Goldman Sachs Research: Fiscal Stimulus- Passing the Peak Effect on Growth

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US Economics Analyst

Issue No: 09/43October 30, 2009

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Goldman Sachs Global ECS Researchat

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Fiscal Stimulus: Passing the Peak Effect on Growth

Jan Hatziusjan.hatzius@gs.com212 902 0394Ed McKelveyed.mckelvey@gs.com212 902 3393Alec Phillipsalec.phillips@gs.com202 637 3746Andrew Tiltonandrew.tilton@gs.com212 357 2619David Kelleydavid.kelley@gs.com212 902 3053

The 3.5% annualized growth rate reported provisionally this week for third-quarter realGDP was a stronger-than-expected exit fromrecession. It featured rebounds in consumer spending and residential investment, while business fixed investment and state and localspending fell less than we had anticipated.Although precise estimates are not possible,our analysis of the distribution of this growthsuggests a heavy contribution from federalfiscal stimulus. In addition to the widelyreported impact of the “cash for clunkers” program, we see more general evidence of afiscal effect from income support tohouseholds and aid to states and localities.Unfortunately from this perspective, the lastquarter also marked the peak of the impactof fiscal stimulus on growth, at least as weevaluate current law. To those who aresurprised by this statement, we note that: (1)the bulk of last February’s package was intax cuts, income support, and state and localaid, which took effect quickly, rather than inslow-starting investment projects; (2) theeffect of stimulus on growth depends on the

changes

in spending it induces rather than onthe level of spending itself.As the impact of stimulus fades, the onuswill be on job creation to sustain growth. Inthe absence of that, policymakers will almostsurely extend some of these programs. Infact, the first of these efforts is alreadyunderway as several expire before year-end.We do not expect major changes in theFOMC statement next Wednesday. In particular, while officials are reportedlythinking about how they might eventuallymodify the language regarding future interestrates, a change at this meeting is quiteunlikely.

Transfers and Tax Cuts Have CarriedAfter-tax Income in 2009

-200-150-100-50050100150200250300JanFebMarAprMayJunJulAugSep-200-150-100-50050100150200250300Disposable Personal Income (DPI) vs February LevelDPI Less Tax and Government Transfer EffectsBillions of dollars, annualizedBillions of dollars, annualizedSource: Department of Commerce.2009

The Growth Effect Peaks Earlier than the Impact on Spending

-200-1000100200300400Q1Q2Q3Q4Q1Q2Q3Q4-2-101234GDP Level (left)Billions of dollars, annualizedPercentage points, annualized2009Source: Congressional Budget Office. Recovery.gov. Our calculations.GDP Growth (right)2010Impact of Stimulus On:

Important disclosures appear at the backof this document.

GS Global ECS US Research US Economics AnalystIssue No: 09/43

October 30, 2009

I. Fiscal Stimulus: Passing the Peak Effect on Growth

Yesterday the Bureau of Economic Analysis (BEA)marked the onset of recovery in the US economy as it published its provisional estimate that real GDP rose3.5% at an annual rate in the third quarter. This wasin the upper half of the range of private forecasts andwell above our 2.7% estimate. The report featuredrebounds both in consumer spending (+3.4% in realterms) and in residential investment (+23.4%). Real business investment and state and local spending fell, but by less than we had expected (-2.5% and -1.1%,respectively).How much of the rebound in real GDP was due to thefiscal stimulus, and where do we stand in terms of theeffects of stimulus thus far? Although precise answersare impossible at this juncture, several aspects of thereport are consistent with our estimates that the fiscal package enacted in mid-February as the AmericanRecovery and Reinvestment Act (ARRA) would haveaccounted for virtually all of the growth reported for the third quarter. Unfortunately, those same estimatesalso suggest that the growth impact of fiscal stimulushas passed its peak, absent significant extensions or new initiatives. Without these, the fiscal contributionsto real GDP growth will subside between now andmid-2010, after which we expect them to becomedrags. Growth at that point will then require at least amodest pace of job creation to replace the support thatUncle Sam is now providing.

Fiscal Stimulus Helps Third-Quarter Growth…

Gauging the precise effect of fiscal stimulus on third-quarter growth is difficult for two reasons. First, theARRA law had many provisions—in our analysis wesplit it into more than 50 line items—whose effectsare scattered throughout the national income accounts.Second and more importantly, we cannot know whatwould have happened in the absence of the stimulus.That said, we can see clear patterns in the third-quarter data that, in conjunction with prior developments,suggest a strong helping hand from Uncle Sam:

1. The “cash for clunkers” program, which was notactually part of ARRA, spurred a large increase inpurchases of new motor vehicles.

Real outlays onnew vehicles rose to $191 billion (bn) at an annualrate in the third quarter from $154bn in the secondquarter, as shown in Exhibit 1. This accounted for slightly more than two-fifths (1.1 percentage point) of 2.5% annualized increase in real final sales. Althoughwe cannot know for sure how much of the increase invehicle sales was due to cash for clunkers, themonthly data strongly suggest that most of it was.The program was in effect from July 24 to August 24;consistent with that timing, both unit sales and themotor vehicles and parts component of real spendingspiked in August after a more modest increase in July,and the September data show pull-backs to levelsconsistent with pre-clunker behavior.The effect on real GDP is more problematic, as someof this demand was undoubtedly met by drawingdown inventories or by imports. Indeed, real importsof autos and trucks surged more than $27bn at anannual rate last quarter. However, domestic vehicleoutput also rose sharply, accounting for just about half (1.7 percentage points) of the increase in real GDP.Although some of this increase in output would haveoccurred in any event, it is hard to avoid theconclusion that the cash for clunkers program was animportant contributor.

2. Consumer spending on other items probably gota lift last quarter from tax cuts and extensions of benefit programs implemented during the first half of 2009.

While investment and infrastructure projectsgot much of the attention when ARRA was passed lastwinter, a more immediate purpose of this act was toshore up income-strapped state and local governmentsand households—in the latter case via tax cuts andenhancements to unemployment insurance and incomesupport programs. The effects on personal disposableincome are clear; as shown in Exhibit 2, sinceFebruary increases in government transfer paymentsand reductions in taxes have largely offset the effectsof large and persistent declines in labor compensationand in income on assets on disposable income. Whilethe government support did not rise further in the thirdquarter, the level of this support remained high andessentially provided the wherewithal for last quarter’s

Exhibit 1:Real Spending on Vehicles Surges

1501701902102302502702900001020304050607080910150170190210230250270290Billions of 2005 dollars, annualizedSource: Department of Commerce.Billions of 2005 dollars, annualizedPersonal Consumption Expenditure: New Motor Vehicles

GS Global ECS US Research US Economics AnalystIssue No: 09/43

October 30, 2009

increase in spending, as other components of incomecontinued to erode on balance. Given these patternsand the impact of the cash for clunkers program, it isnot too much of a stretch to attribute most of lastquarter’s increase in real consumer spending to fiscalstimulus.

3. The homeowner tax credit helped spark anupturn in residential investment.

This provision of ARRA provides an $8,000 tax credit—an effective price cut of nearly 5% on the median-priced existinghome—to first-time homeowners who buy homes by November 30. It has been widely credited for helpinglift home sales from the historical depths to whichthey fell last winter. Although some rebound was aptto occur from these lows, the timing and magnitude of this year’s gains in home sales and housing starts— increases of more than 20% since January—probablyowe at least something to this tax credit.If so, then last quarter’s increase in real GDP wouldshow the effect in two places. First, brokeragecommissions are part of residential investment. The“other structures” component that includes them rose$7.3bn at an annual rate in the third quarter, or $6.6bnin nominal terms. This latter figure compares closelyto the $7.1bn increase that would be implied from thesales data themselves. Neither one is purely due to thetax credit—“other structures” include manufacturedhomes and major home improvements as well, whilesome of the increase in existing home sales might nothave been due to the tax credit—but it surely played arole. And if it did, then it would also be responsiblefor at least part of the $14.8bn annualized increase insingle-family homebuilding that more than accountsfor the rest of the rise in real residential investment, asmultifamily construction continued to sag.

4. State and local spending would likely have fallenmore if not for ARRA.

As noted above, states andlocalities were also specifically targeted by ARRA inan effort to soften the tax increases and spending cutsthat these jurisdictions had to make to balance their operating budgets. As with the personal incomeaccounts, a large part of this support shows up as asharp increase in federal grants-in-aid beginning in thefirst quarter of 2009, as shown in Exhibit 3. Withoutthis help, it is unlikely that real state and localspending would have rebounded as it did in the secondquarter or dipped as little as it did this past quarter,which marked the first quarter of fiscal 2010 for most jurisdictions. Notably, this increase was concentratedin construction outlays, which rose almost $13bn inthe second quarter and nearly $2bn further in the third.

5. Business fixed investment may have gotten a liftfrom the expiring depreciation bonus.

Given thedepths to which capacity utilization has fallen and thedifficulties many firms have experienced in obtainingfunds, the 2.5% annualized decline reported for real business investment in the third quarter is surprisinglymild. One possible reason is that some companiesaccelerated the purchase of equipment in anticipationof the expiration of the depreciation bonus, which wasextended to the end of 2009 in ARRA.Taken as a whole, these observations imply that theUS economy would have continued to contract lastquarter in the absence of fiscal stimulus. Note, for example, that gains in consumer spending and housingactivity added 4.2 percentage points to last quarter’sgrowth; in other words, without them real GDP wouldhave contracted by another 0.7% (the same as in thesecond quarter). With fiscal stimulus providing mostof the impetus to these increases. plus other components of business and state and local spending,it is hard to see how real GDP could have increasedwithout these programs.

Exhibit 2: Transfers and Tax Cuts Have CarriedAfter-tax Income in 2009

Exhibit 3:Stimulus Helps States and Localities

35037540042545047550007080915151520152515301535154015451550Federal Grants-in-Aid to S&L Govt (left)Real S&L Govt Consumption & Investment (right)Billions of dollars, annualizedBillions of 2005 dollars, annualizedSource: Department of Commerce.

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