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Economic Forecasting, 101

Economic forecasting is much easier than generally realized.Every country’s economy is measured in terms of its Gross Domestic Product, or GDP. And, the GDP of every country is comprised of only four major parts: personal consumption expenditure, private investment, net trade and government spending. If you understand the direction in which those four parts of the economy are moving, then you know how the economy as a whole will perform.

In 2011, the United States’ GDP was $15,088 billion in size .Of that amount, personal consumption expenditure, that is the amount spent by individuals on goods and services, accounted for $10,723 billion, or 71%. Private investment on things such as factories, equipment and residential and non-residential buildings, amounted to $1,914 billion, or 13%. Net exports, which means the amount the US exports minus the amount it imports, deducted $578 billion, or 4%, from the size of the economy because the country imports so much more than it exports. Finally, government spending at the federal level and the state and local level accounted for $3,030 billion, or 20% of GDP. That’s it. Those four parts make up the entire economy.

I recommend that you take a look at the numbers for yourselves by visiting the website of the Bureau of Economic Analysis (BEA). Here is the link: http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1

The BEA also provides tables showing the annual growth rate of each of the GDP components (http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1) as well as the contribution of each component to growth during each period (http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1). By clicking on the “Options” button, it is possible to obtain historical data going back to 1947.You can also choose to look at either annual data or quarterly data. Finally, the data can be easily downloaded to an excel spreadsheet.

So far, so good. The next step in forecasting economic growth (or contraction, as the case may be) is to develop an understanding of the forces that drive each of the four components of the GDP. Personal consumption expenditure, at 71% of US GDP, is by far the most important. How much individuals spend is determined primarily by two factors: how much they earn and how much they can borrow. Those two factors are also the most important determinates of private investment. That is because business investment and residential construction both ultimately depend on consumer demand.

Net exports are decided primarily by the competitiveness of a country’s goods and services in the global marketplace. Government spending in the United States is determined by elected officials in response to the demands of the voting public, as well as the demands of corporate donors.

The expansion of debt owed by individuals was the most important factor driving the US economy from the early 1990s up until 2008 when the economic crisis began. The total debt of the household sector first topped $4 trillion in 1993. It peaked near $14 trillion in the third quarter of 2008. At that point, individuals buckled under their debt burden and began to default on their loans.

Between 2002 and 2007, the household sector increased its borrowing by an average of $1 trillion each year. That debt funded the expansion of personal consumption expenditure and therefore GDP. When loan defaults began to skyrocket in 2008, the financial sector refused to lend the household sector any more money. With their credit lines cut, individuals were forced to spend less. Personal consumption expenditure began to contract and private investment contracted even more sharply. As a result, in the fourth quarter of 2008, US GDP shrank by 8.9% (on an annualized basis) and unemployment shot up to 10% soon thereafter. At that stage, the US government began to spend much more. Had it not done so, the economy would have collapsed into a new Great Depression. It’s simple arithmetic:

GDP = personal consumption expenditure + private investment – net trade + government spending.

The true magnitude of the increase in government spending is not fully reflected in the data as reported in the BEA tables.That is because the BEA data does not capture transfer payments made by the government, but instead only reflects who ultimately spends the money.So, for instance, when the government gives money to the unemployed, and it is spent by the unemployed, that is recorded in the BEA data as personal consumption expenditure rather than government spending.

The actual increase in federal government spending can be found in the data provide by the Congressional Budget Office (CBO), which provides a detailed projection for the outlook for the budget and the economy each January. This is a long report and there is much to be learned from it. Here’s the link: http://www.cbo.gov/ftpdocs/126xx/doc12699/01-31-2012_Outlook.pdf

Page 132 of the CBO’s 2012 Budget And Economic Outlook shows that government outlays (that is, spending) increased by 29% between 2007 and 2009 to $3,517.7 billion. In 2009, government spending was equivalent to 25.2% of GDP, up from 19.7% of GDP in 2007 (as shown on page 133). In other words, in 2009, the federal government spent the equivalent of $25 out of every $100 spent in the economy. Put differently, government spending created 25% of the United States economy that year.

During the weeks ahead, we will explore how that government spending was financed, as well as many other issues touched on today. For now, however, consider this: when the government spends money, it adds to GDP…regardless of how it spends the money. In terms of the GDP arithmetic, it makes no difference whether the government purchases stuffed animals, builds nuclear bombs or invests to find a cure for cancer or to develop solar energy. In terms of our future prosperity, however, how the government spends makes all the difference in the world.