(January 22, 2008) Forget the GDP accounts that you learned about in macroeconomics class. The big economic and financial earthquakes always take place in the asset markets. Policy actions that target spending, like the stimulus measures being discussed today by President Bush and Congressional leaders, are not going to solve the problem.
When most people talk about the economy they mean gross domestic product (GDP), which measures the market value of the goods and services produced during a given year or quarter. This is a rough estimate of the value of the work produced by the economy over that period. Macro textbooks illustrate this concept with an island economy, as depicted in the figure below where some islanders catch fish and others pick coconuts and GDP is the total value of fish and coconuts produced during the year.
To get a handle on the size of GDP, the most recent report indicates that GDP in the third quarter of last year (Q3/07) U.S. nominal GDP, using current market prices, was $14.0 trillion at an annual rate. Real GDP, calculated by adjusting nominal GDP to remove price changes since 2000, was $11.7 trillion in 2000 dollars. We will get our first estimate of Q4/GDP from the Commerce Department on January 30.
Changes in GDP, which we use to measure growth, are much smaller. In Q3/07 real GDP increased $138.8 billion at an annual rate, a 4.9% annual rate compared with the previous quarter.
Within the Q3/07 GDP accounts, residential construction accounted for $463.3 billion or 4.0% of real GDP, but fell by $27.4 billion compared with the previous quarter.
It is important to remember that all of these numbers are measured at annual rates, which means that they tell us what GDP would be over a year if all four quarters of the year looked exactly like this one. That means real production of goods and services actually only increased by about $35 billion (one quarter of the $138.8 billion annual rate number and that residential investment actually fell by about $7 billion (one quarter of $27.4 billion) during the quarter.
I am not writing this to make light of the housing crisis but to illustrate that it is a story measured in the billions of dollars–not trillions.
Compare these numbers with measures of privately-owned assets. According to the most recent Flow of Funds Report from the Federal Reserve Board, the market value of U.S. assets at the end of Q3/07 is roughly $195 trillion, or about 14 times the size of GDP. (This estimate does not include the value of the vast government land holdings.) Because the numbers are so large, even a small disturbance in the asset markets–a change in people’s relative desires to hold assets–can send shock waves through the economy that will dwarf anything going on in the GDP accounts.
What is happening in today’s asset markets is not a GDP event; it is not the result of late mortgage payments. It is a profound reduction in the willingness of wealth-holders to own the existing stock of assets. It will not be fixed by giving checks for $12.50 to every man, woman and child. The fix must restore confidence in the underlying assets. More on this to come.