the right, 12 month moving averages of real goods consumption less food and energy are plotted as purple dots. This curve shows a similar change of trend as for the case of real personal consumption expenditure in the middle of 2005. However, the purple curve does not show a sudden flare up even at the face of a sharply lower oil price and a down turn in the red curve in recent months. This implies that the recent vigor in real personal consumption expenditure is related to the rebound of the consumption of gasoline as oil price drops.
With the effect of oil price on the economy analyzed in the previous paragraph, we are now ready to consider US economy in 2007 and beyond. US economy will have a base line growth rate of 2.5% to 3.0% in real GDP due to the moderately expanding trade deficit in consumer goods and autos. If oil price stays at the current level, this base line growth rate will persist, and FED will have no reason to tighten nor to loosen the monetary condition. If oil price shoots up again, inflation rate will accelerate, and the growth rate of real GDP will drop accordingly. This will put FED at a very uncomfortable position of the need to tighten at the time of a weakening economy. If oil price drops moderately from here, inflation will ease further, real GDP will grow faster and FED probably will still opt for the current level of monetary condition. However, if oil price drops big, the positive effect on inflation can be overwhelmed by the sudden drainage of trade deficit dollar, and financial and equity markets will be in turmoil. In that occasion FED needs to lower interest rates drastically to resupply liquidity to the markets. But doing so can cause the sudden unwinding of Yen Carry Trades and trigger a wholesale collapse of Dollar. If that happens, Japanese Government will be required to come back to the currency market to reopen its massive dollar buying operation as in the period from 2003 to 2004, in order to save the globalization scheme from collapse. In one word the economy of US in 2007 and beyond will become increasingly the hostage of oil prices.
The most difficult part is apparently to predict the price of oil. As mentioned previously gasoline consumption in US is bouncing back strongly as oil prices fell. Moderately expanding consumer goods imports implies that Chinese economy will continue to grow strongly and so is its oil consumption. Thus the demand of oil will not slacken. The question is the supply. If nothing happens in the oil producing countries, the supply of oil probably still can meet the demand, and the price of oil can stay at the current leve. However, if geopolitical instability develops in major oil producing regions, we will see oil price flaring up again, and US economic growth will be hurt.