The fallacies of GDP

Alasdair Macleod
11 June 2015

The common error of confusing growth with progress goes largely unnoticed, though it permeates all macroeconomic analysis. There is no better example of this mistake than the fallacies behind the interpretation of Gross Domestic Product. GDP is the market value of all final goods and services in a given year. As such, it is only an accounting identity reflecting the quantity of money in the economy.

Econometricians constructing GDP have devised a sterile statistic that should not be used to set economic policy. It leads to the common error of assuming any increase in GDP is desirable. Statistics like GDP tell a story of an economy based on historical prices but devoid of any qualitative value; and progress, the improvement in the human condition, is what really matters.

Transactions reflecting both wealth creation and also economically destructive state spending are included in GDP without differentiation. Far from the government component of GDP being singled out from the total, it is often welcomed as contributing to economic growth. Macroeconomists, with an eye on the statistical impact of cuts in government spending, discourage governments from making them. The lack of distinction between wealth-creation and wealth-destruction is fundamental to their belief that state intervention is beneficial.

More light can be shed on this issue with an example. Imagine an economy with a fixed quantity of money and credit; further assume foreign trade is in balance, and that the population is stable. Products will succeed, stagnate or fail. People will get pay rises, pay cuts or be encouraged by reality to move from the least successful businesses into more successful businesses. The businesses of yesteryear fade and those of tomorrow evolve. Winners will redeploy resources released from the failures. Annual GDP, the sum total of all production paid for by everyone’s earnings and profits, will therefore be unaltered from the previous year: it is a zero sum, assuming that as a whole people’s money preferences relative to goods do not change. Without the injection of extra money, people are always forced to choose between items: they cannot add to the purchasing power of their income through extra credit created out of thin air, creating demand that otherwise would not exist.

Progress is, therefore, marked by improved products and lower prices, because as the volume and quality of production increases the total money value of them must remain the same. This is true for both final products and for investment in the higher orders of production. But importantly, GDP growth is nil.

Now we must consider what happens in the case of unsound money; that is to say money and credit that can be expanded by the will of the state and the banks it licences. Over a period of time, this new money is absorbed into the economy, reflected in new transactions that otherwise would not have occurred. The value of transactions attributable to the expansion of money and credit is likely to be a multiple of the new money introduced, as it passes from the original beneficiaries to later receivers.

If we assume this is a single expansion of the quantity of money these new transactions will only be a temporary feature. The prices of goods bought with the new money rise to compensate with a time lag. Having initially expanded, real GDP would then contract as the temporal lag between stimulus and price effect is fully unwound. With all transactions fully accounted for real GDP ends up unchanged, always assuming there has been no change in consumer preferences between money and goods.

The dubious benefit of stimulating demand by increasing the quantity of money and credit has been only temporary. Changes in GDP described above reflect not economic progress, but the absorption of the extra quantity of money and credit deployed. If the matter stopped there, the damage to a properly functioning economy would be limited, but monetary inflation also triggers a transfer of wealth from the majority of people to a small rich minority. This happens because price increases spread from where the new money is first deployed (typically through the banks and financial markets), leaving the majority of people to face higher prices with no offsetting monetary benefit. There is, therefore, a secondary impact: the apparent benefit of increasing the quantity of money is followed by a fall in demand for goods and services because of the wealth-transfer effect, the opposite of the intended result. The economy as a whole ends up worse off than if no monetary stimulus had occurred. This is why extreme monetary inflation is always accompanied by economic collapse.

In the foregoing example, the effect of a single injection of additional money and credit was considered, but once this policy is embarked upon it is almost always continued at a compounding pace. Macroeconomists note only the initial benefits, and when they fade, as described above, they clamour for more. The result over time is that weak-money policies lead to the continual currency debasement with which we are familiar today, together with the build-up of debt, which is the counterpart of expanding bank credit. As the currency buys less, more is required to achieve the same initial effect.

That changes in money and credit do not equate accurately to changes in GDP in practice is partly due to econometricians selecting which activities to include in GDP. They interpose an artificial distinction between categories of spending with the intention of isolating spending on new goods and services deemed to be consumption. This is an error, because these economists are forced into making a subjective judgement that is bound to be at odds with reality. In practice, a consumer can only be described in the broadest terms.

Consumers may spend money on buying assets such as housing, art or stocks and shares: there is no difference between spending on these and on anything else, because they all have a valid purpose in the mind of the consumer. In addition, there are unrecorded transactions on the black market or not recorded from small businesses, as well as transactions in second-hand goods which are specifically excluded on the grounds that the purpose of GDP is to record new production only. Therefore, much economic activity is excluded from the GDP calculation with the complication that money will flow between the econometrician’s version of GDP to the wider transaction universe, undermining all the macroeconomists’ attempts to link an increase in prices to an increase in the quantities of money and credit.

In conclusion, GDP has nothing to do with economic progress. It is a flawed statistic that imperfectly summarises the money-value of selected transactions over a given period. The fact it is usually positive is a reflection of the temporal difference between monetary inflation and the lagging effect on prices, and has nothing to do with economic progress.

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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.

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