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Economic News, Data and Analysis

Animal Spirits: Dissecting the Economic Slowdown

Animal Spirits

“…most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits–of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities…if the animal spirits are dimmed and the spontaneous optimism falters… enterprise will fade and die,” – J.M Keynes: The General Theory of Employment, Interest, and Money

Don’t blame the consumer

If the U.S. economy does slip into a recession, and it’s not clear that it will (as of 7.13.01), we may already know the culprit: businesses have cut back on investment.

Mixed messages – no recession yet?

The most recent data (7.27.01) on the total production in the economy shows that the gross domestic product (GDP) grew at an annual rate of 0.7% in the second quarter. This was down from 1.3% in the first quarter, and was the slowest growth rate in several years, but it was still positive.

The unemployment rate stands at 4.5% in June (up from 4% at the end of last year, but stable since April). In addition, employment seems to be leveling off (see graph) but not yet substantially declining.

In addition, there have been several months of declining production in the industrial sector of the economy, and weaknesses in other areas as well.

Who’s nervous?

If there is indeed a recession on its way, what might be the cause?

It appears that consumption is holding up well, but investment appears to be dragging the economy down.

The following graphs show investment and consumption growth rates over the past couple of years. The big outlier appears to be the recent decline in investment. (Fixed non-residential investment is primarily investment by firms). Residential investment has been growing over the past two quarters.

These graphs suggest that the slowing of the economy is the result of reductions in investments, rather than a reduction in consumer spending. (But see note 1 below).

Putting it together: components of GDP.

Gross Domestic Product (GDP) is the most common measure of the economic output, and can be broken down into components. The basic idea is that supply equals demand. Supply is the total amount of goods and services produced (Y) as measured by GDP, and demand is measured by the sum of consumption (C), investment (I), government expenditures (G), and net exports (exports, X, minus imports, M).

This relation is easily described by Y = C + I + G + (X – M).

Each year each of these components will change by a certain amount, and so we can decompose a percent change in GDP into a change in each of the demand components. The following graph shows such decomposition for the past two years. As you can see, the reduction in the growth rate of output, especially in the last quarter is associated with a drop in investment. (But see note 2 below).


Explanations for weak investment:
  • Weak forecasts of consumer spending
  • Higher interest rates from Fed actions in 2000
  • Waiting for lower interest rates from Fed actions in 2001
  • Over-investment correction
  • Stock market decline
  • Election turmoil / uncertainty
  • Animal Spirits
  • Of course, even if we conclude that a decline in investment was the cause of a slowdown, what was the cause of the decline in investment?

    One idea is that firms saw a decline in consumer consumption in the future and decided to reduce investment now. However, since consumption has held up well, this story seems unlikely.

    A second idea is that the higher interest rates that resulted from Fed policy in early and mid 2000 caused the decline. Since monetary policy works with a time lag, the investment reduction may be in part a response to higher interest rates from last year.

    However, since then, the Fed has worked aggressively to lower rates and the recent decline in investment should have been mitigated by the recent actions of the Fed. This might lead to another explanation – once the Fed began to lower interest rates, firms could reasonably conclude that rates would fall even farther and would therefore delay investments until the rates hit bottom.

    Some observers have suggested that firms “over-invested” last year and prior to 2000 (in part because of fears of the Y2K bug). The current decline in investment may simply be a correction to the excesses of the past.

    Yet another idea has to do with the stock market. Since the stock market has fallen considerably since last year, it is reasonable to conclude that the level of investment will fall as well. (If you remember Macro 101, this is just Tobin’s-q theory of investment).

    The election turmoil of last year would also seem to be a candidate since it may have added a degree of uneasiness to people’s perceptions of the economy. However, throughout the election mess one thing was always clear: either a democrat or a republican would be in office in January. In this respect, this election was no different than most.

    Finally, as the Keynes quote above would suggest, the decline in investment might simply represent “animal spirits,” and a decline in optimism might create a self-fulfilling prophesy.

    Most likely it is a combination of these effects.


    Recession 101.

    For a comprehensive and up-to-date collection of macroeconomic data I highly recommend the national economic trends publication by the St. Louis Fed.

    Click here for a discussion of some basic investment theory including Tobin’s q.

    Note 1: Since investment by its nature is forward-looking, a decline in investment can come about because of a forecast of future declines in consumption. So, a decline in investment could in principle be a result of producer’s gloomy forecasts of consumers. However, there seems to be little it in the macro data that would suggest that gloomy forecasts would be the result of lower consumer spending (especially with the tax cut on tap).

    Note 2. It also appears that a drop in exports may also be part of the story, although it appears that the reduction in imports offsets this change.

    Photo credits:

    St. Louis Fed.

    Bureau of Labor statistics

    Filed under: Recession

    Perceptions of Race and Economics

    The Survey

    Recently, the Washington Post reported the results of a survey on racial attitudes. Part of the survey asked respondents how they saw the economic conditions of various groups. Specifically, two of the questions asked were:

    Thinking specifically about African Americans, do you think the average African American is better off, worse off, or just about as well off as the average white person in terms of {income / types of jobs}?

    The results showed a large gap between the perceptions of each group. While 38% of white respondents thought that African Americans were just about as well off as the average white person in terms of income, only 15% of African Americans thought this. There was a similar pattern for the other questions.

    In light of this survey finding, I thought I would take a closer look at the economic situation of various racial groups in the U.S. over the past 35 years.

    What the data show

    The data on income, poverty levels, and the unemployment rate all show the reality of how well various racial groups are doing relative to whites in the U.S..

    Each piece of data shows the same thing-there is still a large gap in the economic outcomes of groups. While there does seem to be a narrower gap than 30 years ago, the pace of the convergence is very slow.


    Per-capita income for each group is graphed below. While there is an overall upward trend in the data, the gap between whites and the other groups has narrowed only slightly (in percentage terms).


    Over the past 40 years there has been a drop in the poverty rate, (but note that over the past 30 years poverty rates have declined only for blacks). Again, the difference between whites and other groups still persists.


    The unemployment rate has shown a dramatic improvement since the early 1980’s for all groups. Again, the gap has narrowed, but still persists.


    In light of these differences, should policy actively work towards closing the race gap?

    The survey also asked the following question:

    Do you believe it is the responsibility or isn’t the responsibility of the federal government to make sure minorities have equality with whites in each of the following areas, even if it means you will have to pay more in taxes? Making sure minorities have jobs equal in quality to whites?

    In answering this question, 57% whites thought it was not the responsibility of the federal government to pursue equality with respect to jobs. A majority in the other racial groups thought that is was the responsibility of the government.

    This disparity raises an interesting question: If people were better informed, would they have a different attitude towards policy?



    Income: Census Bureau : Income data

    Poverty: Census Bureau : Poverty data

    Unemployment: Bureau of Labor Statistics : Unemployment Data


    Washington Post article

    Poll results

    Filed under: Economy

    TRA 2001 – The Economic Growth and Tax Relief Reconciliation Act of 2001

    Some notes on tax policy and the macroeconomy


    Budget Consequences
    The Macroeconomy: Spend or save?
    Side note: NBER on the recession
    The IRS letter

    Rebates – the check is in the mail (maybe)

    rebate checks
    will be mailed out beginning in the next few weeks and
    will be up to $300 for singles and $600 for couples. The rebates will go only
    to those that pay federal income tax. This distinction is important
    because even if you’ve paid Social Security or Medicare taxes you may not
    have earned enough income (after deductions) to qualify for the rebate.
    One estimate
    says that 42% of people earning less than $44,000 a year
    will get no check.

    In addition
    to the rebate check, the amount of paycheck withholdings will also change
    (as of 7.1.01).
    Details can be found here. Briefly, rates will drop about ½
    percentage point per year until they reach the new rates.  

    Budget Consequences

    The Congressional
    Budget Office (CBO) has
    revised their estimates
    of the projected surplus. Last January, the
    CBO budget forecasters had expected the surplus (excluding Social Security
    and Medicare funds) to total $489 billion from 2001 through 2004. The more
    recent estimate is $127 billion.

    all of that reduction — $310 billion — was due to the tax cut. Most of
    the remainder was due to lower corporate profit tax receipts from a slowing

    For more
    information see:
    An Analysis of the President’s Budgetary Proposals for Fiscal Year 2002


    The Budget and Economic Outlook: Fiscal Years 2002-2011

    OMB HomePage

    Will the rebate checks boost the economy?

    It depends
    – will people go out and spend the money or will they save it by putting it
    in the bank or paying off credit card bills?

    In theory,
    people are more likely to spend the tax cut if they know that it will be
    a permanent cut. If the cut is temporary, then they should save the money
    to pay for higher tax bills down the road. (Officially the tax cut is temporary
    – to keep the published 10-year cost down, the tax cuts expire after 9 years;
    but most expect congress to make the changes permanent).

    So whether
    or not the cut will spur people to spend depends in part on people’s perceptions
    of the persistence of the cut.

    In addition
    let’s do some simple math to check on the size of the rebate. If every member
    of the workforce were to receive the check (and they’re not), it would mean
    an influx of $300 x 140 Million = $42 Billion. The size of the economy is
    roughly $10 Trillion. So we’re talking about a rebate of 0.42% at most.

    The total cost of the tax cut is about $74 billion this fiscal year, with much of that coming from changes
    in withholdings.

    See the BLS website for labor force data.
    [Note: 7.8.00. The above numbers were adjusted from a previous version of this article to take into
    account the size of the labor force and to correct a math error.]

    Tobin on
    Fiscal Policy: The Macroeconomic Perspective

    The Phantom Recession (con’t).

    A few weeks
    ago I wondered what was happening with this so-called recession that
    everyone is obsessing over. Real GDP in the first quarter of 2001 grew at a slower-than-average-but-greater-than-zero
    1.2 percent. It looks like others are not yet ready to declare a recession

    The organization
    which determined the official beginnings and ends of recessions, The National
    Bureau of Economic Research (NBER), recently (6.18.01) posted
    a note on their website
    saying that the business cycle dating committee
    has yet to meet 

    “In summary,
    the data normally considered by the committee indicate the possibility that
    a recession began recently, but the economy has not declined nearly enough
    to merit a meeting of the committee or the determination of a peak date.”

    The note
    comments that employment has declined only slightly, and that the contraction
    appears to be limited to the industrial sector and has not spread.

    The IRS Letter

    In addition
    to your check from the IRS you will also receive a mailing from the IRS telling
    you to expect a check in the mail.
    It was reported
    that the text of this letter has raised a few eyebrows
    because it appears to be slightly partisan in nature. In addition, the letter
    will cost somewhere between $20 and 30 million.

    From the
    IRS letter
    : “We are pleased to inform you that the United States Congress passed and
    President George W. Bush signed into law” the tax bill, “which provides long-term
    tax relief for all Americans who pay income taxes. The new tax law provides
    immediate tax relief in 2001 and long-term tax relief for years to come.”

    Filed under: Economics