Wednesday, April 11, 2007

Ritholtz v. Luskin, Round 3

This week Barry Ritholtz is engaging in a debate with Donald Luskin over at Capital Commerce, the economics blog for US News and World Report. The central theme of the debate is Luskin's relative bullishness versus Barry's relative bearishness about the short and medium-term prospects for the US economy.

Needless to say, Barry has the debate well in hand. But after reading Luskin's entry today, I couldn't help but take a few minutes to address one of Luskin's central assertions so far: that the US economy, other than the housing sector, is actually doing well, and even improving.

The evidence that Luskin cites when he makes that assertion comes from last quarter's GDP numbers. They show that the fall in residential investment (i.e. new house construction) subtracted 1.2% from the nation's overall real GDP growth.

But one could just as easily exclude any other disliked portion of GDP, and come up with the opposite conclusion. How about "real GDP actually grew by 2.5%, but was propped up by the large rise in government spending, without which economic growth would have only been an anemic 1.9%," or "falling imports (which may well signal falling consumer demand) artificially boosted GDP growth, which would otherwise have been only 2.0%."

The point is a simple one: it makes no sense to exclude portions of the economy when trying to discern its direction, since all sectors of the economy contribute to its overall performance.

Barry does a good job trying to explain why many observers are worried about the recent slackening of broadly-measured economic growth, citing a number of important measures of economic growth that are flashing warning signs. I'd like to add just a couple more. The two primary components of private-sector economic growth - consumption by individuals and investment by businesses - have both slowed noticeably over the past year, as the following chart shows.

Production by US industry has also stalled. The growth of ndustrial production has slowed sharply over the past six months, and excess productive capacity in the US has risen.

One last point. In his post, Luskin questioned the importance of mortgage equity withdrawals (MEW) in sustaining consumption spending in the US in recent years. From Luskin's post:
MEW is nothing more than a hypothetical explanation for consumption. If it were a good explanation, you'd expect personal consumption growth to have surged when MEW started rapidly expanding in 2002. But it didn't.
A few sentences later Luskin admits that consumption is largely explained by income, as is commonly known. Given that income growth has been very weak during this economic expansion (see this post for details), we would NOT have expected consumption growth to have surged due to high levels of MEW. Instead, we would have expected consumption growth to have merely been sustained at a moderate level despite weak income growth... which is exactly what we did see.

In other words, MEW did a nice job filling the gap between income growth (which was low) and consumption growth (which was moderate) during the period 2002-06. Given that, however, it makes all kinds of sense to start worrying about what might happen to consumption growth in the next year or two as MEW dries up, given that income continues to grown only anemically.

In short: it seems to me that Barry has good reason to worry.

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