The Meaninglessness of GDP as an Economic Indicator
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How’s The Economy Doing? Don’t look to GDP for the answer. While GDP is universally regarded as the prime measurement of economic growth and rising standards of living, in reality, this mathematical calculation is, first, mostly a measure of inflation and, second, a measure of spending on consumption of goods as opposed to spending on the production of goods.
GDP is held to reflect the value of national income and output simultaneously, or, more generally, the value of what a country produces. My intention is to show, in contrast, that it reflects primarily the amount of money, and therefore the amount of inflation, in the economy. As more money is created by the central bank and inserted into the economy, prices rise. Higher prices necessarily mean that the value of goods and services, corporate revenues, profits, wages, investments, and expenditures included in the calculation of GDP rise as well (as demonstrated in chapter 2). Thus, GDP largely reflects inflation.
By way of illustration, if the quantity of money in the economy did not increase, neither could nominal nor real GDP. We have seen that there are only two ways that prices can rise: the supply of goods and services must fall or the supply of money must increase. Clearly, our volume of goods is not declining—at least not rapidly enough to cause price increases of 3%-6% per year—but the quantity of money is increasing.
Prices in the GDP calculation are “deflated” with a price index in order to adjust for inflation, but they are only partially deflated because price indices, as we have learned, significantly understate the actual inflation rate.
As evidence that creating money lifts GDP, consider the following scenario. If the money supply of the economy were static, i.e., if the central bank neither added to nor subtracted from the amount of paper bills and bank credit in the economy, GDP would be the same each and every year, because the fixed quantity of money would have to be distributed across an increasing amount of goods (and velocity, or the number of times we spent those same dollars, would also necessarily remain essentially unchanged each year ). In other words, no matter how many goods exist in the economy, the value of the amount of total spending and incomes in the economy would be the same every year because the quantity of money would be the same—an increased number of goods each selling at lower prices would leave the total sales value (price x quantity) constant.With a fixed money supply, our real economic prosperity would be measured by the extent to which prices of goods and services fell relative to our static incomes, since with the same amount of dollars chasing more goods, the price of each good would necessarily fall. This analysis demonstrates that prices and wages cannot rise without an increasing supply of money, and that an increased production of goods would actually reduce prices. Thus, GDP measures inflation, not production.
What GDP is ideally trying to measure is the physical volume of goods and services at our disposal. But, as Keynes himself signified, since we can’t add up oranges, trucks, movies and airplane tickets, and since there is not a stable and reliable monetary benchmark with which to measure all such items, we must accept that we can’t fully count our domestic product in monetary terms (but we can calculate the rate of increase of units produced of individual products and services).
The second major problem with using GDP as an economic indicator is that it counts mostly consumer spending and consumption, not the production of goods and services. Indeed, consumer spending is generally held to account for approximately 70% of GDP. However, since the production of goods, and not the consumption of goods, is what constitutes real wealth, an increase in GDP signifies mostly an increase in spending and consumption, not an increase in real economic prosperity.
As economist George Reisman has shown, an increase in GDP in fact correlates with a decrease in economic progress because most business spending—productive spending—is subtracted from the calculation of GDP in order to avoid so-called double-counting (which will be explained below). The greater the amount of productive spending in the economy, the greater is the corresponding number that is subtracted from the GDP calculation.
To understand this more clearly, consider the following:
1. GDP ≈ National Income
2. National Income ≈ profits + wages + interest
3. Profits + wages + interest ≈ total business sales revenues-(total business costs-wages)
4. GDP ≈ Sales revenues minus all costs except (most) capital goods expenditures
Total business sales revenues minus only capital goods costs leaves profits, wages, and interest. Thus, GDP approximately equals total sales revenues minus only capital goods costs. This means GDP has capital goods costs subtracted out, leaving only (mostly) expenditures for consumer goods (derived largely from wages). Therefore, the greater the amount of capital goods expenditures, the more that is subtracted from GDP and the lower is GDP. As a result, the stated GDP is lower than would otherwise be the case. This is significant because productive spending, as I have shown, is virtually the sole means of wealth production. Saving, not consumption, is the primary source of spending.
Most business costs are subtracted from GDP in order to prevent “double counting,” because it is thought that the value of most goods associated with business spending is reflected in the value of the final product, and should be counted as such. Therefore, GDP counts the final product as representing both the final product and all the products that went into it. It says that if we produced bolts, screws, and automobiles, in sum, we produced only automobiles. This is wrong because the screws and bolts were in fact produced, in addition to automobiles, and they have their own separate values, even if they are eventually used to create the composite automobile.
Since, then, most business spending is excluded from GDP, the resulting calculation over-represents the contribution of consumer spending to total expenditures, and under represents total productive spending, which far exceeds consumer spending and pays most wages—business spending is what is likely 70% of the economy. GDP, therefore, leads people to believe that prosperity comes about by means of spending and consuming our wealth. Government officials and pundits, in turn, tell us to go and spend in order to “help” the economy. But it is savings, i.e., abstaining from consumption, which pays for the production of goods—real wealth—and increases our ultimate amount of consumption. Contrary to popular belief, savings do not usually sit under a mattress being hoarded, but are actively invested and financing production. All the assets companies possess are owned by capitalists (individuals), via their invested savings.
After all, if we spent all our savings on consumer goods, what money would finance factories, tools, and machines (and home mortgages and credit cards)? What money would pay the wages of workers producing products that have yet to be sold? As a reminder, machines and workers are paid for the products they make before consumers buy them. When we purchase a house, the hammer and the construction worker have already been paid and have moved on to building the next house. Food, groceries, and CDs, as well as the tools and people that make them, have all been paid for before the consumer compensates (by purchasing these goods) the companies/employers who have paid to have the products created. Similarly, an automobile factory is paid for many decades prior to the complete reimbursement of the investors (when the last cars are produced). Almost all workers and machines are paid in advance with savings, not with sales revenues from consumers.
In sum, economic progress consists of increased productive capabilities, not production-sacrificing consumption. Therefore, GDP does not measure our wealth-producing capabilities. It can give us an idea of the relative wealth between countries (assuming exchange rates can freely adjust to the relative quantity of money, production, and capital flows across countries). And it shows us an approximate rate of inflation and how much we are consuming. But it should not be understood as an indicator of economic progress or standards of living.
Additionally, GDP merely counts the monetary value of things produced; but what’s produced may not be what really adds value to a society. For example, leftwing government economists such as John Kenneth Galbraith used to cite the Soviet Union’s strong GDP growth as an example of successful socialist policies (Similarly, Latin America had GDP growth rates as high as developed countries for many decades in the 20th century, but it’s real standard of living did not grow comparably). The truth is that the Soviets created little of value. They had tons of screws, but not enough screwdrivers; they had scores of bricks, but not enough mortar with which to assemble the bricks into a building. According to the mathematics of calculating GDP, the Soviets could have produced nothing but screws, and seen their GDP rise. If they produced more screws each year, or even the same amount of screws while the quantity of money increased, they could have shown a rising GDP. To Galbraith this would represent wealth; but to the soviet citizens, having tons of screws, but no new clothes, food, or houses, would mean death and poverty. Given the assumptions and methodology of GDP calculations, a nation could really increase its GDP by having each citizen simply pay their friends and neighbors to scratch their backs while the government simultaneously printed a lot of money. The more backs that were scratched, and the faster the government printed money, the faster GDP would rise. It should be clear from this that simply having an increase (or decrease) in GDP, like simply having jobs, does not necessarily mean anything. For real wealth to be created, both jobs and GDP must entail the creation of goods and services society needs.
Kel Kelly @ January 20, 2009