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It’s Time for a New Measure of Economic Growth

by Guest Author Martin Hutchinson, Global Investing Strategist, Money Morning

Gross domestic product (GDP) is the most commonly used measure of economic growth. But GDP isn’t just inaccurate and misleading – it’s the contrivance of Keynesian economists seeking to push their own, big-government agenda.

That’s right. GDP is a financial ruse – the biggest of the past half-century. And it’s time to move past it to another, more accurate measure of economic growth.

Keynesian economist Simon Kuznets designed GDP at the height of the New Deal era. Kuznets first revealed the measure in a report to Congress in 1934. GDP takes into account consumption, investment and government expenditure to create a measure of economic growth.

But the Keynesians employed some chicanery, or sleight-of-hand, to generate this statistic. A close look reveals the dirty little secret about GDP:  It intentionally overplays the importance of government spending – and in doing so inflates the role that Washington plays in each of our lives.

And it’s been doing this for 77 years …

The Biggest Lie of the 20th Century

Gross domestic product is supposed to be a measure of all the goods and services produced here at home.

But there’s a discrepancy.

You see, private-sector output is measured by the price people are prepared to pay for it. But government output is fudged: It’s measured by its cost.

That means GDP increases any time the government spends money. It doesn’t matter if that money is actually put to productive use or not – GDP rises nonetheless.

The bureaucrat devising regulations that damage business? His salary increases GDP. The $300 million Alaskan “bridge to nowhere” of a few years back? That was $300 million added to GDP. The jet-fighter project that costs billions, and is plagued by huge overruns that lead to its cancellation? Those billions add to GDP.

Even public-spending “stimulus” programs, however foolish, are always effective according to the GDP definition, because their cost is simply added to output.

It’s obvious why big-government Keynesians would like this calculation: It substantiates their claim that government spending stimulates economic growth.

In the real world, however, this makes no sense. Indeed, none of the examples above actually add to economic welfare.

Don’t misunderstand – some government output is very valuable. We could not exist in a free society without a court system that protects our property rights and a national defense that protects our borders. In most other cases, however, if government output were truly cost effective, the private sector would’ve already taken the initiative (and probably done so at lower cost and greater impact).

So how can you get an accurate measure of economic growth?

Arithmetically, there’s a simple solution: You take Line 1, “Gross Domestic Product,” in the Bureau of Economic AnalysisGDP Table and subtract from it Line 21, “Government Consumption Expenditures and Gross Investment.”

That gives you a net number, which we can call “gross private product,” or GPP. It’s a measure of all the output produced by the private sector. In general, it will underestimate national “welfare” unless government is really bad. But it will give you a much better idea of the output the market economy is producing.

Indeed, looking at GPP’s past performance helps to explain some things that GDP doesn’t.

Keynesians like to proclaim that World War II got America out of the Great Depression: Thus, if you make stimulus big enough, it will solve economic problems.

This is the biggest lie of the 20th century.

A New Measure of Economic Growth

If you look back through history, and look only at GDP, it seems correct. After all, GDP did increase sharply during World War II.

But if you look at GPP, the real story becomes quite clear.

GPP declined somewhat more than GDP at the beginning of the Depression, as U.S. President Herbert Hoover threw money about in a futile attempt to stop the horrific downturn.

Then it increased somewhat more slowly than GDP during the 1930s, falling back in 1937-38.  GPP really took off after that, rising at more than 9% per annum in 1938-40. New Dealer losses in the midterm elections of November 1938 had put an end to some of the group’s spending and most of their meddling.

When war came, GPP collapsed while GDP rose. By 1944, GPP was down to half its 1940 level, and 25% below where it was in 1932 at the trough of The Depression. Then when war ended, it took off. In 1946, while GDP fell, GPP more than doubled, as the economy was converted to peacetime. Overall, however, the GPP level in 1946-48 was about 10% to 12% lower than it would have been had the 1938-40 recovery continued – or had the economy continued steady growth after 1929.

By the GPP measure, the U.S. economy was recovering quickly by 1940. The war caused a huge downturn, but postwar reconstruction saw it bounce back, although not quite to the level it would have reached had the war not happened.

That narrative makes far more sense than the conventional Keynesian fable – that the manufacture of guns, tanks, uniforms and other instruments of war alone led to an economic revival.

The ultimate fallacy of Keynesian analysis was demonstrated last weekend, when Nobel Prize-winning economist Paul Krugman claimed that an excellent solution to our economic problems would be to stage an imaginary invasion by space aliens.

Under Keynesian analysis, all the money spent making weapons and munitions to fend off aliens would boost the economy, as it allegedly did during World War II.

But by using GPP analysis, we can be smarter than that. We know a major anti-alien war effort would damage private output, and potentially push the U.S. Treasury into bankruptcy.

Gross private product also tells us a couple of other things.

To begin with, the federal government’s $800 billion-plus in stimulus spending didn’t work. The quarters in which government spending increased the most saw sharp declines in GPP. Conversely, the best quarters of growth since 2007 were in the two winter quarters of 2009-10, when government growth stopped and even shrank slightly (mostly at the state and local level).

Of course, there’s also some good news. GDP in the first half of 2011 expanded at a lousy 0.8% per annum, slower than population growth. However, GPP did significantly better, growing at a rate of 1.9% – as the government once again shrank somewhat.

That doesn’t guarantee we won’t have a “double-dip” recession, but it does indicate that if we keep government spending under control, and stop Federal Reserve Chairman Ben Bernanke from throwing money at the economy (which simply causes speculative bubbles, and does no good), then a real, healthy recovery is possible.

The private sector creates jobs, and pays for government. We need to keep track of its output through GPP, and run the economy to put GPP on a healthy long-term growth path.

No alien invasion, real or imaginary, is called for, as Paul Krugman did last week.

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5 Responses to It’s Time for a New Measure of Economic Growth

  1. demand side says:

    What a joke. Yes, the value of government spending is assumed to be its cost. As you can see with a few trivial examples, the market value is often far above the cost. What is the value of a road system, the NY transit system, the courts, the educational system, the police and fire protection? Without roads all those cars are useless. Any private banker in control of the road system would have a heyday. Education is shown to have a 6x return on investment, for the individual, for the employer, for the society.

    GDP is useless, yes, but not because it values police protection less than beer delivery. Nor because it values health care in the US at twice the rate as in other countries, never mind the poorer outcomes (i.e., service delivery). What did Paul Hawking say, something like, “We steal from the future and consume in the present and call it GDP.” Which illustrates the incredible charade of consuming the commons off the books.

    Why doesn’t the private sector produce police and fire protection and education for the non-rich, courts and roads and utilities? Because they are either natural monopolies or they are public goods. Public goods, defined as non-excludable and non-depletable, cannot be captured in a transaction. You are never going to toll every road. You are not going to hire a cop for every neighborhood. You are not going to get a fire department. The free riders, like Mr. Hutchinson, would live off your investment.

    There are good reasons for getting rid of GDP, but not because the private economy is more efficient. If that were so, countries with a smaller private economy would be doing worse instead of better. Amartya Sen and Joe Stiglitz chaired a report looking at this kind of thing in 2008. No surprise that Mr. Hutchinson’s view was out on the fringe.

    Hard to see how this got on the blog. Didn’t the private sector, the banking sector, just crash the economy and produced mega-trillions of useless housing? What value did those banks have absent the government’s interference? It wasn’t government spending that crashed the economy. It was the government’s coddling of the financial sector, which Mr. Hutchinson no doubt approves of.

    • demand side – - -

      A number of contributors, readers and commenters have expressed the opinion privately that GDP is not the best measure of economic activity. This article was specifically recruited by your editor to try to bring some of that discussion forward into public light.

      So far, so good, although I am still urging those who have commented privately to go public with something constructive.
      I hope your public contribution to the discussion will be the first of many.

  2. Paul Hanly says:

    To start I’ll declare I’m in favour of a level of government services and control or regulation of natural monopolies and many other activities and for the government to be insurer of last resort and to maintain a balance between egalitarianism and meritocracy at the expense of unfettered capitalism and nepotism.

    This article lost credibility when it confused activity with growth. GDP is not a measure of growth, it is a measure of activity.

    There are many weaknesses with GDP or how it is used. Increasing GDP is not a measure of how well off citizens are overall. When Japan suffers a tsunami and then rebuilds there is clearly only a small, if any, improvement even though there has been a huge contribution to GDP from the rebuilding. As equipment, roads, transport systems, communications and buildings depreciate or become obsolete GDP does not recognise this deterioration. If enough money is spent on flat screen TV’s GDP can go up even if the usable assets of an economy are destroyed by tsunamis, wars or being used up. No account is taken of the depletion of scarce resources such as minerals or the destruction of soil productivity or other parts of the environment. GDP does not take into account the consequential costs of certain activities. Production of cigarettes adds to GDP, then medical facilities and services are needed to treat resultant cancers and that also adds to GDP. If everyone works 50 hours a week and families break down or people are stressed and unhappy, GDP goes up.

    There are many problems with GDP as it is used or misunderstood or misused, but I don’t think the author of this article has really identified them.

    Having said all that, GDP does have its uses.

    The basic Economic identity of GDP = Public + government +/- External balances shows that if private spending falls as the private sector repays debt/saves if the government sector does not increase spending then, unless there is an offsetting change in the external sector GDP falls – by definition.

  3. demand side says:

    John,

    I appreciate your reply. I’ve read Martin Hutchinson’s stuff elsewhere, and appreciated it. My vigorous reply, I hope, reflects a concern with the subject.

    It is a very real problem for economics that our primary method of describing its health is the growth of monetized activity. GDP is activity, as Paul. Hanley so rightly discusses, and is blinds to the health and stability of the economy.

    I do think that the accounting for public activity biases GDP in precisely the opposite direction indicated by Mr. Hutchinson, however. In addition to the notion above, by not having a capital account, government cannot finance its investment transparently. By valuing government activities at cost, it ignores their contribution to private wealth.

    Ray Kroc who built McDonald’s once asked a protege what business he was in. The fellow answered, “The restaurant business.” To which came the reply, “No, the real estate business.” Fast food and the mall society is based on location and access. Or just take the example of a bridge built over a river (to somewhere). Instantly the private property on the newly accessible side is more valuable. In fact, it started going up in value the moment the bridge began its design. Very likely, because of the nature of the public good, the values went up in multiples of the cost of the bridge.

    And so on.

    Reflecting on this, however, leads to discouragement, since GDP even in its current form and supported by record deficits is now flat-lining and government expenditure is entering the Age of Austerity. A better description of economic health, as we once knew, is employment. Full employment means investment private or public, for reasons described better by Minsky or Wynne Godley or others. Of course, high employment does not do better in terms of looking forward for the economy. Witness the full employment of WWII.

    This is a good discussion to open up. Appreciate it.

    • demand side – - –

      Good discussion. What so many do not recognize, at least overtly, is that public deficits finance private savings. The reverse is also true – private savings are reduced by public savings (deficit reduction). These are basic accounting facts.

      Paul Hanly discusses the accounting very well in his comment.

      Not all of public deficits end up as private savings, however. In those cases where public deficits are used to fund consumption there are no private savings. Those situations can properly be called living beyond your means on a national level.

      It all comes back to a basic idea that I like: Good debts and bad debts. Good debts fund the future means of production. Bad debts fund consumption.