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WebMemo #812 on Economy

July 29, 2005

GDP Growth Continues to Impress

By and

The economy continued its steady forward movement from April to June this year, growing at a 3.4 percent pace-boring and not flashy. In some ways, this is the best kind of growth because there are no signs of inflation heating up. Investment is once again hotter than usual, which indicates that the pro-growth tax policy enacted in 2003 is working. Two other interesting points in today's GDP release are the extensive downward revisions to the data from previous years-nine consecutive quarters, from the first quarter of 2002 to the first quarter of 2004, saw growth downgraded by an average of 0.36 percentage points-and the fact that investment continues to be the main driver of the current expansion, not consumption.

 

Given headwinds from high oil prices, stagnant stock markets, and ongoing terror jitters, the second quarter's continued momentum is exceptional and bodes well for continuing job and wage gains. GDP growth averaged 3.6 percent in the last four quarters, and 3.2 percent since 9/11, compared to an average of 3.3 percent during the 1990s and 3.2 percent during the 1980s.

 

Previous "advance" numbers from the Bureau of Economic Analysis were revised upwards by half a percent or more during the last two quarters, which may signal that next month's revision will be positive as well, especially because the main weakness in the second quarter from an accounting perspective was in inventories. Inventories are notoriously fickle but have an average effect that is negligible (their average impact has been 0.01 percentage points since 1974) and rarely affect GDP by more than one percentage point. This quarter, the inventory drop reduced GDP growth sharply by 2.32 percentage points.

 

Investment and the "Stealth Boom"

Non-residential fixed investment continues its strength in this recovery, accounting for over 25 percent of economic growth in the second quarter. This trend has led Ken Mayland, president of ClearView Economics, to declare a "stealth boom going on in the business world." Real business investment grew at 9 percent in the second quarter, far exceeding first quarter growth of 5.7 percent. Investment in computers and software was particularly strong in the second quarter.

 

Business investment (i.e., non-residential fixed investment) has grown by 9.1 percent, on average, since the passage of the 2003 tax cuts-nearly double the average rate of 4.8 percent since 1974. The 2003 tax cuts reduced the cost of capital investment and temporarily allowed businesses to write off more investment costs. These incentives encouraged business expansion over the past nine quarters. The bonus depreciation part of the 2003 tax bill expired at the end of 2004, which could slow business investment in the future. To ensure continued robust investment expansion, Congress should make permanent all of the tax cuts on capital in the 2003 tax legislation.

 

What about China?

There's been a lot of talk lately about the amazing growth of China's economy. For example, the cover of the most recent Fortune magazine featured a send-up of the famous body-building advertisement, with Uncle Sam as the 97-pound weakling being threatened by a muscular beach bully in the image of a Chinese worker. What's missing in all of the comparative analysis is a sense of perspective. First, China is remains a much smaller economy. Second, a prosperous China that embraces free markets is better for America's economy and security than an impoverished China that embraces Marxism.

 

In absolute dollar terms using purchase power parity figures from the World Development Indicators, China had a $6.1 trillion economy in 2003, compared to a U.S. GDP, in similar terms, of $10.3 trillion (in 2000 U.S. dollars). China's economy is slightly more than half the size of the U.S. economy, which means if America is a 97-lb. weakling, China must be a 57-lb. skeleton.

 

The real concern is growth, and the Chinese growth rate of 10 percent translates into $610 billion in additional productive capacity per year. The U.S. growth rate may be slower, but it is based on a much larger GDP, translating into $371 billion of absolute growth per year. Keep in mind that the economics of growth become much more challenging as a country approaches the productivity frontier. China is growing by catching up-that is, reforming its economy based on principles and institutions pioneered in the West. America's growth is based entirely on the discovery of new techniques, technologies, and institutions. Nations in the past that grew rapidly towards the frontier found their momentum stall out when the catch-up process was fully exploited (usually around 80 to 90 percent of comparable per capita productivity). In per-capita terms, America will remain the productivity leader for decades to come, and even longer if it maintains its culture of innovation and freedom.

 

Tim Kane, Ph.D., is Bradley Fellow in Labor Policy, and Rea S. Hederman, Jr., is Senior Policy Analyst, in the Center for Data Analysis at The Heritage Foundation.

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