Saturday, February 5, 2011

Is Final Sales of Domestic Product Flawed?

Years ago, I began to favor a  target for money expenditures on currently produced output.    In abstract, I usually thought of it as "nominal income targeting."    For some time, I have thought that the best measure is Final Sales of Domestic Product.   As I noted in a recent post, that statistic grew at a more than 7 percent annual rate in the fourth quarter of 2010.   Since it's current value is well below any sensible target, I counted that as a very good sign that perhaps a decent recovery will soon begin.    The positive news on the unemployment rate--down to 9 percent--is another positive sign.

Soon after last quarter's statistics came out, I received an email from Scott Sumner in which he pointed to a possible flaw in the statistic.   He said that he had been told that  Final Sales of Domestic Product includes sales of goods that were imported during the previous quarter.    Spending on those goods is not spending on domestic product in the current period.   It is spending on foreign products in the current period.    It is just that they didn't enter the country in the current period.    As best I can tell, this is correct.  

As usual, my review of the procedures used to measure income and output left me troubled regarding the degree of extrapolation and "judgement" that is involved.   In particular, the BEA has a good explanation of the calculation of inventory investment.    As far as I can see, there is no effort to determine what part of inventory changes represent changes in inventories of foreign goods, or goods in process or finished goods produced partially with foreign goods and services.  

Reviewing the calculation of inventory investment, however, suggests that such calculations could be made much as many of the calculations are made--by extrapolation.    In other words, while such an adjustment could be made, it would be unclear how objective such calculations would be.    My own view has always been that planned inventory investment should be included in a proper measure of money expenditures on domestic product, but that unplanned inventory investment should not.    While polling firms about their plans to accumulate inventory and comparing that to actual inventory accumulation might seem a bit subjective, I can only recommend reading what they in fact do.   It will shatter any illusions you might have regarding the objectivity of these measures.

Perhaps quasi-monetarists can add to our wish list of macroeconomic statistics, (with monthly measurements of GDP on the top of the list) more information about inventory changes, such as planned versus unplanned and inventories of domestic versus imported products.

While those of us who favor targeting money expenditures have a special interest in this issue, others are more concerned about whether the strong growth in Final Sales of Domestic Product in the Fourth Quarter of 2010 was not quite the good news it seemed.    The speculation is that the much of the increased spending on goods and services was for goods that were imported in the third quarter of 2010.    Now (more than 1/3 of the way into the first quarter of 2011) firms will be busily importing goods to replenish those inventories, and a recovery in U.S. output and employment will not occur.

Final Sales to Domestic Purchasers increased at a 5.2 percent annual rate in the fourth quarter.   This is how much U.S. residents spent on consumer goods and services, capital goods, and government goods and services.  It does not include expansions of inventories.  It increased by $200 billion.  This is the most rapid growth since the beginning of the recession.

Final Sales to Domestic Purchasers doesn't include exports.   Exports increased at a 16 percent annual rate, which is $75 billion.    So, when the additional exports are added to the additional purchases by U.S. residents, the total would be $275 billion.  

Of course, some of those consumer goods and services, capital goods, and perhaps even government goods and services were imports.   Imports increased at a 3 percent annual rate, or $17 billion.    The increase in  Final Sales of Domestic Product is found by subtracting those imports from the $275 billion, which was $258 billion.   That is an increase at a 7 percent annual rate.   However, these are good imported in the fourth quarter, which is not exactly the same thing as imported goods and services sold in the fourth quarter, much less those and goods and services sold in the fourth quarter that had used imported goods and services in the production process.    

What about inventories?   They increased $5.2 billion in the fourth quarter of 2010, after increasing $139 billion in the third quarter of 2010.    Interestingly, by the fourth quarter of 2010, inventories were still $400 billion below the level before the beginning of the Great Recession.    They fell approximately $673 billion before starting to recover in the first quarter of 2010.   While this would be very puzzling if inventories are visualized solely as finished goods, they also include stockpiled inputs and goods in process.    Meeting a lower level of sales by using up already purchased inputs and completing partially finished goods will result in falling inventories even if any excess inventory of finished goods has been sold off long ago.

There is not enough data to determine whether the increase in inventories in the fourth quarter of 2010 masks a large depletion of inventories of imported goods.   Perhaps imports will grow rapidly in the first quarter of 2011 as those hypothetically depleted inventories are replenished.  

I would point out however, that a decrease in the dollar exchange rate or more rapid inflation in those parts of the developing world that try to maintain a fixed dollar exchange rate should result in more rapid growth of U.S. exports and slower growth in U.S. imports.   Only time will tell.

Still, the goal should be for growth in money expenditures on currently produced U.S. output to remain on a predictable path.    I favor adjusting the growth path from that of the Great Moderation, but with the current level being so low compared to the Great Moderation (12.5 percent too low,) some reflation is desirable. Until some new measure of money expenditures is developed, perhaps including planned inventory investment and excluding inventories of imported goods and the value added by imported goods and services to  inventories, I am still calling for $16.4 trillion of Final Sales of Domestic Product in the fourth quarter of 2011.  Yes, 9 percent more than in the fourth quarter of 2010.

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