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Final Demand and the Inventory Cycle

Friday, 30 July 2010 15:17

Economics seems to be the science of forgetting. All the great truths that were pounded into our heads when we grad students, or even undergrads, seem to be missing from the thinking of those making pronouncements on the economy and economic policy.

For example, the housing wealth effect, a well-established economic doctrine firmly rooted in the center of the discipline, seems to have disappeared from most discussion of consumer spending patterns. The basic point -- that a dollar of additional housing wealth leads to 5-7 cents in additional consumption each year -- explains both the consumption boom at the peak of the bubble and the falloff in consumption in the wake of its collapse. Instead of noting the huge amount of lost housing wealth and recognizing the drop in the consumption and rise in the saving rate are permanent, economists and economics reporters are looking at consumer attitudes and hoping that greater optimism will lead to a new spending boom.

In the same vein, it is remarkable how little attention a very classic inventory cycle has received in explaining the changes in GDP over the last five quarters. The basic story is that firms were shedding inventory as fast as they could in the 4th quarter of 2008, with the rate of decline increasing into the first quarter of 2008. Although inventories continued to decline in the second quarter, they declined at a slower rate, which meant that inventories added to growth. Eventually firms stopped cutting inventories and began rebuilding. In the most recent quarter they were adding inventories at a very rapid pace, $85.9 billion a year.

With the latest figure, the inventory cycle has come to an end. I don't have a crystal ball telling me the rate of inventory accumulation in the next few quarters, but it is unlikely that it will be much higher than the current rate. This means that inventories will provide little boost to growth in future quarters, making GDP growth look like final demand growth and that is not very good.

While GDP growth has been erratic over the last four quarters, final demand growth has been much less so. It has been consistently weak, averaging just 1.2 percent. In the most recent quarter it was 1.3 percent. So unless we have some good reason for final demand growth increasing (state and local cutbacks, the end of the housing tax credit, and the phasing down of the stimulus all push the other way), we can expect very slow GDP growth for the next several quarters and rising unemployment.



Comments (7)Add Comment
written by izzatzo, July 31, 2010 10:05
Inventories and final demand do not match
Counting output chickens before they even hatch

Reporters can't wait till the fat lady sings
Better to report what inventories bring

Than final demand for that produced
Sitting on shelves awaiting ultimate end use

We're in a terrible recession, no wait, we're out again
Leading inventory indicators trump final demand trends

Like consumer uncertainty trumps deflated bubble wealth
Like concentrated media trumps reporter occupational health
Y vs what?
written by JBG, July 31, 2010 1:53
You guys need to learn to label the abscissa in your graphics.

I did figure this one out, but I had to ponder a moment. Things this basic shouldn't be left to the ingenuity of the reader.
Wow, JBG, you're a f*cking retard
written by Chuck Mertz, July 31, 2010 7:24
Dean Baker needs to learn to label his chart of GDP for each of the last 5 quarters on the X axis?

It's the f*cking last 5 quarters of GDP! God damn it you're a moron!
Nicely Done
written by Mark, August 01, 2010 8:51
This is a particularly lucid post. Thanks. A graph of inventory rates would add to it's clarity.
Could it be that all "those great truths" were tosh?
written by yoganmahew, August 01, 2010 6:38
"For example, the housing wealth effect, a well-established economic doctrine firmly rooted in the center of the discipline, seems to have disappeared from most discussion of consumer spending patterns."
Perhaps this only worked when inflation was going to eat away at the debt, or more importantly, increase the salaries of those taking on the purchasing debt.

This hasn't been the case since the 'eighties. Inflation has been negligible, despite that, real incomes have declined. You can't really claim that taking on debt that increases in real terms is economically expansive?

So the problem, as I see it, is that in a low inflation environment, the housing wealth effect is at best nil, at worst (given that real incomes are falling) negative. Therefore the falloff in consumption is doubly damaging. It is not just the fall in house prices that is a problem, it is the increased burden of debt that falling real wages is having.

But then, debt doesn't appear in the great truths, does it?
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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.