The extraordinary tale of a false statistic

Alasdair Macleod – 7 October 2011

An American economist and econometrician, Simon Kuznets, was awarded a Nobel Prize in 1971 for “his empirically founded interpretation of economic growth which has led to new and deepened insight into the economic and social structure and process of development”. It was Kuznets who is credited with the invention of Gross Domestic Product, which he worked on in the late 1930s.

Before his work on GDP there was no statistical measurement of the size of an economy. The problem was to reduce the diverse production of goods and services to a single measurement, so that apples and pears could be lumped in with motor cars and trucks. GDP is the value of all goods and services in an economy measured in the currency of the country, in this case US dollars because Kuznets worked for the US Government. Allowance was also to be made for government provisions of goods and services, many of which were provided to end-users for free. The solution was to include these at cost.

GDP might be useful when quantifying the size of one economy compared with another, and it allows us to construct a table showing their relative importance to each other. But GDP was taken further in its use by Keynesian economists to become an important, and now the most important statistic, for assessing the effectiveness of macro-economic policy. And because it does not differentiate between the value of consumer-driven GDP and government-driven GDP, it has been easy for politicians and their economic advisers to slip into the habit of assuming they have similar economic values. This allows a politician to spend money and know that that spending contributes to “economic growth” as reported in the GDP statistic, to the same degree as does an increase in private sector output.

This lack of value-judgement in the GDP number is analogous to valuing a company on its balance sheet alone. The balance sheet might say the company has productive assets at a figure in the books, but no serious investor is going to take the accounting information as read: he will go and look at the trucks, the factories, and the equipment therein and then form a judgement on their condition and value to the enterprise. The numbers in the balance sheet are no more than an accounting identity of the factors of production. In the same way, a GDP figure will be comprised of the output of some businesses that are dynamic, inventive and have a commanding global product. There will be other businesses that rely on government subsidies to remain in business: the value of their product is less perhaps valuable to the economy, except in the eyes of the politicians who have authorised the subsidy. In that case, it cannot be said that the product of these subsidised businesses are wanted by the consumer in the quantity produced or at a profitable price. There are also those businesses whose output is dependent on government contracts; contracts that may or not add true value to an economy. And then there is the cost of government services, which are forced upon people whether they want them or not, which diverts through taxes financial resources that would otherwise be applied to products and services that people actually do want.

This much the Austrian School of economists agree with. Von Mises himself wrote that “the attempt to determine in money the wealth of a nation or the whole of mankind is as childish as the mystic efforts to solve the riddles of the Universe by worrying about the dimensions of the pyramids of Cheops”.[i] But we can advance criticism one step further to demolish any pretence the GDP statistic has to represent the values of production, and therefore be a valid measure of economic output.

To do so, we need to consider an economy with sound money, with no change in the quantity of money and bank credit, and a balance in trade and cross-border capital flows. If, on the last day of the previous year, GDP is one billion monetary units, what will it be on the last day of the current year? It has to be the same one billion units. Production activity can change, the ratio between consumption and savings can change, the ratio of private sector to public sector in the economy can change, but if there is no change in the quantity of money, GDP must be the same. The adjustment is on prices, so a rise in overall production leads to lower prices, and lower production to higher prices.

Having established that in a sound money regime there can be no change in GDP, it becomes clear that in a fiat money regime, GDP will change only to reflect monetary inflation, independently of production activity. In this case the stock of money is simply being increased, and the effect on the prices of final goods is a secondary consideration, just as it is in the sound-money example.

But there is a further difference between the two conditions. In the sound money example, prices can be expected to fall over time, making the application of savings to business investment an attractive proposition for savers. Not only does the saver get a modest interest return, but the purchasing power of his capital increases over the years. For this reason surplus capital tends to be productively invested as savings rather than speculated with, positive returns being certain, except for individual entrepreneurial risk.

In a fiat money regime, this relationship between savers and productive investment is interfered with by the consumption of capital that results from inflation, and by the destabilising effect of credit-driven boom-and-bust cycles. As savers become aware of the loss of their capital they seek other ways to protect it. And because they, or financial intermediaries acting on their behalf, increasingly seek to protect their savings from inflation, money-savings shift away from productive investment. Instead they are reapplied to more speculative activitites, such as gambling in stock markets and other asset classes thought to benefit from monetary inflation.

The long-run effects are demonstrated in the contrast between economies primarily driven by savings and those driven by consumption. In the post-war years, Germany and Japan developed a strong savings culture that flourished under successive governments, which pursued an anti-inflation bias in monetary policy. The consequence was interest rate stability at levels that were more influenced by supply and demand for savings than by the central banks’ monetary expansion. The benefits enjoyed by these savings-driven economies are in accordance with the Capital Theory developed by adherents to the Austrian School of economists. Stability in the cost of money and other factors of production allowed intermediate manufacturing processes to thrive, and both Germany and Japan developed into economic power-houses as a result.[ii]

The position of consumption-driven economies has been entirely different. In the post-war years the governments of the US and UK (taken as an example) have relied on monetary expansion as the driver of economic growth as they followed Keynesian and Monetarist macro-economic policies. Inevitably, the ethos whereby savings are applied to industrial investment has suffered considerable and increasing disruption. The decline in the savings ethos in both these Anglo-Saxon economies has been driven by monetary inflation and the unstable economic conditions for productive investment that results from monetary expansion. Again, this is easily deduced from Capital Theory. The consequence is that manufacturing, with unstable costs of both money and the other factors of production declined, leaving these economies increasingly dependent on consumption.
The growing pool of speculative capital

Attempts to manage the GDP statistic through injections of fiat money have not only distorted the relationship between genuine savings and productive investment, they have also led to a growing accumulation of speculative capital, as mentioned above. For this reason, monetary expansion does not automatically feed into GDP. To the extent that this leakage occurs, monetary expansion has to be pursued more aggressively to bolster this number. And here a self-defeating mechanism becomes evident. The more monetary inflation is injected into the economy, the more capital owned by the private sector is consumed, and therefore the more monetary expansion favours financial speculation over productive investment. Further injections of fiat money are simply ceasing to bolster the GDP statistic.

Not that this will stop economic policy from continuing to try to grow the GDP accounting identity: Keynesianism and Monetarism is based in large measure on the delusion that the GDP statistic is actually economic growth and not just growth in the money in the economy. The only way this process will cease is when all confidence is lost in the purchasing-power of fiat money. Only then, in the post mortem, might the mistake of confusing an accounting identity for the real thing become clear to the economic establishment and the wider population at large.


[i] Human Action as quoted in an article by Dr Frank Shostak published by 3 Sept 2007.

[ii] See Capital Theory

Published by


Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

Leave a Reply

Your email address will not be published. Required fields are marked *