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WebMemo #1572 on Economy

July 27, 2007

Surprises in the Bullish GDP Report

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On Wall Street, there is a widening gulf between bulls and bears, and today's GDP report has surprises for both sides. On its face, the overall real growth rate of 3.4 percent in the second quarter of 2007 was higher than expected and higher than the average of 3.2 percent over recent decades. Yet the report cannot dispel the genuine threats to the economy, notably the continuing weakness in the housing and specifically subprime mortgage sector; oil prices nearing $80 a barrel; and the likelihood of Congress passing protectionist legislation later this year. Congress must reject such action for strong economic growth to continue for the rest of the year.

Behind the Numbers
The number one concern of market watchers is that the American consumer is losing steam. The cliché is that consumption makes up two-thirds of GDP, and so any sluggishness in consumer buying power (higher interest rates, lower home prices, and, therefore, weaker equity credit lines) will curtail spending. That was the dominant story when GDP growth all but flatlined in the first quarter of 2007. The consumption cliché played out again this morning, which is to be expected with the annualized growth rate dropping from a 3.7 percent annualized growth rate last quarter to just 1.3 percent. Yet the other shoe did not drop, because overall GDP surged at its fastest rate in a year.

More surprisingly, the trade balance has turned around; net exports actually added to GDP growth rather than taking away from it (which is all international trade does, according to many in Congress). According to the Commerce Department's press release:

Real exports of goods and services increased 6.4 percent in the second quarter, compared with an increase of 1.1 percent in the first. Real imports of goods and services decreased 2.6 percent, in contrast to an increase of 3.9 percent. (italics added)

When examining the reasons for GDP growth, the report shows that roughly one-fourth of the second quarter's growth is due to consumption (0.9 of the 3.4 percent). A similar percentage is attributed to rising government expenditures, while half a percentage point comes from gross private investment. The surge in net exports is the largest slice, accounting for 1.2 of the 3.4 percent GDP growth.

Today's report marks the first time since 1991 (65 quarterly reports ago) when the contribution from net exports exceeded consumption. This fact is especially significant when one observes that net exports, like profits, frequently go into negative territory, unlike consumption which is almost always growing to some degree. Some will argue that the declining dollar is helping to restore the trade balance, but investment flows are a much larger influence on exchange rates. Furthermore, it is investment policy where the U.S. may face the most significant downside risk.

Conclusion: Protectionist Agenda Threatens Economy
Congress has all but shut down the trade agenda in recent months and is prepared to pass a dramatic new law to "fix" currency misalignment-a euphemistic approach to raising tariffs on trade with China. Likewise, congressional efforts to "fix" inequality have focused on raising taxes, notably on capital formation. The rhetoric of fighting inequality plays well politically, but if anti-capital legislation moves ahead, the main casualties will be American jobs and wages. Investors will not wait for the bills to become law and will preemptively start pulling out of U.S. equities and bonds as soon as the bills move through committee.

The debate between bulls and bears will continue for at least one more quarter. It will likely be Congress that decides the winner three months from now.

Tim Kane, Ph.D., is Director of the Center for International Trade and Economics at The Heritage Foundation.

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