Sharpest Consumption Drop Since 1980 Pushes GDP Negative

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By Dean Baker

A surge in defense spending added 0.86 percentage points to gross domestic product (GDP) growth.

Consumption spending fell at a 3.1 percent annual rate in the third quarter, which was the main factor leading to a 0.3 percent decline in GDP. Inventory build-ups prevented an even larger decline; final demand fell at a 0.8 percent annual rate.

The fall in consumption spending was the largest drop since an 8.6 percent decline in the second quarter of 1980. It was driven primarily by a drop of 14.1 percent in durable good purchases. Car sales fell at 25.6 percent annual rate in the quarter. Purchases of nondurable goods also fell sharply, declining at a 6.4 percent rate. Spending on services continued to increase, rising by 0.6 percent. Health care spending was the main factor behind this growth.

Residential construction fell for the 11th straight quarter, falling at a 19.1 percent annual rate. This reduced GDP growth for the quarter by 0.72 percentage points. Residential construction is now equal to just 3.3 percent of GDP. It peaked at 6.3 percent of GDP in the fourth quarter of 2005.

Nonresidential investment fell at a 1.0 percent rate, with a 7.9 percent increase in nonresidential structures largely offsetting a decline of 5.5 percent in equipment investment. Real investment in structures has increased by 40.3 percent since the fourth quarter of 2005. There has been somewhat of a bubble in this sector, which is bursting now. Office vacancy rates had been rising in many areas even before the recent downturn. There was also excess capacity in retail. While projects underway will be finished, excess supply coupled with tighter credit will lead to sharp declines in this sector over the next year.

The government sector added 1.15 percentage points to growth, with an 18.1 percent increase in defense spending being the main factor. Real defense spending now stands 7.7 percent above its year ago level and 12.3 percent higher than its level of two years ago.

The trade balance continued to improve in the quarter, adding 1.13 percentage points to GDP growth. Exports rose at a 7.5 percent annual rate, while imports fell at a 1.9 percent rate. However, this picture may be reversed in the quarters ahead, as foreign economies slide into recession and the rise in the dollar again makes US goods less competitive.

This report should help eliminate any immediate concerns about inflation. The overall price index rose at a 2.8 percent annual rate, while the core index rose at just a 2.4 percent rate. The sharp drop in commodity prices makes it virtually certain that inflation will slow even more in future quarters.

It is worth noting that net GDP actually stands 0.5 percent below its year ago level. This means the country had less to consume and invest based on the current quarter's output than it did based on the output from the third quarter of 2007.

The saving rate was 1.3 percent in the quarter. This is down from 2.7 percent in the second quarter, but that number was inflated by tax rebates. (Some checks were mailed in the first weeks of July.) The saving rate was just 0.2 percent in the first quarter of 2008 and has not been above 1.3 percent since the fourth quarter of 2004. It is likely the saving rate is on its way back to more normal levels as people begin to adjust to the loss of $5 trillion in housing-bubble wealth. This is a necessary process, as families will need to increase their savings, however, it raises the prospect of serious shortfalls in demand over the next two years. If the saving rate were to return to its normal post-war level of approximately 8 percent, it would imply a fall in annual consumption of approximately $700 billion.

The effect of falling consumption in the immediate future will be amplified by the reversal of the recent jump in defense spending, declines in nonresidential construction and a constant or rising trade deficit. The fourth quarter is almost certain to show a much sharper fall in GDP than the current quarter and the first quarter of 2009 could be even worse in the absence of an effective fiscal stimulus - even assuming that the financial situation stabilizes.