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 Gross Domestic Product is universally regarded as the prime measurement of economic growth and standards of living, in reality, this mathematical calculation called GDP is, first, mostly a measure of inflation and, second, a measure of spending on consumption of goods as opposed to spending on 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 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. Increased 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. 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. Indeed, there are only two ways that prices can rise: the supply of goods and services must fall or the supply of money must increase (any possible alternative causes of rising prices can easily be shown as faulty). 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, but only partially, because price indices significantly understate the real inflation rate. There are many reasons for this, one of which is the application of such techniques as “hedonics” to the value of goods and services, with the result that that even when prices are generally rising, product improvements are deemed to be larger than the price increases, and the calculated inflation rate will be less.
As evidence that simply 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). 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 the existence of an increasing supply of money (likewise, having more money does not help to produce more goods), and that increased production of goods would only reduce prices. Thus, GDP measures inflation, not production.
What GDP is ideally trying to measure is the actual volume of goods and services at our disposal. But 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 numeric terms.
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 Pepperdine University economist George Reisman has shown, an increase in GDP in fact correlates with a decrease in economic progress. This is because most business spending, or productive spending, is subtracted from the calculation of GDP in order to avoid so-called double-counting (as will be explained below). The greater the productive spending in the economy, the greater is the number that is subtracted from the GDP calculation. The result is a lower stated GDP than would otherwise be the case. This is significant because productive spending – factories, tools, supplies, and work in progress – is what produces both other producers’ goods as well as all consumer goods. Productive spending is the sole means of wealth production.
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 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. GDP, therefore, leads people to believe that prosperity comes about by way of spending and consuming our wealth. Wall Street and government officials, in turn, tell us to go and spend in order to “help” the economy. But it is savings, i.e., abstaining from consumption, which pay for the production of goods – real wealth – and increase our ultimate amount of consumption. Contrary to popular belief, savings do not usually sit under a mattress being hoarded, but actively finance production. All the assets companies possess are owned by capitalists, via their invested savings.
After all, if we spent all our savings on consumer goods, what money would finance factories, tools, and machines (and mortgages and credit cards)? What money would pay the wages of workers producing products that have yet to be sold? 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. Similarly, an automobile factory is paid for 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 gives 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 the 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.
Kel Kelly @ January 20, 2009