“Kee” Points with Jim Kee, Ph.D.

  • Fourth Quarter GDP
  • Thoughts on Growth
  • Policies and Growth

Fourth Quarter GDP

Fourth quarter 2017 annualized GDP growth came in at 2.6% (advance estimate), a bit below 3% expectations but pretty solid. Following the advance estimate is a second and third estimate, each containing more complete information. On average these revisions tend to be positive, according to the Bureau of Economic Analysis that publishes the numbers. An upward revision would also be consistent with the various Nowcasting models. For example the Atlanta Fed’s GDPNow model’s final 4th quarter estimate is 3.4% (3.8% for the New York Fed’s model). The second estimate will be released on February 28th, and third estimate will be released on March 28th. First quarter 2018 estimates by the Fed and by private sources have started out strong in the 3%+ range. I suspect they will be revised down somewhat as the quarter progresses, which is the typical pattern for first quarter GDP.

Thoughts on Growth

I have mentioned before that I think the most interesting part of the policy landscape is the interaction of tax cuts with a switch in direction in regulatory policy. But I don’t really think much of “econometric” (economics and statistics) models that attempt to estimate the impact of various policy levers. I pay attention to the likely direction that growth might take, but not so much the numerical estimates. Growth really happens at the individual enterprise level, which takes initiative, and that is a very hard thing to anticipate. I have mentioned before UCLA economist Arnold Harberger, who has probably been involved with more countries and their economic policies than any living economist. Harberger emphasizes that we don’t really know as much as we would like. His exchange with the IMF some 15 years ago is instructive:

IMF: Let’s talk in more general terms now about the link between growth and economic policies…How do we bring in the role of economic policies?

Harberger: Certainly bad policies can screw up growth – we have plenty of evidence of that. Bad policies can stop investment from happening or make the return on investment low. But can you predictably make the rate of return on an investment jump to 20 percent by doing two or three things on the policy front? No. When you get right down to business, there aren’t too many policies that we can say with certainty deeply and positively affect growth.

I’ve mentioned Harberger’s work before, particularly his Presidential Address to the American Economic Association in which he used the mushrooms versus yeast analogy. True growth and innovation is pretty sporadic and unpredictable, like mushrooms popping up, rather than evenly spread across the economy, like yeast causing bread to expand evenly. Harberger’s deeper point was that the true innovation and disruption that characterizes growth lie in what he called “Real Cost Reductions,” or RCRs. Let me expound on that, as I think you will find it insightful.

Economists talk of “costs curves,” usually a downward sloping curve that shows that the cost of producing a good or service usually falls as you produce more of them. That’s because fixed costs, like an engine die or metal fabricating machine (or insurance or accountants) are spread over more units of output, often called the volume effect (per unit costs decrease with increases in volume). If General Motors only produced 10 cars, the cost per car would be in the millions of dollars. But by producing thousands of cars, the cost per car is dramatically lower. That’s a very simple point in economics that people often forget, i.e., that how much an item costs to produce depends upon how many of them are made. A company generating real cost reductions, like Uber or Lyft in transportation services, dramatically lowers the costs of providing services (rides) to customers, allowing these companies to take market share from existing businesses, in this case taxicab companies. This forces the existing businesses (taxis) backward (and upward) along their cost curves. They are now selling fewer rides, so their costs - cost per ride - are higher because of the volume effect. Many go under or have to dramatically reduce their scale of operations, their fixed costs. Since customers spend less for rides, they have more money to spend on other things (including rides), so aggregate activity increases. That’s how economic growth happens. It's no different than when agricultural innovation reduced the number of people engaged in farming from roughly 30% of the population a hundred years ago, to less than 2% today, but with dramatically higher output. Taxicab operators now, just like farmers then, have to find something else to do, which is the disruptive part, but it is also why economic activity in the aggregate increases. That’s how economic growth is achieved.

So that’s an economist’s description of the disruptive effects of innovation, which is the unfortunate side effect of the process of economic growth. As economist Paul Romer, former World Bank Chief Economist put it, “Everyone wants progress. Nobody wants change.”