Investors Are Scared, and That's the Good News

In case you hadn’t noticed, we’re in a severe recession. Need proof? Take a look at the gross domestic product report that was released Wednesday morning.

The report covered the first quarter of 2009—January, February and March. In inflation-adjusted terms, it was the sixth-worst three-month period since quarterly records started being kept in 1947, with economic output falling 6.1% at an annual rate.

It’s the worst performance for the economy since—uh, I hate to tell you this—since the previous quarter, the fourth quarter of 2008. That one was the fourth worst in history, with output falling 6.3%.

Put those two awful back-to-back quarters together and you almost have a record. They’re the second-worst two quarters in history (the only two that were worse were more than 50 years ago—the fourth quarter of 1957 and the first quarter of 1958).

So perhaps it’s strange that on the same day that horrible data were reported, the Federal Reserve made a statement that has been generally interpreted as optimistic—that “the pace of contraction appears to be somewhat slower.” I guess that’s what passes for optimism these days.

But it’s true. Stocks are off 44% from the October 2007 all-time highs. But they’re up 29% from the lows two months ago. Credit markets have begun to calm down, too.

And if you know how to look at it, even that ghastly GDP report has some encouraging elements.

For one thing, as has been widely reported, 2.8% out of the 6.1% drop in output—almost half—was due to liquidation of inventories. In case you don’t understand what that means, let me explain.

When manufacturers add to their inventories, it means they’ve produced goods but haven’t sold them yet. So the GDP report counts those goods as part of economic output, even though they’re sitting in a warehouse somewhere. So later, when those goods are actually sold, it counts as a decline in output.

In the first quarter of 2009, manufacturers reduced their inventories by $137 billion, the most in more than 20 years. The bad news is that they were apparently so pessimistic about the economy, they emptied those warehouses and didn’t fill them back up. The good news is that with empty warehouses, as soon as there’s even a hint of economic recovery, factories are going to have to run full throttle to fill them up again.

Another element that’s been widely reported is that consumer spending was up for the quarter. Personal consumption expenditures grew at a 2.2% annual rate. That’s a decent number at any time, but in the context of a deep recession, it’s downright amazing.

And all the more so, because it completely confounds some of my least-favorite economists—those perma-bears who think they’re geniuses now, just because we’re finally in the recession they started predicting 10 years ago. These are the guys who said that the U.S. economy is doomed to blow up and never recover because of the profligate excesses of consumers—credit-card waving maniacs who spend, spend, spend, borrow, and spend again.

The perma-bears always point to the fact that personal consumption has come to make up a huge fraction of overall GDP. At its peak in the second quarter of 2008, it made up 70.9%. Then the wheels started coming off the economy, and consumption plummeted. In the fourth quarter of last year, the consumption share of GDP had fallen to 60.9%, and the perma-bears started saying we were heading into a “new era.”

One prominent bear said it would be a new era of “scrimp and save.” Another said it would be a new era of the “frugal future.”

Well, it turned out that the new era was really the old era. In the first quarter just reported, with GDP down and consumption up, consumption now represents 70.8% of GDP—the second-highest percentage in history.

So if the profligate, over-indebted U.S. consumer isn’t blowing up, what is? Other than inventories, what’s responsible for the first quarter’s big drop in output?

Simple. It’s really mostly one thing. In fact, it’s all one thing—investment. That means housing, office buildings, equipment and software. It accounts for 6% out of the 6.1% decline in output. All the other factors cancel each other out.

And what does that tell you? It tells you that what’s wrong with this economy is investing. Nobody wants to take any risk. All the money’s in T-bills. But we already knew that, right? After all, the banking sector and the credit markets completely froze up last autumn. And the bear market we’ve been in has been even worse than the one that occurred during the Great Depression.

And that’s really terrific news.

Huh? What’s so terrific about that?