Imagine that you are an innovative economist back in, say, the 18th century, and you discover a brand new way of measuring private prosperity. You throw out old ideas of valuing a person by what they own, the value of their land, their assured income and so on. Instead, you decide to measure them purely on what they spend. Lord Snogglesthwaite spent £100,000 a year this year as opposed to £70,000 last year, an increase of £30,000 or around 30%. So according to your new measure of Gross Personal Spending, Lord S’s GPS has shown a 30% year on year improvement. What’s wrong with this picture, and why will your contemporaries throw bricks at you rather than shower you with praise?
They will bounce hard objects off your head because they know full well that Lord S is currently being hounded through the streets of old London by hordes of outraged creditors for debts he can’t pay. Your critics will call you an idiot for trying to measure a man’s prosperity by how much he spends. And they will be right. You will deserve a sound pummelling. Where then, does that leave us with GDP, or gross domestic product, a measure beloved by politicians and economists alike, which, in analogous fashion seeks to measure a country’s increase in prosperity by how much it spends? Why is this practice daft for an individual, but great for a country?
The problematic GDP
Let us refresh ourselves as to the meaning of GDP. It is arrived at by calculating the increase in private spending, plus the increase in government spending, plus the increase in exports, minus the increase in imports. That’s it. While the balance of trade (exports minus imports) is not a spending measure, the other two constituents are. What this means, as Rob Arnott, chairman and founder of the California based investment firm, Research Affiliates, which has about $55 billion assets under management, is that GDP is a highly suspect measure of a country’s prosperity.
In a recent newsletter, John Mauldin points out that one of the downsides of GDP as a measure of prosperity is that the way it is calculated can mask the fact that a seemingly steady increase in GDP can be about nothing more than ever increasing government expenditure, with no private sector growth at all. Take the equation, GDP = government spending (G) + private sector spending (P) + net exports (NE). If P and NE stay flat and G rises through an ever increasing public sector deficit (very much the story of the US public sector over the last 10 years) then the public, and indeed, the world at large, can be fooled into thinking that a country is growing steadily whereas, in reality, it is plunging head over heels into debt with a moribund private sector struggling to stand still.
Mauldin points out that the US private sector, per capita, in 2011 is roughly where it was in 1998.
"The growth of the “economy” has come from government spending. Private sector spending is where it was almost 13 years ago, accompanied by no growth in median real income and no growth since 2000 in the actual number of jobs, even as the population grew by 30 million."
Moreover, with both Republicans and Democrats now both starting to talk as if they grasp the fact that the US simply has to do something to get off an unsustainable upward debt trajectory, the inexorable logic of the GDP equation could well push US GDP into negative territory. If you cut “G” and want to see a positive GDP figure, you have to increase “P” or “NE” by at least as much. US manufacturing output figures are starting to look encouraging, but so far job growth has only been sufficient to keep the jobless total from rising. As Mauldin says, "Government cutbacks are going to be a very significant headwind for GDP." On the positive side, he argues, “smaller government expenditures and deficits will mean more money for private sector investment and productivity growth”, but, again, that could take years to come through. As the saying has it, there are statistics, and there are damn statistics, but GDP is one of the worst – not least because it is so beloved of politicians and means so very little...
Further reading on GDP, inflation and austerity:
- Inverse Stagflation and the Global Economy: When Real Assets and Paper Assets Part Company by Renée Haugerud
- Nothing but Painful Choices Ahead as the Global Debt Supercycle Ends by John Mauldin
- New Dollar Area: The Makings of the Mess by Brian Reading
Tags: Democrats , exports , GDP , government spending , imports , John Mauldin , private spending , Republicans , Research Affiliates , Rob Arnott