THE BEAR'S LAIR Time to ditch GDP
By Martin Hutchinson
Much commentary this year has been devoted to the dramatically negative effect the "sequester" spending cuts would have on US gross domestic product. In Japan, one leg of Prime Minister Shinzo Abe's three-part plan to revive the economy is additional state spending, predicted to increase gross domestic product (GDP) in spite of its damaging effects on Japan's huge debt and budget deficit.
Yet in both cases, the economic effects predicted are statistical artifacts, not real changes. GDP, which includes government spending at cost, unlike its treatment of all other economic
activity, is a deeply flawed statistic, rigged up by Keynesians to make Big Government look better.
Several economic statistics have similar flaws. Consumer Price Indexes, for example, no longer include house prices or any realistic proxy therefore, allowing inflation watchers to miss price bubbles like that of 2002-06 in the US, which if statistics had been collected properly would have led to far higher interest rates and a resultant deflation of the housing bubble. Similarly, the 1996 "hedonic pricing" adjustment, which over-compensates for quality improvements in the tech sector by pretending that each Moore's Law doubling in chip capacity produces an actual doubling in value, has suppressed reported CPI inflation since it was introduced.
While the elimination of asset prices from the CPI and the suppression of tech sector inflation had substantial academic support when they were introduced - in economics, you can always find academics to support anything - their true driver was political. Politicians like lower interest rates, which asset-bubble-driven CPI increases would prevent, and want the appearance of good economic stewardship produced by lower reported CPI figures.
It also doesn't hurt that lower reported CPI figures greatly reduce the actuarial future cost of social security and other benefits politicians have promised the electorate. Voters will never notice a little chiseling on the CPI figures by which their benefits are adjusted, whereas they will certainly notice the tax increases that would be necessary to fund them properly.
The current proposal to adjust benefits by "chained CPI" figures, which reflect a re-balancing of consumption on price movements that bears no relation to consumers' actual behavior, is another step in this direction that will remove another tiny slice each year from social security recipients' welfare. Truly, the proponents of these CPI changes should go into the salami business.
As with the CPI, the designers of the GDP statistic (and its Gross National Product brother, which bases output on ownership, rather than physical location) had their own political agenda. Simon Kuznets, who unveiled the GNP statistic to the US Senate in 1934 (and published it in the National Bureau of Economic Research Bulletin of June 7, 1934) was a lifelong Keynesian who was trying to put an economically sound foundation under the New Deal's intellectually incoherent policies. Since he regarded government activity as a positive good that should be expanded in downturns, he included the cost of government directly in GNP/GDP at full cost - thus automatically producing an increase in output when the size of government increases.
Kuznets should not be blamed inordinately. To get GDP, he went through "national income paid out" and then adjusted for business profits. That's not the way we'd calculate the statistic today, and it makes the inclusion of government at cost more understandable - he simply assumed government made neither a profit nor a loss.
In reality, on his methodology, government makes a huge loss, because the market value of its outputs is greatly exceeded by the cost of its inputs. You can see the effect of this in the US Postal Service, which some want to privatize, as with a US$4 billion privatization of the Belgian postal service, planned for this month.
However if you look at the Post Office's financials, privatization is obviously impossible, because the entity has negative value, with a net worth of minus $35 billion and an operating loss of $16 billion in 2012. By GDP accounting, if the USPS is included in government its output is deemed to be its $81 billion of expenses, while considered as a private sector entity its output is only $65 billion.
From a national accounting perspective, the US Postal Service is one of the easiest bits of government to assess: its output is sold at market prices, just like a private corporation, albeit a horrendously unprofitable one. Other parts of government are much more difficult. The State Department and Department of Defense have no measurable outputs at all and, in the case of defense, vast inputs, yet few would argue that the government could function without them, at least in some form.
Conversely, the Environmental Protection Agency, issuing regulations covering effectively the whole of US economic activity, imposes a vast hidden cost through regulation that is nowhere accounted for in GDP. That's the pernicious effect of regulation: if the US improved automobile fuel efficiency through a higher gasoline tax, the costs would be out there for all to see, whereas by imposing the Corporate Average Fuel Economy Standards the EPA is able to impose far higher costs on the economy that are completely invisible directly.
Some of those costs are visible indirectly, in the higher costs and lower profits of US automobile manufacturers; others, such as the additional lives lost of inadequately protected passengers in high-gas-mileage cars involved in automobile accidents, are completely invisible. (Lives would also be lost if a higher gas tax caused manufacturers to make the automobile fleet flimsier, but in that case consumers would have the option of buying a steel-reinforced gas guzzler and paying the extra fuel cost, whereas under CAFE regulation they don't.)
There are thus two approaches to reforming GDP. One would be to take each division of government and attempt to assess the value of its output, which is negative in the case of the EPA, parts of the Commerce and Agriculture Departments (protectionism) and possibly the Education Department (dumbing down schools).
That sounds like a fun intellectual exercise, but it would involve endless political judgments about which the two sides could not possibly agree. In the extraordinary US political system, that could perhaps be managed - you could have two different party groups in the Congressional Budget Office, producing Republican and Democrat GDP estimates. The Republican estimate would take a free market approach, assigning a negative value to large parts of government. Conversely the Democrat estimate could go further than current GDP accounting, and include all kinds of hedonic adjustments, as in Joseph Stiglitz's "well-being" proposal, supported by France's ex-president Nicolas Sarkozy in 2009. However every time control of congress changed, the "official" estimates of GDP would be revolutionized, altering the entire economic history of the preceding decade - and causing the utmost confusion in the markets.
A better alternative therefore would be to ignore government altogether, and calculate a Gross Private Product, the national output of the private sector, from which almost all government costs must in any case be borne. To a first order of accuracy, this can be done already from the Bureau of Economic Analysis' published data - you simply subtract line 21 (government consumption expenditures and gross investment) from GDP (line 1) and the result is a decent ballpark estimate of GPP.
Using GPP, US economic history takes a different shape, most notably around World War II. Economic growth becomes more sluggish in 1933-38 than the conventional record shows, (still with a downturn in 1937-38) then in 1939-40 (after the November 1938 mid-term congressional elections had swung heavily to a bipartisan conservative consensus and stopped the New Deal in its tracks) there was a rapid recovery that brought back the output levels of 1929. Later, instead of soaring in World War II as did GDP, GPP was squeezed during the war, before enjoying an astonishing recovery in 1946 that doubled real GPP and finally pushed prosperity beyond 1920s levels.
Paul Krugman proposed in 2011 that the US would benefit from an alien invasion, since the military expenditure on death rays and so forth to fight the aliens would stimulate the economy. Indeed, later he even proposed that the government stage a fake alien invasion to achieve the same effect. His proposal demonstrates nicely the fallacy of GDP accounting.
Under GPP, the additional government waste on death rays would be ignored, while GPP would decline as the private sector was squeezed to provide the resources for the extra military spending. Krugman's proposal also illustrates nicely the intellectual (and incipient financial) bankruptcy of Keynesianism; it's obvious nonsense if you do the accounting properly.
GPP accounting also illustrates the true effect of government cutbacks in the last six months. First quarter GPP, boosted by the sequester and defense cuts, both of which allowed more room for the private sector to thrive, grew at 4.1% compared with the anemic 2.4% growth in GDP. It's not surprising the stock market has taken off.
When leftists whine that cutbacks will destroy growth or cheer that stimulus spending will increase it, they can be confident of their forecast - because the GDP statistic is constructed to make it true. The spending stimulus of 2009-10, which peaked in the fourth quarter of 2009, delayed the recovery of GPP by six months, into 2010.
Moving from GDP to GPP would kill off many damaging economic policies, as well as giving us a much better picture of where the economy is really going. It's a slam-dunk.
(Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country. Gross National Product (GNP) is a measure of a country's economic performance, or what its citizens produced (ie, goods and services) and whether they produced these items within its borders.)
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com. Copyright 2005-13 David W Tice & Associates.)