The Real Economy versus Statistical GDP: How Reducing GDP Increases Economic Growth

At the Ludwig von Mises Institute, Austrian economist Joseph Salerno differentiates statistical GDP with the real economy and explains why a reduction of statistical GDP INCREASES real economic growth (italics original, bold mine)

Recently, the Financial Times published an article containing charts displaying the correlation between government spending and real GDP growth.1 Based on these correlations, the author of the article, Matthew Klein, comments: “It’s no secret that spending cuts (and tax hikes) have retarded America’s growth for the past four years.” He goes on to argue that from mid-2010 to mid-2011, the reduction in government spending in the US shaved 0.76 percent off of the economic growth rate. Klein conjectures that this slowdown in the growth rate caused a level of real GDP today that is 1.2 percent less than it would have been in the absence of this exercise in “austerity.” He also points out that since 2012 almost all of the depressive effect on real GDP growth of government austerity was the result of the reduction in military spending. While some of the reduction was beneficial, Klein opines, “some of it represents a self-inflicted wound.” Indeed it may represent a self-inflicted wound on the Federal government, but in that case it benefits the private economy. 

Now it is certainly true that a reduction in real government spending causes a reduction in real GDP, as it is officially calculated. But contrary to Mr. Klein, the reduction in government spending does not retard the growth of production of goods that satisfy consumer demands and, in fact, most likely accelerates it. In addition, real incomes and living standards of producers/consumers in the private sector rise as a direct result of the decline in government spending. The reason for this seeming paradox lies in the conventional method used to calculate real output in the economy. Let me explain with a simple example.

The Problem with Calculating GDP

Let us suppose a simple island economy in which the private sector produces 1,000 apples per year. Suppose further that the government of the island taxes the private producers 200 apples per year to sustain its military as it invades a neighboring island in order to neutralize a “potential terrorist threat.” According to standard national income accounting, which is deeply rooted in Keynesian economics, real GDP is calculated as 1,200 apples: the 1,000 (pre-tax) apples either currently consumed by the producers, invested by them in planting new apple trees to provide for future consumption, or paid out in taxes plus the 200 apples expended on the island’s military which is busily producing the “public good” of national defense. In other words, the island’s real GDP2 includes the 1,000 apples voluntarily produced by the private sector plus the “apple value” of national defense which is valued at its cost of production, that is, the 200 apples of compulsory tax revenues spent on conquering the adjacent island. 

Now let us assume that by the next year the conquest has been completed and the island allegedly harboring the terrorists has been pacified. Our island’s government decides to cut its military and reduces taxes by 100 apples. All other things equal, real GDP falls from 1,200 to 1,100 apples, since national defense now contributes only 100 apples worth of government services to the 1,000 apples produced by the private sector. But there is the rub. The apples were voluntarily produced and therefore were demonstrably more highly valued than the resources (effort and time) used to produce them. In sharp contrast, there is no evidence whatever that the private producers/consumers valued the military services supplied by government more highly than the cost of producing them or even that they valued them at all. The reason is because government military spending was financed by the coercive extraction of resources from the private sector, whose members had no choice and therefore expressed no valuations in the matter.

No Way to Calculate Real Value of Tax-Financed Amenities

The same conclusion holds for any coercively-financed venture, such as government construction of an island infirmary. In the absence of voluntary production and exchange, there is no meaningful way of ascertaining the value of goods and services. The government investments and services may have some value to private consumers, but there is no objective scientific method of gauging what that value is. Indeed, assuming government wastes at least 50 percent of the resources expended, the net benefit to consumers of government production would be zero.

Using “Gross Private Product” Instead

So for these and other reasons, national income accounting on Austrian principles would exclude government expenditures in calculating the total production of the economy. Thus in our island economy real output or what Austrians, following Murray Rothbard, call “Gross Private Product” or “GPP”3 is equal to only the 1,000 apples produced by the private sector and excludes government expenditures of 200 apples on the provision of military services (or an infirmary).4 But the 1,000 apples of GPP actually overstates the resources left at the disposal of the private sector, because 200 apples were forcibly siphoned off from potentially valuable private consumption and investment activities to fund government activities that can only be judged as wasteful from the point of view of the original producers of those resources. In this sense the 200 apples paid in taxes can be seen as a “depredation” on the private economy as measured by GPP.5 

Netting out this depredation we then arrive at what Rothbard calls “private product remaining in private hands” or PPR. PPR equals GPP minus total depredation (i.e., government spending).6 In our hypothetical island economy PPR is therefore 800 apples (= 1,000 apples – 200 apples). Thus government spending should not be added to private production but rather subtracted from it to get a sense of the living standards of private persons engaged in productive economic activity.7

Reducing Taxes and Spending Increases Welfare

Based on the above analysis, when the island government cuts military spending by 100 apples, assuming no other changes, it does indeed reduce real GDP from 1,200 to 1,100 apples. However, from the Austrian perspective, real output of valuable goods remains constant at GPP = 1,000 apples, while the economic welfare of producers is significantly enhanced because depredation on their output falls by 100 apples causing PPR to rise from 800 to 900 apples! But this is not all. A portion of the tax cut of 100 apples will be devoted to investing in the seeding of new trees, thus increasing the capital sock and accelerating economic growth over time.

Even in the short run, there is likely to be positive growth of GPP due to “supply-side effects.” For instance the cut in marginal tax rates increases the opportunity cost of leisure and spurs producers to work more hours. The private labor force further expands with the influx of former soldiers. Thus it may turn out that GPP increases from 1,000 to 1,075 apples (and, consequently, PPR from 800 to 975 apples). In this scenario the 100-apple cut in government expenditure would be partially offset by the 75-apple rise in private product so that the GDP statistic would register a smaller decline then previously calculated, from 1,200 to 1,175 apples. Despite the decline of the meaningless GDP statistic, however, the result would be a boon for the private economy, as apple production, the real incomes and living standards of apple producers, and the capacity to produce apples in the future all improve.

From the Austrian standpoint, then, the path back to immediate economic health and sustainable long-term growth is massive tax and spending cuts anywhere and everywhere. Yes, this is austerity — but only for the government. Slashing political depredation on the private economy will release a cornucopia of current and future benefits on private consumers. And these benefits are virtually cost free because the resources consumed by the government budget are almost all a pure waste from the point of view of the private producers of those resources.

Deeply slashing the bloated budget of the US government by, say, 25 percent would not only cure the sham deficit problem, but more importantly it would rapidly reverse the trend of the declining middle class and powerfully and permanently stimulate the anemic long-run US economic growth rate. For the real problem is not the size of the budget deficit per se, but rather the depredation on gross private production contributed by the overall federal budget.8 Thus a US government budget of $4 trillion and a deficit of $500 billion represents far greater depredation on and is far more harmful to the private economy then a budget of $3 trillion partly financed by a deficit of $1 trillion.

• 1.A report on the article that includes some of the charts may also be found on an ungated website here.
• 2.For simplicity, we ignore capital depreciation in this in this simple island economy, assuming that the apple trees once planted live forever never needing to be maintained or replaced. Thus GDP = NDP.
• 3.Once again, absent depreciation, GPP = NPP.
• 4.The Austrian approach to national income accounting was pioneered by Murray Rothbard, pp. 339–48 and Rothbard, pp. 1292–95.
• 5.I am using the term “depredation” to mean the forcible taking of the property of another, whether legal or not, and for whatever purpose. There is precedent for this usage in older law codes. In French law, “depredation” denoted “the pillage that is made of the goods of a decedent.” Old Scottish law defined “depredation” as “the (capital) offence of stealing cattle by armed force” (Lesley Brown, ed., The New Shorter Oxford English Dictionary on Historical Principles, 4th ed. [New York: Oxford University Press, 1993], p. 639).
• 6.Actually, depredation is calculated as government spending or tax revenues, whichever is greater (Rothbard, p. 340). But since the US government has rarely run a surplus since World War 2 we can ignore this complication.
• 7.Robert Batemarco uses Rothbard’s approach to calculate GPP, PPR and PPR/Employment (nongovernment) for the years 1947–83 to track the movement of private living standards during these years.
• 8.To calculate total depredation on the private economy, of course, state and municipal spending must be accounted for.

Quote of the Day: The Value of Superfluous Fluff

Some economists like to believe (although this belief has blessedly faded in the recent decades) that economics is an edifice built on the rocks of mathematical theory and statistical empiricism, and everything else is superfluous fluff. McCloskey (1983) thoroughly strafed that conceit, pointing out in “The Rhetoric of Economics” that the research and analysis of economists is built on uncertain and subjective judgments, and often uses, among its rhetorical tools, analogy and metaphor, appeals to authority and to commonsense intuition, and the use of “toy models” counterbalanced with the choice of supposedly illustrative real-world episodes.

Economic arguments rooted purely in mathematical formalism or statistical analyses are superb at specifying the steps leading to the particular conclusion. However, cynical economists (but I repeat myself) know that a model can be built to illustrate any desired conclusion, and that if the data are tortured for long enough, they will confess to anything. Persuasiveness requires a multidimensional argument that reaches beyond formalism. As McCloskey (1983) wrote: “There is no good reason to to make ‘scientific’ as opposed to plausible statements.”

That’s from economist Timothy Taylor on the issue of editing economists (hat tip Professor David Henderson).

Phony and manipulated “tortured” models function as standard instruments used to justify social controls through public policies. Think anthropomorphic global warming, Keynesian stimulus, mercantilism and etc…

Okun’s Law: A Failing Industrial Age Economic Model

A popular traditional economic model has reportedly been losing its efficacy.

That’s according to the Wall Street Journal Blog, (bold emphasis mine)

In 1962, Yale professor Arthur Okun laid out in very clear and understandable terms a long-standing relationship between economic growth and the behavior of unemployment. If the economy dropped one percentage point below its long-term growth rate in a given year, the unemployment rate tended to rise by about a third as much. So a recession that pulled economic output three percentage points below the economy’s long-run trend would push the unemployment rate up by a percentage point.

Okun’s law has been a staple tool for economists ever since, but it’s been driving them crazy lately because it doesn’t seem to be working all that well.

The blog gives some possible reasons why the popular model can’t seem to explain today’s environment.

But they seem to overlook what matters.

Anyway here’s a clue from the same article...

Productivity – or output per hour worked by a country’s labor force — continued to rise in 2008, unusual for a recession, and surged by 3.7% in 2009

My bet is that economic models based on the industrial age will fall massively short of explaining the radical changes being brought about by the dramatic advances in technology that has been shaping the current economic framework.

Velocity Of Money: A Flawed Model

``Economics is a social science. Econometric models spit out results that lack the accuracy of chemistry experiments and the precision of mathematical equations. Central bankers are forced to deal in the realm of the touchy-feely all the time. If their work could be reduced to an equation, we wouldn’t a) need them or b) find ourselves in the mess we’re in now.” Caroline Baum Central Banks Can Do Better Than Just Mopping Up

Zero Hedge’s Mr. Tyler Durden comment of ``And instead of this excess money hitting broader aggregates such as M2 or MZM, it is held by the banks, who proceed to buy securities outright on their own, either Treasuries or Equities. Apply the proper "money multiplier" to get the monetary impact on the S&P 500, as a result of the banks not lending these excess reserves, and instead simply speculating with it, and you will likely get the increase in the market cap of the S&P since the launch of QE” provoked my inquisition to mainstream’s allure to use money velocity as benchmark for arguing the case for deflation.

Velocity of money is the turnover (circulation) rate of money in terms of transactions.

It is assumed that a low money velocity, which means lower rate of circulation, can only support lower prices.

Yet if US banks have indeed been directly speculating, and if such activities haven’t been registering in money aggregates, as postulated by Mr. Durden, then the whole premise built around the inefficacy of monetary policies seems tenuous because statistics have not accurately captured such bank speculations in the asset markets.

Besides, Velocity of Money is a statistical measure based on the Keynesian consumption model, where spending equates to income.

The idea is more spending would result to higher prices and higher national income and or higher economic growth.

This is an example from wikipedia.org,

``If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy goods and services from each other in just three transactions over the course of a year

Mechanic buys $40 of corn from farmer.

Farmer spends $50 on tractor repair from mechanic.

Mechanic spends $10 on barn cats from farmer

``then $100 changed hands in course of a year, even though there is only $50 in this little economy. That $100 level is possible because each dollar was spent an average of twice a year, which is to say that the velocity was 2 / yr.”

In short, velocity of money measures transactions only and not of real economic output.

Moreover, it is also implies that money printing or increasing systemic leverage as the key driver to an increased velocity of money.

From the Austrian economic perspective, this concept is pure flimflam.

Henry Hazlitt wrote ``What the mathematical quantity theorists seem to forget is that money is not exchanged against a vacuum, nor against other money (except in bank clearings and foreign exchange), but against goods. Hence the velocity of circulation of money is, so to speak, merely the velocity of circulation of goods and services looked at from the other side. If the volume of trade increases, the velocity of circulation of money, other things being equal, must increase, and vice versa.” (bold emphasis mine)

Similarly Ludwig von Mises scoffs at the concept, ``They introduce instead the spurious notion of velocity of circulation fashioned according to the patterns of mechanics.” (bold emphasis mine)

Figure 5: Hoisington Management: Velocity of Money

Some deflation exponents say that the two major forces, which drove up the velocity of money, which has characterized the previous boom (see figure 5), particularly financial innovation and leveraging, will be materially less a factor in the post boom era.

The general notion is that the collapse of the shadow banking system and the deleveraging in the US households and its banking system would lead to deflationary pressures from which the government or the central bank inflationary policies won’t be able to offset.

That is from a mathematical standpoint, from which presumes to capture all the variables of human actions. Unfortunately, these macro based math models don’t reflect on reality, because it can’t impute the cause and effect, before and after outcomes of human decisions.

Other reasons why I think velocity of money is a flawed model?

One, such outlook depends on the accuracy of each and every variable that constitutes the equation, such as money supply. If Mr. Durden is correct, then velocity of money model automatically crumbles.

Two, it disregards the impact of pricing dynamics on the marketplace, e.g. how will lower prices impact demand?

Three, it discounts man’s adoptability in acquiring technology [see earlier post, Technology's Early Adoptor Disproves Deflation]

Fourth, such measure focuses entirely on the leveraging of the financial sector and leaves out the contributions from the real economy.

Fifth, it treats the economy as a homogeneous constant (single form of capital, labor and output), from which excludes the evolving phases of the interlinkages of the marketplace, governments and technology.

Lastly, it oversimplistically omits the transmission mechanism from the interactions of the US (policies and economic activities) with the world.

As Professor Arnold Kling observed, ``Structural models do not extract information from data. Instead, they are a method for creating and calibrating simulation models that embody the beliefs of the macroeconomist about how the economy works. Unless one shares those beliefs to begin with, there is no reason for any other economist to take seriously the results that are calculated.” (bold emphasis mine)

Or as Warren Buffett on warned on depending on models, ``Our advice: Beware of geeks bearing formulas.”