The market got a nice surprise on Friday morning when the Department of Commerce reported that the U.S. economy grew 2 percent (PDF) in the third quarter. That’s better than the consensus estimate of 1.8 percent by economists surveyed by Bloomberg, and a good bit stronger than the 1.3 percent pace in the second quarter. Investors were clearly expecting to be disappointed; the Dow Jones popped by about 25 points during the first few minutes of morning trading. But as they dug into the numbers, those surprised smiles turned into grimaces, and the selloff that’s been going on for the last nine days continued apace.
That’s because that 2 percent headline number looks a lot better than it actually is, which is scary because 2 percent isn’t exactly robust to begin with. “Lukewarm” might actually be an overstatement. It’s certainly not enough growth to eat into the 7.8 percent unemployment rate. Or produce enough tax revenue to reduce the deficit. A good chunk of that 2 percent growth came from a bizarre surge in defense spending that masks some pretty crappy fundamentals, particularly on the business side of things.
After falling for the previous eight quarters, total government consumption and investment grew 3.7 percent during the third quarter. Most of that came from the federal government, which increased 9.6 percent. And most of that came from national defense spending, which surged 13 percent, after a string of three straight quarterly contractions of 0.2 percent, 7.1 percent, and 10.6 percent going back to the fourth quarter of last year. That’s a head-scratcher for a lot of economists. Julia Coronado, chief North America economist for BNP Paribas (BNP:FP), says she and her team called the Bureau of Economic Analysis on Friday morning to ask about the blip in defense spending. “They said it was this odd category related to maintenance,” says Coronado.
Given the drawdowns that are happening in Iraq and Afghanistan, defense spending so far this fiscal year has been below the budget, says Coronado: “So they either had to use it or lose it.” That spending could’ve gone to anything from planes and tanks to any other kind of field equipment. Given the automatic defense cuts included in the fiscal cliff, this might be a bit of a last hurrah for defense contractors. The sudden surge in national defense spending and investment pushed the seasonally adjusted annual rate from $807.8 billion to $834.6 billion. ”The idea that we’ve clustered this huge amount of defense spending into this one quarter is not a positive for the economy,” says Mike Englund, chief economist for Action Economics. “It’s nice to see that 2 percent headline number, but the defense boost certainly drained from activity in the fourth quarter.”
So is this a case of those “Chicago guys” in the White House goosing the numbers in the lead-up to the election, as Jack Welch not so subtly intimated after a surprise jobs number earlier this month? Not likely. “This is a huge difference between Jack Welch’s claims of the administration cooking the books,” says Englund. “It’s a completely different animal.” Defense spending tends to be lumpy, since it’s mostly for big-ticket things. Buying an extra plane or tank can spike spending by a few hundred million dollars. According to Englund’s reading of the data, spending spiked in May and June, flattened in July and August, and then spiked again in September. Figuring out that volatility is a “matter of sorting through the big procurement projects that went through,” says Englund.
This also looks to be a situation where the lack of resolution surrounding the fiscal cliff seems to have benefited the Obama administration less than two weeks before the election. Defense analyst Michael O’Hanlon, a senior fellow at the Brookings Institution, writes in an e-mail: ”Looming sequestration convinced people to finalize contracts with previous year budget authority so it wouldn’t risk being lost.” In other words, smoke ’em while you got ’em.
More troubling, though, is just how bad business investment continues to be. Spending on equipment and software was totally flat from last quarter. The last time that happened was the second quarter of 2009, during the absolute teeth of the recession. Meanwhile, consumers are downright giddy, sharpening the divergence with gloomy corporations. Personal consumption rose 2 percent. Cars and trucks continued to fly off the lots as auto sales grew at an annual rate of 14.9 million, the fastest since March 2008. Consumer sentiment is higher than it’s been since September 2007. Which is just plain weird. Ignorance, it seems, really is bliss. When it comes to the fiscal cliff that’s looming just a few months away, consumers are “happily oblivious,” says Coronado. “They’ve been humming along not understanding what the cliff means or how they’ll be impacted.”