INSIGHTS: THE FATAL FLAW OF THE GDP MEASURE, AND WHY IT LEADS TO BAD POLICY
GUEST COLUMNIST: Bradley Thomas, a libertarian activist and writer, published at Mises Insitute, Libertarian Insitute, AustroLibertarian.com, and Foundation for Economic Education.
On the eve of the Great Recession, former President George W. Bush in a 2007 speech urged people to “go shopping more” in order to keep “our economy growing.”
Indeed, the business press scarcely completes a report on the U.S. economy without informing us that “consumer spending makes up 70 percent of the economy.”
If the politicians and business media are to be believed, consumption is king. Consumer spending drives the economy.
But does it?
The laser-like focus on consumer spending as the driver of economic health is largely the result of the government’s premiere measure of the economy: Gross Domestic Product (GDP).
Significant flaws in how GDP is measured, however, not only make it a misleading indicator, but have led to erroneous conclusions about what makes the economy tick. Such errors lead to extremely costly and damaging public policies.
In short, GDP attempts to measure the total value of finished goods and services produced in the nation in a given period – typically a year.
But does this focus on final goods paint an accurate picture of total economic activity? As any reader of the classic Leonard Read essay “I, Pencil” can attest, the bulk of economic activity lies well beneath the surface level of the finished product we see on the store shelves.
Finished products are typically transformed through multiple layers of intermediate stages from their beginnings as raw materials to the finished good. Aiding in the transformation process are capital goods, labor and complimentary inputs that are required to bring the final product to fruition.
This is where the shortcomings of GDP’s methodology are revealed.
The fallacy of “double counting”
To avoid what economists call “double counting,” GDP does not count money spent by businesses investing in intermediate goods.
Intermediate goods are classified as those goods used up in the production of a final good. For instance, a loaf of bread sold on the shelves at the grocery store is a final good. Machines like mixing bowls and ovens purchased by the bread maker and used to make the bread are also considered final goods for GDP calculations, because they are not used up in the production process.
In contrast, the flour, wheat and other ingredients produced and then included in the finished bread are considered to be intermediate goods. As such, money spent by the bakers on these items are not included in GDP. Similarly, the trucking company that delivers the flour to the bakery provides what is considered an intermediate service, so money spent on such transportation is likewise left out of GDP.
The classic explanation for avoiding the ‘double counting’ of intermediate goods in GDP is exemplified by claiming that if the sale of steel were added to Ford’s sales, the steel would be counted twice; once when it was sold to Ford and again when Ford sells the car containing said steel.
Such logic is faulty, however, because it conflates the total value of intermediate goods with their value added to the final sale price.
Returning to the example of bread, we can imagine this simple example:
A fertilizer manufacturer sells wheat seeds to a farmer for $1
The wheat farmer then sells his grown wheat to the flour miller for $3
The flour miller then sells his flour to a baker for $5
The baker processes this into bread, and sells the bread to the consumer for $6
The final sale price of the bread is $6, but total money spent on intermediate goods in the process is $9. Obviously, the total amount spent on intermediate goods is not included in the final sale price.
What is included in the sale price is value-added at each phase by the intermediate goods.
The fertilizer manufacturer’s value-added is $1
The wheat farmer’s value-added is $2 (the $3 he sold the wheat for minus the $1 he spent on fertilizer)
The flour miller’s value-added is $2 (the $5 he sold the flour for minus the $3 he spent on wheat)
The baker’s value-added is $1 (the $6 he sells the bread for minus the $5 he spent on flour)
It is the value-added that comprises final sales price.
Business investment spending, not consumption, is majority of spending in economy
Once all the spending on intermediate goods is also factored in, consumer spending only comes to about 30 percent of the economy.
Economist Mark Skousen has for years written about this vital insight, and his efforts paid off years ago when the Bureau of Economic Analysis developed a measurement called “Gross Output” (GO) that captures all economic spending. This measure reveals that the majority of economic activity involves not consumption spending on finished goods, but businesses investing in the production of such goods.
From this, we can surmise that consumer spending indeed does not drive the economy.
Increased consumer spending the result of, not the cause of, economic growth
Society can not consume its way to prosperity. Savings provides the necessary resources for businesses to invest in productive activity, and business spending on production is what truly drives the economy.
To further underscore the primacy of investment spending to economic conditions, consider the following data from the Great Recession: According to the 2010 report of the president’s Council of Economic Advisers, private consumption spending dropped by only 2 percent from its peak in the fourth quarter of 2007 to its low point in the second quarter of 2009.
Total private investment spending, however, began its much more significant drop nearly two years earlier. Total private domestic investment reached its high point in the first quarter of 2006 and then fell by roughly 36 percent to its low point in mid-2009.
Bad measures lead to bad policy
Relying on the flawed and misleading GDP measure to gauge economic health leads politicians to favor destructive policies aimed at the wrong goals. Politicians focus on initiatives to “stimulate” consumer spending at the expense of savings and investment, which can lead to greater consumer debt and a depletion of the economy’s productive capacity.
A drying up of the pool of resources needed to fuel productive investment translates to economic stagnation, harming low-skilled people disproportionately because they are often the first to be laid off when the economy turns south.
One of the most widely-accepted, and damaging, economic fallacies is the notion that consumer spending drives the economy. The government’s most widely publicized economic measure, GDP, is largely to blame.
To improve our economic conditions, more need to reject the flawed GDP measure and the damaging conclusions it leads to.
ON THE ECONOMY: GOLD DUST WOMAN
John Dunham, Managing Partner, John Dunham & Associates
Well did she make you cry, make you break down, shatter your illusions of love? And now tell me, is it over now, do you know how? Pickup the pieces and go home – go home – go home. So go the lyrics to the chorus of the 1976 song Gold Dust Woman, written by my all time favorite artist Stevie Nicks, and recorded by Fleetwood Mac on their legendary Rumors album. While nominally about cocaine, Nicks said that the song itself was a symbolic look at somebody going through a bad relationship, doing a lot of drugs, and trying to make it. Trying to live. Trying to get through it.
Many Americans today are still just trying to get through it, in spite of record employment statistics, an extremely low unemployment rate, virtually free credit, and reportedly no inflation. But something must be wrong. If the economic statistics are correct, the economy is booming and families should be thriving. However, at the same time one of the country’s major political parties is literally calling for a socialist revolution.
The disconnect might be due to the fact that the statistics rely on an underestimate of inflation. This is not because of some sort of conspiracy, or because the folks toiling away at the Bureau of Labor Statistics or the Commerce Department are not doing their job. It’s simply that all statistical measures – and all data for that matter – have inconsistencies in them that often times give the wrong signals.
Inflation does not necessarily mean nominal price increases. For example, it there are 100 fetchmarks in an economy, and they are used to purchase 100 pounds of products, the value of a fetchmark is 1 pound of products. If the national bank were to revalue the currency such that the new fetchmark is worth 1/10th of an old fetchmark, nominal prices would increase to 10 fetchmarks a pound. This is not inflation as long as fetchmark holders can easily transfer their currency at a 10 to 1 rate. Rather, inflation is a reduction in the value of a currency relative to a neutral measure. If for example, one could purchase 10 ounces of gold with a fetchmark prior to the revaluation, but just 1 ounce of gold following the revaluation, then there would have been 9000 percent inflation in the economy.
Also, inflation is not a measure of relative supply and demand for a single product or service. If, for example, people want to travel a lot over Thanksgiving the demand for airplane seats will rise relative to the supply, and therefore the market clearing price will rise over that period. Once travel patterns settle back to normal prices will fall.
Inflation is a monetary phenomenon. It occurs when the amount of currency in an economy outstrips the quantity of goods and services. If a government prints currency to pay its bills, but the economy does not create additional useful products or services, there will be inflation. Likewise, if an economy creates more stuff while the amount of currency in circulation remains the same, then there will be deflation.
The US government uses a statistic known as the consumer price index (CPI) as its benchmark measure of inflation. The CPI is based on a sampling of products and services sold around the country. It is adjusted to account for changes in consumer purchasing patterns, as well as a sort of arbitrary measure of changes in the quality of products and services. Because of these adjustments, the CPI underreports actual inflation. The government has other inflation indicators. The Federal Reserve uses the index of personal consumption expenditures (PCE) as its measure. There is also the producer price index (PPI) which measures input costs into the manufacturing process.
So how do these measures stack up against a neutral indicator, in this case, the price of an ounce of gold? Following World War II, an ounce of gold was established to be $35. This gold standard was abandoned during the Nixon Administration in 1971, when rampant inflation forced the US to start to devalue, and it was completely abandoned in 1976. After that, the value of the dollar was left to float. So what happened?
Since the end of the gold standard, the value of a dollar has fallen relative to an ounce of gold, such that a dollar today is worth just 8.5 percent of a 1976 dollar. In other words, if it cost a dollar to purchase a sprocket in 1976, it would cost $10.80 in today’s dollars. This is a baseline measure of inflation. But people don’t purchase a lot of gold, and anyway, all currencies float today. So another baseline measure would be to look at the value of a dollar versus the currencies of trading partners. Here over the same period the dollar has fared much better, actually decreasing in value by just 6 percent. This takes into account that all major countries have been experiencing pretty substantial inflation following the end of the gold standard.
During the period where the dollar’s value decreased by 91.5 percent against gold, the CPI measured the dollar’s value decreases by 78.4 percent, the PCE indicated a decrease of 92.5 percent and the PPI a decrease of 69.8 percent. So, against a gold standard, the PCE statistic used by the Federal Reserve is a better measure.
But what about the price of important goods like gasoline or housing? Beginning with a 1987 base year, both home prices and gasoline prices have increased by about 234.0 percent in dollar terms, which is just slightly slower than what would be indicated by the gold standard. Both have grown faster than the CPI which is up by 131.4 percent, so yet again, the CPI seems to be underrepresenting inflation in important markets. The same is true for both the PPI, while the CPE is growing at double the rate, meaning consumers are spending less of their income on housing and gasoline as a percent of total.
While prices in general, and prices of key goods have been rising, wages as measured by the employment cost index (which includes benefits), have been growing at a much slower rate. Beginning with data from 2001, overall compensation is up by 62.9 percent. Over the same period inflation as measured by CPI is up by 47.0 percent, meaning that the statistical measure of real wages has been rising. But if PCE, housing prices or gasoline prices are used as denominator, real wages are down, and if wages are compared to the price of gold, they have fallen by almost a third since the beginning of the century.
All of this suggests that at best, the average American has held their own against prices since 2000, but using indicators like prices for key products or gold, people are becoming relatively poorer. There are improvements based on the quality of products – TVs, computers and cars are better now than they were in 2000; but it is taking a larger and larger share of income to pay for them. The data also show that inflation is insidious in the world economy, and while the US is doing better than most, suggesting that prices are tame is incorrect. This should get all of us to think more about what the media is reporting on our economic situation. In the end it just might, make you break down, shatter your illusions and maybe even make you cry.