The truth about GDP

Alasdair Macleod
26 November 2015

“I can prove anything by statistics except the truth” – George Canning

Canning’s aphorism is as valid today as when he was Britain’s Prime Minister in 1817. Unfortunately, his wisdom is ignored completely by mainstream economists. Nowhere is this error more important than in defining economic activity, where the abuse of statistics is taken to levels that would have even surprised Canning.

Today we describe the economy as being in one of two states, growth or recession. We arrive at a judgment of its condition by taking the sum total of the transactions selected by statisticians and then deflating this total by a rate of inflation devised by them under direct or indirect political direction. Nominal gross domestic product is created and thereby adjusted and termed real GDP.

The errors in the method encourage a bias towards a general increase in the GDP trend by under-recording the rate of price inflation. From here it is a short step to associate rising prices only with an increase in economic activity. It also follows, based on these assumptions, that falling prices are to be avoided at all costs.

Assumptions, assumptions, all are assumptions. They lead to a ridiculous conclusion, that falling prices are evidence of falling demand, recession or even depression. Another of Canning’s aphorisms was that there is nothing so sublime as the truth. There’s no sublimity here. If there was, the improvement in everyone’s standard of living through falling prices for communications, access to data, and the technology in our homes and everyday life could not possibly have happened.

Well, they have happened, and the falling prices of the products of the greatest private sector corporations on earth are proof that they are both popular and good for business. Furthermore, the either/or condition of inflation/deflation firmly believed by macroeconomists would logically rule out the impoverishment of people in hyperinflations. If rising prices are good for the economy, how come everyone was so unhappy in Germany’s Weimar Republic in 1923, or in Zimbabwe fifteen years ago? Surely, as inflation accelerates the happiness level should rise……

No sublimity here, either.

Error compounds upon error. So what is economic growth? It is not what the name suggests, it is merely an increase in the total monetary value of statistically eligible transactions. There is no qualitative judgment in this: governments can and usually do goose the GDP number with needless bureaucracy and projects few consumers would be prepared to pay for with their own money. Furthermore, an increase in GDP only occurs if the quantity of money and bank credit has been increased, and then applied to the part of the economy explicitly covered by the statisticians’ statistics.

The following is what happens when new money or bank credit enters the economy. The banks create money out of thin air and lend it to a favored customer. The customer spends it before prices adjust, reaping the full benefit of prices that do not take the creation of the new money into account. Only then will the prices of goods bought with this new money reflect the extra demand that has materialized seemingly out of thin air, and this price effect subsequently spreads, always one step behind the new money being spent. The large majority of consumers will find prices have already risen against them, without any compensation in their income, or if they are retired, the value of their pensions and savings. So the end result is wealth has been transferred from the weakest in society up the line incrementally to the first receivers of the new money.

As the new money gradually spreads through a community, prices will tend to rise. If one could record the effect, it would be found that in real terms the extra economic activity from currency debasement is gradually dissipated into higher prices. It is a short-term increase in demand that is then reversed. In a perfect statistical world, real GDP would faithfully track the effect. Unfortunately, we have the vested interests of statisticians and their paymasters to contend with, and also the inappropriateness of the application of statistical method, more suited to measurement in natural sciences such as physics than to an imprecise social science akin to psychology.

Instead of taking into account these temporal effects of monetary inflation on prices, it is just assumed that an increase in the quantity of money and credit leads to straightforward price increases. All else being equal, it eventually does, but all else is never equal. Of far greater importance is the public’s relative preference between money and goods. Money retains its role as money only because people accept it as such. Fiat currencies, which have no value for any other purpose, are at continual risk of becoming valueless. The condition required for a fiat currency to retain any value is that demand for it has to be maintained, so that it is always scarce.

Assuming that condition applies, the most important determinant of the level of money’s purchasing power is the marginal balance of peoples’ preferences for it relative to goods. In practice, and because government ensures a monopoly exists for its fiat currency, this is usually stable, tolerating large changes of the amount of money and credit in circulation without altering radically.

If this marginal preference changes from consumption goods towards money, prices of goods will tend to fall. This was dramatically illustrated during the financial crisis in 2008/09. The opposite is also true, when the marginal preference swings away from money towards goods. It is this condition which leads to hyperinflations, not the rapid expansion of the quantity of money as commonly supposed, though monetary expansion is usually part and parcel of the condition.

It should now be obvious that economic planning through monetary policy can never succeed. Even assuming that the planners are blessed with a prescience they do not have and that no economic model can give them, it appears they are unaware that concepts of growth and recession are not the same as economic progress or the lack of it. For measurement of this thoroughly bad substitute they rely on the one thing, which as Canning wryly observed, can tell them everything but the truth.

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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.