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.

Definition of Money

There are two common ways to characterize money. The first is the idea that money is a commodity like gold, silver or apples. And like any commodity when the supply increases the value or price declines. The second theory of money stated in my book, Rule of Money, defines money as a coupon equivalent to the work effort expended. Money, in whatever form, equals the work done to earn it.  Money is the physical evidence of earnings obtained by working for someone. It is a chit that can be exchanged for products equal to the value of the service provided to earn it. This right of exchange is guaranteed by law in most countries.

I define the Rule of Money as it must be earned to distinguish it from money created by the Central Banks of the world. I draw this distinction and show in my book that funds that Central Banks create do nothing to increase the wealth of a country unless the money is earned. If this was not the case countries with hyperinflation rates approaching 1,000,000% like Zimbabwe or Hungry and Greece after WWII would be the envy of the world with their currencies denominated in billions and trillions. When currency is stated in a billion or trillion Zimbabwe dollars or Hungarian pengo it is no longer connected to the value of work. It is only a point on an inflationary spiral. At this point money is no longer connected to reality. Money must be grounded in the value of work otherwise it is a meaningless value.

Money is not a new invention. It began as a way for Kings, Pharaohs, Sultans and similar political leaders to increase their wealth. They could make money for less than the value they stamped on the coin. The more they produced the richer they became. Most early inflation occurred when these Princes decided to reduce the thickness of a coin or insert lower valuable minerals during casting, but left the value stamped on the back unchanged. Their attempt to gain some unearned income usually failed. Most of the time this attempt to maintain the value of their coinage while reducing the precious metals inside was rejected by users of the coins resulting in currency inflation. The value of coinage dropped, but still reflected  the market value of the precious metals contained within the coins. If a monarch reduced the silver content by half, the value of the coin lost half its value.

When money is defined as a commodity it is subject to supply and demand pricing. Supply and demand pricing of money allows Central Banks to push the value of money up and down by adjusting interest rates for people or banks that have money. For people and companies that need to borrow money it makes their life more difficult and more expensive. Conversely, when money is defined as a receipt for work it is not affected by changes in interest rates.

Similarly, when money is defined as a commodity it is subject to inflation. The value of money fluctuates up and down with the commodity the currency contains or is redeemable for. On the other hand when money is defined as a receipt for work it is not affected by changes in commodity prices. It is affected by changes in labor rates. This is why in the 2000s inflation was low in western countries and high in Asian countries as labor rates adjusted.

One of the prevailing theories in modern Economics is the assumption that simply increasing the quantity of money in circulation causes inflation. When money is defined as a receipt for work it is not affected by changes in the quantity of money in circulation, because there is a one to one relationship to increasing earning and an increasing quantity of money.  On the other hand, when money is defined as a commodity the quantity of money in circulation is paramount, because an increase in a commodity reduces the overall value of the commodity in circulation. It is the level of supply that determines value. In conventional Economics, if a government increases the quantity of money in circulation the theory states the value of money will fall, because the demand for money is less relative to the supply. Whereas, N Theory states the quantity of money does not matter as long as the money is earned through work. But “unearned” money added to the money supply causes the value of all money to fall. One of the most prevalent kinds of unearned money is sovereign debt. Sovereign debt is unique among all other debt. It is not an investment, but only a promise to repay. It is not backed by an asset or redeemable by acquisition of collateral.

When a Central Bank like the Federal Reserve Bank in the U.S. decides to increase the amount of money in circulation they do so to stimulate business activity, thereby creating more jobs. But by modeling money as a commodity the Fed is constrained by their fear that increasing the amount of money in circulation will cause inflation. On the other hand, if the Fed understood money as only earned revenue according to the rules of N Theory they would not fear inflation. They would expand monetary assets by encouraging new business creation.

 

The way the Fed defines money affects how they manage the monetary resources of the country. The definition of money affects government policy. When money is considered a commodity the government is in charge of opening and closing the money spigot. Unfortunately, this opening and closing is governed more by a fear of inflation than by the factors of employment or business creation. On the other hand, when money expansion occurs according to N Theory employment is step one. Consequently, the justification for monetary expansion precedes the increase in the money supply effectively preventing currency inflation since there is no excess.

How should money be defined? Money is any object or equivalent electronic notation recorded to an account in a financial institution that is earned through work, and that can be exchanged for different products or services.