New GDP Revisions to Boost US Economy by 3%
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. About the US Bureau of Economic Analysis (BEA)
2. Major GDP Calculation Revisions Coming Tomorrow
3. Research & Development Becomes Capital Investment
4. Artistic Originals – Art, Movies, TV Shows, Books, Etc.
5. Changes Needed, But Can Be Tricky in Practice
Tomorrow morning at 8:30 EST, we get the government’s first look at 2Q GDP. The pre-report consensus is for a rise of 1.1% (annual rate) in the 2Q following 1.8% in the 1Q. Most forecasters agree that the economy slowed somewhat in the 2Q, so a reading of 1.1% shouldn’t come as a big surprise. However, this is one economic report I would not bet on.
At the end of April, I pointed out that the Commerce Department’s Bureau of Economic Analysis (BEA) announced it would be making some significant revisions to the way it calculates Gross Domestic Product on July 31. It will revise economic growth for all years going back to 1929. This change is somewhat controversial in that it is expected to add up to 3% to total GDP in one fell swoop tomorrow morning. That’s about $1,500 worth of extra goods and services for every person in the US!
The reason for the changes is the fact that our economy increasingly depends on the production of intangible goods, and the BEA believes that the production of ideas is an important form of investment. So in the future, the BEA is going to count a company’s research and development as a form of investment, just like the purchase of a new office building or a new printer. And the creation of a lasting work of art – a painting, a movie, a television series, etc. – that can be sold or viewed year after year will likewise be treated as a capital investment.
Since the US GDP is increasingly made up of intangible assets, some of these revisions probably make sense. Yet the caveat is that intangible things such as R&D and art are far more difficult to value precisely. So today we’ll discuss the GDP revisions coming out tomorrow and whether or not such changes are a good thing.
About the US Bureau of Economic Analysis
The monthly US Gross Domestic Product estimates are arguably the most watched economic reports on the planet. Before we delve into the sweeping changes that lie ahead for how GDP is calculated, let’s take just a moment to understand what the BEA is and how it operates.
The BEA’s mission is to provide the most timely, relevant and accurate information on the US economy. The BEA's GDP estimates are key ingredients in how we make critical decisions on a wide range of issues including monetary policy, tax and budget projections, business plans, investments, etc., etc.
The BEA is part of the US Commerce Department and is widely considered to be non-partisan. The Director of the BEA is Steve Landefeld, who has served in that position since 1995 under both Republican and Democratic presidents. Mr. Landefeld has presided over a number of GDP revisions, which typically happen every five years.
Major GDP Calculation Revisions Due Out Tomorrow
The revisions we’ll see tomorrow morning, however, are said to be the most significant in more than a decade, not only for the changes themselves but also due to the fact that they are expected to instantly add about 3% to the overall size of GDP, even though the revisions will be spread all the way back to 1929.
Back in April, the US economy (ie – GDP) topped $16 trillion for the first time ever according to the BEA. If the revisions coming at the end of July are as large as expected, that will mean that GDP will swell by $400-$500 billion to above $16.4 trillion. That’s the equivalent of adding another Pennsylvania to our economy.
GDP seeks to capture the value of all goods and services produced within the US in a given period (quarterly). The BEA generally does this by measuring the value of goods purchased by consumers. The BEA calls these purchases “Personal Consumption Expenditures” or the PCE Index. PCE (consumer spending) makes up apprx. 70% of total GDP
The logic goes like this: When you buy a washing machine, the price you pay captures the value of the work of everybody in that chain of labor and the cost of materials that went into creating that washing machine. That includes the sales person who sold it to you, the trucker who delivered it, the factory worker who assembled it, the marketing staff that created the advertising, the raw materials used to build it and the salaries of the executive officers who run the company that made it.
Research & Development Becomes Capital Investment
The single biggest change to the GDP methodology tomorrow will be the inclusion of research and development as a fixed/capital investment instead of just a cost of producing goods. Initial estimates show that this R&D change alone will add a little more than 2% to overall GDP. About two-thirds of that increase in GDP will come from the private sector and around one-third from the government. Brent Moulton, head of national accounts at the BEA, put it as follows:
“The world economy is changing and there’s greater and greater recognition that things like intangible assets are very important in the modern economy and play a role similar to tangible capital that was captured in the past.”
The changes will have a ripple effect. The new methodology will make corporate profits look larger, as companies will no longer be counting net R&D after depreciation as a cost. BEA Director Steve Landefeld said that the inclusion of R&D was just the beginning to help get a more accurate picture of growth:
“You need to go further in this exploration of investment in intangibles. R&D – the scientific and engineering stuff – is just a piece of the puzzle.”
Artistic Originals – Art, Movies, TV Shows, Books, Etc.
The Internet Movie Database (IMDb.com) may not seem like a natural source of information for the BEA, but its researchers scoured through film studio records as far back as the 1920s to build a database on the history of investment in movies.
The result is not only an estimate of the capital value of all America’s movies, TV programs, plays, books, greeting card designs, etc., but also a fascinating picture of how their importance to the economy has changed over time.
A film or book or TV series is often produced in one year but may be enjoyed for many years thereafter. For example, it is estimated that the popular sitcom SEINFELD has generated $3.1 billion in revenue since it went off the air in 1998.
Another example is George Lucas, the writer, producer and director of the popular STAR WARS movies. His company spent a lot of money to create these films. It owns the copyright and has made money for many years afterward on that investment. The same is true for a lot of “intellectual property.” For example, when Apple researchers develop the next iPad, or Stephen King writes a new horror novel, it will be an upfront investment that will likely have a long payoff.
So starting in July, the BEA will treat the creation of artistic works as longer-term capital investments, not unlike factories, equipment or software. In the current system, the value of the economic output of a Star Wars movie would only show up in GDP over decades to come, in the form of personal consumption expenditures like movie tickets and DVD sales. With the new revisions, that value will show up in GDP sooner.
Preliminary research by the BEA puts investment in artistic originals at $70 billion, so that figure will go into GDP (how they arrived at that figure is not clear). These figures may ignite some controversy because they will amount to the first official estimate of the value captured from copyright laws.
New Pension Accounting Changes, Finally
The change with the most counterintuitive results is pension accounting. At the moment, the BEA counts what companies actually pay into a defined benefit pension plan as wages, and ignores whether the plan is in deficit or surplus. After the new change, it will measure what companies have actually promised to pay.
Measured federal government spending on pension benefits will fall because it has funded its plans better, while state and local government benefit spending will rise because they have promised considerably more than they have paid in.
This change will also result in an instant increase in GDP estimated at about $30 billion. But wait, aren’t many pension plans woefully underfunded? Yes, but under the new rules, the GDP effect is based on what an employer should have paid to fund pension benefits, not what was actually paid. Thus, GDP is positively affected because it will measure employers’ promises going forward.
Having a BEA estimate of the size of pension deficits and their cost could prompt an important shift in the political debate over the future of defined benefit plans. In any case, changing pension fund accounting to reflect employer promises seems like a good idea on one hand; however, it will boost GDP but the money is not really there.
Other Changes of Interest
Some other changes are technical in nature but are still important. For example, the BEA plans to change how commercial banks measure the cost of running customer accounts. Currently, the BEA does not account for services provided by commercial banks for which no specific fees are charged – such as clearing checks, distributing funds, protecting deposited funds, etc. The BEA believes this will make the price of banking services less volatile.
Another update will be to treat all of the costs of buying a house – such as attorney fees, stamp duty (document tax), etc. – as investment rather than spending. That is expected to add about $60 billion to GDP for base-year 2007. At present, only real estate agent commissions are capitalized.
And the BEA will also speed up the depreciation of those commissions, writing them off over the average 12 years that people stay in a house, instead of over the expected 80-year life of the structure. As a result, the change will lower net savings.
I could go on, but these are the highlights of the GDP revisions coming tomorrow.
Changes Needed, But Can Be Tricky in Practice
The new GDP revisions coming from the BEA probably make sense in most cases, especially as our economy increasingly moves from tangibles to intangibles. But valuing many intangibles can be tricky in practice.
When calculating the value of an investment in a truck, we rely on the market price of trucks. When calculating the value of an investment in a new building, we rely on the market price of the land, labor, and the material it takes to construct it.
But research and development and artistic originals aren’t commodities that can be priced like a bushel of corn or an ounce of gold, both of which are traded daily on exchanges around the world. So most likely, the BEA will be forced to value intangibles based on the most recent price paid for that investment, product or service, which could vary greatly. This is where it becomes risky.
For example, there’s no guarantee that an expensive movie is more valuable than a cheap one, and there’s no reason to believe the amount of money spent on a research program is a proper assessment of its value. In effect, this will leave us with the conclusion that a wasteful R&D undertaking adds as much or more to the economy than a thrifty and effective one.
The difficulty of properly valuing these intangible investments is one reason other countries generally haven’t counted them as capital goods. But in a digital, ideas-driven economy, intangibles are increasingly important. The increase in overall GDP coming tomorrow may not be a game changer, but it’s definitely more than a rounding error.
Simply ignoring intangibles gives a misleading picture of the state of the economy, and the new system probably is a step forward. But it is controversial in that valuing intangibles can be difficult and thus susceptible to error (and manipulation). An economy dominated by the output of bushels of wheat and tons of steel is relatively easy to measure, whereas a modern service and information economy simply isn’t.
At the end of the day, we know that measuring economic output involves a good deal of approximation – even using today’s BEA methodology and assumptions. There will be even more approximation when the revisions go into effect tomorrow. Only time will tell if the new revisions give more or less accurate data.
Most of the articles I have read on the revisions conclude that the changes will be positive overall. The question is, will the BEA’s GDP estimates continue to be the most watched economic reports on the planet after the revisions tomorrow? Time will tell. With the information I have presented today, you will at least be in a better position to judge.
Finally, it will be most interesting to see how, if at all, the Obama administration and the Democrats try to spin the revisions to GDP. Will they claim that the economy just got 3% larger? Almost certainly they will claim that our “debt-to-GDP ratio” is smaller, and that will be true. But it’s still almost $17 trillion in debt!
Depending on how the new GDP numbers come in tomorrow, and the markets’ reactions, I may revisit this issue in my blog on Thursday. To subscribe to my free weekly blog, CLICK HERE.
Hoping it’s cooler where you are,
Gary D. Halbert
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.