Movements in GDP cannot tell us what is going on in the real economy. If anything, GDP can actually provide us with a false impression. Here’s why…
by Frank Shostak of Mises Wire
In the New York Times September 14, 2018, in an article “We’re Measuring The Economy All Wrong,” the writer of the article David Leonhardt complains that despite strong gross domestic product (GDP) data most people don’t feel it. The writer of the article argues that,
The trouble is that a handful of statistics dominate the public conversation about the economy despite the fact that they provide a misleading portrait of people’s lives. Even worse, the statistics have become more misleading over time.
According to the accepted rule of thumb, recessions are about at least two quarters of negative growth in real gross domestic product (GDP). Recessions, according to this way of thinking, are seen as something associated with the so-called strength of the economy. The stronger an economy is the less likely it is to fall into a recession. The major cause of recessions is seen as various shocks, such as a sharp increase in the price of oil or some disruptive political events, or natural disasters or a sudden fall in consumer outlays on goods and services. Obviously then, if an economy is strong enough to cope with these shocks then recessions can be prevented, or at least made less painful. For instance, a well-managed company with a well-managed inventory is likely to withstand the effects of various shocks versus a poorly managed company.
Severity of a recession and the strength of the economy
We suggest that recessions are not about two quarters of negative growth in real GDP, or declines in various economic indicators as such. They are also not about successful inventory management. We would suggest that recessions are not about how resilient an economy is to various external and internal shocks.
A recession is about the liquidation of various activities that spring-up on the back of the previous loose monetary policies of the central bank. A loose central-bank monetary policy sets in motion a diversion of real wealth from wealth generating activities to non-wealth generating activities. In the process, this diversion weakens wealth generators and this in turn weakens their ability to grow the overall pool of real wealth.
The expansion in the activities that spring-up on the back of loose monetary policy is what an economic boom, or false economic prosperity, is all about. Note that once the central bank’s pace of monetary pumping has strengthened, irrespective of how strong and big a particular economy is the pace of the diversion of real wealth is going to strengthen.
Once, however, the central bank tightens its monetary stance this slows down the diversion of real wealth from wealth producers to non-wealth producers. Since activities that sprang-up on the back of the previous loose monetary policy cannot now generate an adequate amount of real wealth to remain viable they fall into trouble. (These activities can only survive by means of the diversion of real wealth from wealth generating activities.)
A fall in the money supply growth rate because of a tighter central bank stance slows down the diversion of real funding toward bubble activities, which in turn undermines the expansion ability of these activities — an economic bust or recession emerges. An economic bust or a recession here is about the fact that various bubble activities are forced to curtail their activities.
Observe that irrespective of how big and strong an economy is a tighter monetary stance is going to undermine various bubble activities that sprang-up on the back of the previous loose monetary policy. This means that recessions, or economic busts, have nothing to do with the so-called strength of an economy.
For instance, because of a loose monetary stance on the part of the Fed various activities emerge to accommodate the demand for goods and services of the first receivers of newly pumped money. (These activities emerge on the back of newly issued bank lending out of “thin air.”)
Now, even if these activities are well-managed and maintain very efficient inventory control this fact cannot be of much help once the central bank reverses its loose monetary stance. Again, note that these activities are the product of the loose monetary stance of the central bank. Once the stance is reversed regardless of efficient inventory management these activities will come under pressure and run the risk of being liquidated.
From this, we can infer that what sets in motion boom-bust cycles are changes in the central bank’s monetary policies, which give rise to changes in the growth rate of the money supply. (Note that ultimately the diversion of real wealth from wealth to non-wealth producers is set in motion by changes in the money supply growth rate. Again, the increase in the money supply growth rate sets in motion an increase in the diversion of real wealth, which results in an economic boom. A decline in the money growth rate slows down this diversion, which results in an economic recession (bust).)
Also, note that recessions in this sense are beneficial for various wealth generating activities since the pace of their wealth expropriation slows down or stops altogether.
GDP and the real economy — what is the relationship?
According to Mises the whole idea that one can establish the value of the national output, or what is called the gross domestic product (GDP) is somewhat far-fetched:
The attempt to determine in money the wealth of a nation or the whole of mankind are as childish as the mystic efforts to solve the riddles of the universe by worrying about the dimension of the pyramid of Cheops.
If a business calculation values a supply of potatoes at $100, the idea is that it will be possible to sell it or replace it against this sum. If a whole entrepreneurial unit is estimated at $1,000,000 it means that one expects to sell it for this amount, the businessman can convert his property into money, but a nation cannot.
In addition to all these issues, there are serious problems regarding the calculation of the real GDP statistic. To calculate a total, several things must be added together. To add things together, they must have some unit in common. However, it is not possible to add refrigerators to cars and shirts to obtain the total of final goods. Since the total real output cannot be defined in a meaningful way, obviously it cannot be quantified.
To overcome this problem, economists employ total monetary expenditure on goods, which they divide by an average price of those goods. There is, however, a serious problem with this.
Suppose two transactions were conducted. In the first transaction, one TV set is exchanged for $1,000. In the second transaction, one shirt is exchanged for $40. The price or the rate of exchange in the first transaction is $1,000/1TV set. The price in the second transaction is $40/1shirt. In order to calculate the average price, we must add these two ratios and divide them by 2.
However, $1,000/1TV set cannot be added to $40/1shirt, implying that it is not possible to establish an average price.
On this Rothbard wrote,
Thus, any concept of average price level involves adding or multiplying quantities of completely different units of goods, such as butter, hats, sugar, etc., and is therefore meaningless and illegitimate.
The employment of various sophisticated methods to calculate the average price level cannot bypass the essential issue that it is not possible to establish an average price of various goods and services.
Accordingly, various price indices that government statisticians compute are simply arbitrary numbers. If price deflators are meaningless so is the real GDP statistic.
Even government statisticians admit that the whole thing is not real. According to J. Steven Landefeld and Robert P. Parker from the Bureau of Economic Analysis,
In particular, it is important to recognize that real GDP is an analytic concept. Despite the name, real GDP is not “real” in the sense that it can, even in principle, be observed or collected directly, in the same sense that current-dollar GDP cannot in principle be observed or collected as the sum of actual spending on final goods and services in the economy. Quantities of apples and oranges can in principle be collected, but they cannot be added to obtain the total quantity of “fruit” output in the economy.
Now, since it is not possible to quantitatively establish the status of the total of real goods and services, obviously various data like real GDP that government statisticians generate should not be taken too seriously.
So what are we to make out of the periodical pronouncements that the economy, as depicted by real GDP, grew by a particular percentage? All we can say is that this percentage has nothing to do with real economic growth and that it most likely mirrors the pace of monetary pumping. Since GDP is expressed in dollar terms, it is obvious that its fluctuations will be driven by the fluctuations in the amount of dollars pumped into the economy.
From this, we can also infer that a strong real GDP growth rate most likely depicts a weakening in the process of real wealth formation.
Once it is realized that so-called real economic growth, as depicted by real GDP, mirrors fluctuations in the money supply growth rate it becomes clear that an economic boom has nothing to do with real economic expansion. On the contrary, such a boom is about real economic contraction since it undermines the pool of real wealth — the heart of real economic growth. (Remember that the boom is because of the increase in the money supply growth rate, which gives rise to various bubble activities that undermine the process of wealth generation.)
Contrary to the accepted way of thinking, recessions are not about negative growth in GDP for at least two consecutive quarters. It is about the liquidations of activities that spring up on the back of the loose monetary policies of the central bank. In addition, movements in GDP cannot tell us what is going on in the real economy. If anything, it can actually provide us with a false impression. A strong GDP growth rate in most cases is likely to be associated with the intensive squandering of the pool of real wealth. Hence, despite “good GDP” data many more individuals may find it much harder to make ends meet.