Monday, February 11, 2013

Corrected GDP

We all know what the Gross Domestic Product or GDP is. It is as common as Fahrenheit or Celsius. It is on the nightly news everyday. It has a prominent role in most political speeches about the economy. Gross Domestic Product (GDP) throughout the world is the standard measure of the economic health of a country and particularly when divided by the population to get GDP per capita. Surprisingly, it is not an ancient measure. It was developed by Simon Kuznets in 1934 for a Congressional study. GDP was formalized at the Bretton Woods Conference in 1944 as the measure of a country's economic vitality. Today this calculation is performed by a government agency in each country across the world. Each country makes adjustments to fit their particular social environment, but largely the method of calculation is close enough for statistical analysis. In the United States the figure is produced quarterly by the BEA, Bureau of Economic Analysis.

The importance and wide use of GDP to provide a picture of the economic health of a country is accepted by political leaders across the world, but many economists have concerns. Austrian Economist, Frank Shostak, questioned the underlying assumption that all expenditures reflected economic growth. He provided the example of a pyramid built by a country. Today, we often assert these projects should be part of GDP since they provide income for people and profit for suppliers of construction materials. Frank Shostak's point was that the money was diverted from being invested by a business that could expand production and create "real" jobs into a boondoggle government project.

The idea that who spends the money makes a difference when growth is concerned is subtle, but very important in understanding how an economy actually works. The issue is that governments do not make "investments." When a government spends or "invests" it is not to create a revenue flow. While business does make "investments." Their purpose is to create a revenue stream of profits to repay the investment and a continuing revenue stream. If a company built a pyramid they would put up a billboard and advertise their products enabling them to earn a return out of the pyramid.

Government spending is like giving candy to children. It has no lasting effect. In children it only diverts their attention from playing quietly to demanding more candy. I call this type of government spending an example of the Candy Rule: Government spends to make people happy, not to make a profit. On the other hand, business spends to earn a profit and to make their shareholders happy.

What is the point of this article going into the world of children and candy? I am trying to explain government spending is not the same as business spending. Government spending differs in two ways. The money government spends is not earnings they generate, but earnings taken out of the hands of business. As a society if we allow this, we must do it because we feel government expenditures can use the money better than business can. The second difference is government spending is a dead end. The money is not repaid. It is not invested. Government only consumes money. Sometimes it is necessary to feed the giant, but ideally we would like most of the money to be used to feed the citizens.

Why is this distinction important? When you consider GDP it makes a huge difference. If a country allows their government to spend all the tax money collected each year plus additional borrowed funds, what would happen? Let's assume the government spends all the money on interest payments due foreign investors. All the money would end up in foreign hands. Eventually the economy would go bankrupt since there was no money available for their home businesses to earn a profit and pay a portion in taxes.

Now, let's assume the polar opposite. All the money is spent by businesses to expand production and pay their employees handsome salaries. The businesses make a huge profit and their employees spend their salaries in the local community. The businesses retain much of their profit to expand and grow. This stimulates further growth.

Clearly, it is easy to see that all the money spent in the second example goes toward economic growth. GDP is the total amount spent. In the first example of government spending none of the money goes into local economic growth. Yet, the way we calculate GDP today, all the money in the government spending example would also be calculated as GDP. GDP in both examples would be equivalent.

What does this say about the calculation of GDP? Let me simplify it for you. Instead of including government expenditures in GDP we should only include business and personal expenditures, but not the taxes they pay. It doesn't matter what or how government spends these tax dollars since it is not an investment. When a government borrows a trillion dollars it does not strengthen the economy. It only further burdens the individual citizen.

Governments like the United States and Japan are not as rich as they think they are. The wealth of their citizens is overstated by including government expenditures (especially debt) in the calculation of GDP.