IN THIS ISSUE:
1.About the US Bureau of Economic Analysis
2. Major GDP Calculation Revisions Coming in July
3.Research & Development Becomes Capital Investment
4.Artistic Originals – Art, Movies, TV Shows, Books, Etc.
5.Changes Needed, But Can Be Tricky in Practice
6.Hanlon Investment Management Luncheon
You may have heard that the government is going to make some major changes in how our Gross Domestic Product is calculated later this year. Your first thought might be that this is no big deal. However, I will argue today that it is a very big deal, the biggest in a decade, and you need to know why. So I hope you read what follows with more than a passing interest.
Last week, the Commerce Department’s Bureau of Economic Analysis (BEA) announced it will be making some significant revisions to the way it calculates Gross Domestic Product in late July. This change is somewhat controversial in that it is expected to add a whopping 3% to GDP in one fell swoop in the last week of July. That’s about $1,500 worth of extra goods and services for every person in the US!
The reason for the changes is the fact that our economy increasingly depends on the production of intangible goods, and we need to recognize that the production of ideas is an important form of investment. So in the future, the BEA is going to count a company’s research and development as a form of investment just like the purchase of a new office building. And the creation of a lasting work of art – a painting, a movie, a television series, etc. – that can be sold year after year will, likewise, be treated as a capital investment.
Since the US GDP is increasingly made up of intangible assets, some of these revisions probably make sense. Yet the caveat is that intangible things such as R&D and art are far more difficult to value precisely. We’ll discuss the upcoming GDP revisions coming in July and whether or not such changes are a good thing, as we go along.
But I would be remiss not to first mention last Friday’s encouraging “advance” GDP report. The Bureau of Economic Analysis estimated that 1Q GDP rose 2.5% (annual rate). Although the increase of 2.5% was below the pre-report consensus, it was a welcome relief from the mere 0.4% growth in the 4Q of last year.
About the US Bureau of Economic Analysis
The periodic US Gross Domestic Product estimates that are released monthly are arguably the most watched economic reports on the planet. Before we delve into the sweeping changes that lie ahead for how GDP is calculated, let’s take just a moment to understand what the BEA is and how it operates.
The BEA’s mission is to provide the most timely, relevant and accurate information on the US economy. The BEA's GDP estimates are key ingredients in how we make critical decisions on a wide range of issues including monetary policy, tax and budget projections, business investment plans, etc., etc.
The BEA is part of the US Commerce Department and is widely considered to be non-partisan. The Director of the BEA is Steve Landefeld, who has served in that position since 1995 under both Republican and Democratic presidents. Mr. Landefeld has presided over a number of GDP revisions, which typically happen every five to six years.
Major GDP Calculation Revisions Coming in July
The revisions slated to be revealed in late July, however, are said to be the most significant in more than a decade, not only for the changes themselves but also due to the fact that they are expected to instantly add about 3% to the overall size of GDP.
According to last Friday’s advance estimate of 1Q GDP (+2.5%), the US economy topped $16 trillion for the first time ever ($16.010 trillion) according to the BEA. If the revisions coming at the end of July are as large as expected, that will mean that GDP will instantly swell by almost $500 billion to near $16.5 trillion. That’s the equivalent of adding another Pennsylvania to our economy!
In addition to the sheer size of the changes, these revisions will be applied all the way back to 1929. Even the BEA admits that it is “re-writing US economic history,” much as Hollywood writers and directors remake old movies (more on that below).
GDP seeks to capture the value of all goods and services produced within the US in a given period (quarterly). The BEA generally does this by measuring the value of goods purchased by consumers. The BEA calls these purchases “Personal Consumption Expenditures” or the PCE Index.
The logic goes like this: When you buy a washing machine, the price you pay captures the value of the work of everybody in that chain of labor and the cost of materials that went into creating that washing machine. That includes the sales clerk who sold it to you, the trucker who delivered it, the factory worker who assembled it, the marketing staff that created the advertising, the raw materials used to build it and the salaries of the executive officers who run the company that made it.
But when the washing machine company invests in long-lasting assets – such as a factory or a package of accounting software – it contributes to GDP in a different way that is referred to as “fixed investment” that is expected to have a payoff over a long period of time. This spending is treated differently than the routine expenses involved in producing a specific product.
Research & Development Becomes Capital Investment
The single biggest change to the GDP methodology in July will be theinclusion of R&D as a capital investmentinstead of just a cost of producing goods. Initial estimates show that this R&D change will add a little more than 2% to overall GDP starting in 2007 (the base year of the new methodology). About two-thirds of that increase in GDP will come from the private sector and around one-third from government.
Brent Moulton, head of national accounts at the BEA, put it as follows: “The world economy is changing and there’s greater and greater recognition that things like intangible assets are very important in the modern economy and play a role similar to tangible capital that was captured in the past.”
The changes will have a ripple effect. The new methodology will make corporate profits look larger, as companies will no longer be counting net R&D after depreciation as a cost. BEA Director Steve Landefeld said that the inclusion of R&D was just the beginning to help get a more accurate picture of growth. “You need to go further in this exploration of investment in intangibles. R&D – the scientific and engineering stuff – is just a piece of the puzzle.”
Artistic Originals – Art, Movies, TV Shows, Books, Etc.
The Internet Movie Database (IMDb.com) may not seem like a natural source of information for the BEA, but its researchers scoured through film studio records as far back as the 1920s to build a database on the history of investment in movies.
The result is not only an estimate of the capital value of all America’s movies, TV programs, plays, books, greeting card designs, etc., but also a fascinating picture of how their importance to the economy has changed over time.
A film or book or TV series is often produced in one year but may be enjoyed for many years thereafter. For example, it is estimated that the popular sitcom SEINFELD has generated $3.1 billion in revenue since it went off the air in 1998.
Another example is George Lucas, the writer, producer and director of the popular STAR WARS movies. His company spent a lot of money to create these films. It owns the copyright and has made money for many years afterward on that investment. The same is true for a lot of “intellectual property.” For example, when Apple researchers develop the next iPad, or Stephen King writes a new science fiction novel, it will be an upfront investment that will likely have a long payoff.
So starting in July, the BEA will treat the creation of artistic works as longer-term capital investments, not unlike factories, equipment or software. In the current system, the value of the economic output of a Star Wars movie would only show up in GDP over decades to come, in the form of personal consumption expenditures like movie tickets and DVD sales. With the new revisions, that value will show up in GDP sooner.
Preliminary research by the BEA puts investment in artistic originals at $70 billion for 2007, so that figure will go into GDP (how they arrived at that figure is not clear). These figures may ignite some controversy because they will amount to the first official estimate of the value captured from copyright laws.
New Pension Accounting Changes, Finally
The change with the most counterintuitive results is pension accounting. At the moment, the BEA counts what companies actually pay into a defined benefit pension plan as wages, and ignores whether the plan is in deficit or surplus. After the new change, it will measure what companies have actually promised to pay.
Measured federal government spending on pension benefits will fall because it has funded its plans better, while state and local government benefit spending will rise because they have promised considerably more than they have paid in.
This change will also result in an instant increase in GDP estimated at about $30 billion in 2007 (the base-year). But wait, aren’t many pension plans woefully underfunded? Yes, but under the new rules, the GDP effect is based on what an employer should have paid to fund pension benefits, not what was actually paid. Thus, GDP is positively affected because it will measure employers’ promises going forward.
Having a BEA estimate of the size of pension deficits and their cost could prompt an important shift in the political debate over the future of defined benefit plans. In any case, changing pension fund accounting to reflect employer promises seems like a good idea.
Other Changes of Interest
Some other changes are technical in nature but are still important. For example, the BEA plans to change how commercial banks measure the cost of running customer accounts. Currently, the BEA does not account for services provided by commercial banks for which no specific fees are charged – such as clearing checks, distributing funds, protecting deposited funds, etc. The BEA believes this will make the price of banking services less volatile.
Another update will be to treat all of the costs of buying a house – such as attorney fees, stamp duty (document tax), etc. – as investment rather than spending. That is expected to add about $60 billion to GDP for base-year 2007. At present, only real estate agent commissions are capitalized.
And the BEA will also speed up the depreciation of those commissions, writing them off over the average 12 years that people stay in a house, instead of over the expected 80-year life of the structure. As a result, the change will lower net savings and corporate profits.
I could go on, but these are the highlights of the GDP revisions coming in late July.
Changes Needed, But Can Be Tricky in Practice
The new GDP revisions coming from the BEA probably make sense in most cases, especially as our economy increasingly moves from tangibles to intangibles. But valuing many intangibles can be tricky in practice.
When calculating the value of an investment in a truck, we rely on the market price of trucks. When calculating the value of an investment in a new building, we rely on the market price of the land, labor, and the material it takes to construct it.
But research and development and artistic originals aren’t commodities that can be priced like a bushel of corn or an ounce of gold, both of which are traded daily on exchanges around the world. So most likely, the BEA will be forced to value intangibles based on the most recent price paid for that investment, product or service, which could vary greatly. This is where it becomes risky.
For example, there’s no guarantee that an expensive movie is more valuable than a cheap one, and there’s no reason to believe the amount of money spent on a research program is a proper assessment of its value. In effect, this will leave us with the conclusion that a wasteful R&D undertaking adds as much or more to the economy than a thrifty and effective one.
The difficulty of properly valuing these intangible investments is one reason other countries generally haven’t counted them as capital goods. But in a digital, ideas-driven economy, intangibles are increasingly important. The 3% increase in overall GDP coming in July may not be a game changer, but it’s definitely more than a rounding error.
Simply ignoring intangibles gives a misleading picture of the state of the economy, and the new system probably is a step forward. But it is controversial in that valuing intangibles can be difficult and thus susceptible to error (and manipulation). An economy dominated by the output of bushels of wheat and tons of steel is relatively easy to measure, whereas a modern service and information economy simply isn’t.
At the end of the day, we know that measuring economic output involves a good deal of approximation – even using today’s BEA methodology and assumptions. There will be even more approximation when the revisions go into effect in late July. Only time will tell if the new revisions give more or less accurate data.
The question is, will the BEA’s GDP estimates continue to be the most watched economic reports on the planet after the revisions in late July? Time will tell. With the information I have presented today, you will at least be in a better position to judge.
Finally, it will be most interesting to see how the Obama administration and the Democrats will react to this large 3% jump in the size of GDP at the end of July. Follow me here. We just learned that 1Q GDP went up 2.5% (first estimate) in the 1Q (annual rate). Let’s say it goes up 2% in the 2Q. Then the BEA plugs in this huge one-time revision which adds 3% on top of the 2%, thus making the number 5%. That’s a big number!
Will Obama and the Dems try to fool the public by saying the economy is now growing at a rate of 5%, or will they be honest and point out that most of that increase was due to a historical one-time GDP revision? You can bet I will follow-up, depending on whether they try to “spin” it to their advantage!
Hanlon Investment Management Luncheon
We are hosting a lunch seminar in Austin on May 8th featuring Hanlon Investment Management, a Registered Investment Advisor managing apprx. $3.5 billion in assets. As I noted in myJanuary 8 E-Letter, Hanlon’s Managed Income Strategy is an innovative approach with the potential to increase your returns with an eye on capital preservation.
If you live in the Austin area, or will be in Austin on Wednesday, May 8th, call Joanne at 800-348-3601 to reserve your spot. The lunch seminar will be at the Westin Hotel in The Domain at 11:30 AM. This is also an opportunity for me to meet you personally – I always love to meet my readers and clients. Seating for this event is limited, so I urge those in the Austin area to reserve your spot as soon as possible. I hope to meet some of you there.
Wishing you honest economic data,
Gary D. Halbert
© Halbert Wealth Management