As articles on this blog have noted previously, the core of the Great Recession is the severe fall in fixed investment in developed economies. Factually analysing this is crucial for positively establishing the driving force of developments. It also refutes alternative theories, such as that the dominant factor in the international economic situation is a fall in US consumption – which some projected would be caused by a rise in US saving and deleveraging of US consumers.
Recent publication of the second, revised, estimate of US 3rd quarter GDP, together with aggregated data for the OECD economies in Europe, allows further verification of the actual international trends. Precise quantitative comparisons of the published data should not be made between the US and Europe, as that for the US is in constant 2005 dollars whereas the aggregated OECD data is calculated in parity purchasing powers (PPPs). But in both cases the trend is quite sufficiently clear as to leave no doubt as to the processes occurring
Taking first Europe, the changes in components of GDP between the peak of the previous business cycle, in the 1st quarter of 2008, and the latest available data, for the 2nd quarter of 2010, are shown in Figure 1. The entire decline in OECD Europe GDP during this period, $387bn in constant PPP terms, is more than accounted for by the decline in fixed investment of $396bn. The fall in personal consumption, $80b, is slightly more than offset by the rise in government consumption, $114bn, while the fall in imports, $374bn, is slightly greater than the decline in exports of $360bn.
Therefore essentially 100% of the decline in GDP in Europe is due to the decline in fixed investment.
Turning to the US, the revised second estimate for US 3rd quarter GDP does not show a marked contrast with the first estimate. Annualised GDP growth rate was revised up from 2.0% to 2.5%, which might appear large until it is remembered that, unlike most countries, the US publishes its quarterly GDP changes on an annualised basis. So the upward revision of GDP is only 0.1% or $17bn, in 2005 constant price terms, in a $13,277bn economy.
Taking the components of US GDP, again in constant price terms, US GDP in the 3rd quarter of 2010 remains $86bn, or 0.6%, below its all time peak in the 4th quarter of 2007. Over that period net exports have improved by $54bn, inventories by $99bn, and government expenditure by $135bn. Personal consumption has fallen by a marginal $2 billion – confirming that a fall in US consumption is not the driving force of the recession. Indeed total US consumption, that is personal and government consumption combined, is now clearly above its previous peak level in the 4th quarter of 2007.
The driving force of the US recession is the $405bn decline in fixed investment – residential investment down $200bn and non-residential down $207bn.1 The fall in fixed investment accounts for all the decline in US GDP – indeed the fixed investment drop is approximately five times as large as the entire decline in US GDP and is merely partially offset by expansion in other GDP components.
Long term trends
The sharp decline in fixed investment that has driven the Great Recession in both the US and Europe, however, has longer term consequences for their economic growth. Fixed investment is the prime driving force of economic growth, accounting for about 50% of GDP growth in proper growth accounting terms. A sharp decline in fixed investment in the US and Europe will therefore have not merely immediate but medium and longer-term consequences in slowing the trend rate of economic growth.
As may be seen from Figure 3, measured in current price terms, the recent fall in fixed investment in Europe is the culmination of a long decline in the percentage of fixed investment in GDP. This has now dropped, measured in PPP terms, by seven percentage points of GDP from its peak in 1973, at the end of the ‘Golden Age’ of post-World War II economic growth – declining from 25.3% of GDP to 18.2%.
In the case of the US, measuring in current dollar terms, the percentage of fixed investment in GDP also fell by seven percent of GDP, from a peak of 18.7% in the third quarter of 1979 to a post-World War II low of 11.7% of GDP at its trough in the first quarter of 2010 – see Figure 4. The recovery to the third quarter of 2010 is purely marginal – to 12.0% of GDP.
The severe fall in investment in both the US and Europe is therefore not simply the driving force of Great Recession but ensures that these economies will experience slower than previously attained levels of growth at least in the medium term.
If the driving force of the Great Recession had been a decline in consumption it could be conceived as a very violent cyclical movement that would be followed by a return to 'normal' - i.e. to previous trend growth rates. The fact that the centre of the Great Recession is a severe decline in investment has longer term consequences in depressing trend and therefore average growth rates.
Accurate diagnosis of the driving force of the recession is therefore important not only for short term but for medium and longer term analysis.