4th Quarter GDP Growth

The Drudge Report headline read "NOW FOR SOME GOOD NEWS: 5.7% GDP!," but linked to a Yahoo Finance article by an AP writer with a less enthusiastic headline, "4th quarter's fast economic pace likely to wane."  James Hamilton explains the schizophrenic view of the same Bureau of Economic Analysis report ("Strong GDP growth with weak fundamentals," Econbrowser) after a quick review for some and preview for others of national income accounting.

Gross Domestic product (GDP) is the statistic that attempts to measure the market value of all final goods and services produced within a country over a specified time period, usually one year.  The economy is growing when we produce more and 5.7% growth is good.  To better understand the causes of growth, GDP is broken into four components: consumption, investment, government purchases, and net exports (exports less imports) and the sum of these four components equals GDP.  Those components are further broken into subcomponents.  To understand why the economy grew so rapidly in the fourth quarter, it is necessary to understand how inventories are treated.  As Mankiw explains ("Principles of Macroeconomics: Fifth Edition," Chapter 10: Measuring a Nation's Income," 

...the treatment of inventory accumulation is noteworthy.  When Dell produces a computer and, instead of selling it, adds it to its inventory, Dell is assumed to have "purchased" the computer for itself.  That is, the national income accountants treat the computer as part of Dell's inventory investment spending.  (If Dell later sells the computer out of inventory, Dell's inventory investment will then be negative, offsetting the positive expenditure of the buyer.)  Inventories are treated this way because one aim of GDP is to measure the value of the economy's production, and goods added to inventory are part of that period's production.

Hamilton explains why changes in inventory played such a big part in the BEA report.

Three-fifths of that Q4 GDP growth came from the fact that businesses were drawing down inventories more slowly than they had the quarter before. Firms sold $8.5 billion more goods (at a quarterly rate) in 2009:Q4 than they produced, and met those sales by drawing down inventories by $8.5 billion. This reduction in inventories counts as negative investment spending of -$8.5 billion at a quarterly rate (or -$34 B at the annual rate these numbers are typically reported) for purposes of calculating fourth-quarter GDP. Firms sold $34.8 billion more than they produced in 2009:Q3, which amounted to negative inventory investment of -$139 billion at an annual rate for Q3. Since this component of investment spending went from -139 to -34, it counts as positive growth [-34-(-139)] when you compare Q3 GDP with Q4 GDP. This mechanism alone contributed 3.4 percentage points to the 5.7% growth rate for real GDP reported for Q4.

To put it another way, if consumers, businesses, foreigners, and the government had all purchased exactly the same quantity of real goods and services in 2009:Q4 as they had in 2009:Q3, more of those sales would have come out of inventory drawdown in Q3 than in Q4, so even without any gain in final sales we would have had to produce more stuff in Q4 than Q3, specifically, 3.4% more stuff at an annual rate. In fact real final sales to consumers, businesses, foreigners, and the government were not stagnant, but grew at a 2.3% annual rate during the fourth quarter, and the two effects combined give us the 5.7% reported GDP growth.

Just because the production gains can be accounted for in terms of slower inventory drawdown doesn't mean they aren't real, and doesn't mean they can't continue. I noted in July that we might expect inventory restocking to add 1.6% to the annual GDP growth rate for each of the first four quarters of the economic recovery, and we haven't even yet begun that inventory restocking process. The question, though, is what we'll see for the other components of GDP. Exports grew more than imports in Q4, with the result that net exports contributed 0.5 percentage points to that 2.3% growth in real final sales. That's certainly a very welcome development and a critical step for correcting the imbalances that have been very troubling over the last decade.

Those who project a slow rebound note that growth from slower inventory drawdown cannot continue forever because firms will run out of inventory, and fear that consumer spending will remain sluggish, limiting future hiring.

As a reminder not to read too much into a story, the growth in GDP should not be viewed as evidence that the Obama administration's stimulus package was successful any more than growing unemployment over the past year should be viewed as evidence that the stimulus failed.  A researcher would need to construct a model specifically designed to measure actual economic activity against the projected activity in the absence of a stimulus or measure how different government policies affected economic activity over time and across countries.  Menzie Chinn of Econbrowser has several posts on this topic here.