The Faulty Logic of GDP Necessitates an Economic Paradigm Shift

Reprinted from Mises Institute

Nearly 80 years ago — during the height of the Great Depression — economist Simon Kuznets envisioned a system capable of measuring productivity and economic activity. In a report to Congress, Kuznets proposed charting all economic production with a single measurement that would decrease when the economy struggled and increase when it thrived. He called it gross domestic product, or GDP.

Nations throughout the world embraced GDP as the standard for measuring economic activity; Kuznets eventually won the Nobel Prize for his creation. The popularity of GDP belies its effectiveness, however, as the measure systematically under-reports the significance of production.

#GDProblems

The most recent data from the U.S. Bureau of Economic Analysis showed that the country’s GDP increased by about 1.4 percent in the second quarter of this year, which was encouraging news to some. GDP in the U.S. had increased by about 0.8 percent in the first quarter of the year. While this seems like positive news, it’s difficult to say exactly what it means for the average consumer.

GDP was the only available option for a long time, but it has always been flawed because it assumes a net contribution to consumer value through production. A business that produces a certain good is believed to add only the difference between the product’s monetary value and the cost of all inputs combined.

GDP also mistakenly places too much emphasis on business-to-consumer activity compared to business-to-business transactions, which account for a significant amount of investment and opportunity. In fact, money invested in B2B startups through the end of March increased by about 40 percent compared to 2015 figures.

Moreover, GDP is useless because it measures official statistics rather than actual value. Dollar amounts measured in statistics don’t capture the actual satisfaction — or real value — being produced. It also fails to accurately measure innovations until after the fact, meaning investments are considered a loss until they pan out. An economy investing for future production might, therefore, appear to be contracting.

Quantifying Value

By only measuring monetary values — primarily consumption data under the guise of “produced” goods — GDP ignores the fact that value is added in each step along the production chain. It also specifically tracks expenditure and income rather than well-being.

What truly matters in economic growth is how our well-being has improved: how our lives become more convenient, how we get more time for leisure, and how we can afford everything. This is a matter of perception and ability to consume.

It can be argued that we experience economic growth when prices fall but wages are steady. Those same incomes can buy more goods and services, consequently making us wealthier.

When we talk about inequality, we’re almost always speaking of income rather than well-being. But what does it matter if one person earns $1,000 and another earns $1 million if the goods they both consume are identical? If we’re unable to satisfy more wants by earning significantly more money, income becomes irrelevant.

This is often the case in Western nations, where income inequality is on the rise. The U.S. has seen income inequality increase since the 1970s, with the top 1 percent of U.S. families earning about 25 times as much as the remaining 99 percent. While income inequality is growing, well-being inequality is actually shrinking.

The price difference between a Mercedes-Benz and a Toyota is greater than the gap between having a car and not having one, but the well-being differential is reversed. A Mercedes-Benz doesn’t offer more transportation than a Toyota, but having any car is tremendously better than not having one in terms of well-being.

A Better Indicator

While GDP ultimately fails to track the size of an economy, a different measure offers a much broader view of economic activity.

Economist Mark Skousen has long advocated for gross output as a viable alternative to GDP. Gross output goes beyond finished goods and services that don’t necessarily have a final “value.”

For instance, a business breaking even without any profits still contributes to the economy through production — it consumes inputs to produce outputs, pays suppliers and employees, and provides goods, services, and capital to other businesses. A lack of profit doesn’t mean the economy is smaller or that this business isn’t contributing to the economy. Instead, consumers of its products have added to their well-being.

It’s a matter of perspective. The GDP is based on a faulty theory of the economy as consumption-driven when it’s actually more production-driven. Consumption happens where production facilitates it, through goods and services produced as well as income generated by selling those goods and services.

In a market society, we produce for market needs rather than our own benefit. This allows us to generate income to satisfy our own needs and wants by consuming the goods and services others produce. This allows us to specialize and develop expertise to innovate and simplify our own production, which eventually helps us increase our output, serve more consumers, and generate more money to spend on goods.

Reversing Course

GDP effectively ignores all attempts to improve production because they don’t result in increased consumption. It falsely assumes that consumption drives production; therefore, it’s pointless to map out and measure the latter. In other words, GDP adopts a backward economic perspective.

In reality, entrepreneurs produce what they believe consumers want to buy. The fact that they undertake uncertain production projects helps contribute to our common prosperity and standard of living.

Whereas gross output takes a broader view of economic activity, GDP misunderstands economics by simply counting what statistics capture: net consumption, net profits, net this, and net that. After almost eight decades of flawed logic, we’re due for an economic paradigm shift.

Can the State Reduce Poverty?

Reprinted from Mises Institute

From the beginning of history, sincere reformers as well as demagogues have sought to abolish or at least to alleviate poverty through state action. In most cases their proposed remedies have only served to make the problem worse.

The most frequent and popular of these proposed remedies has been the simple one of seizing from the rich to give to the poor. This remedy has taken a thousand different forms, but they all come down to this. The wealth is to be „shared,“ to be „redistributed,“ to be „equalized.“ In fact, in the minds of many reformers it is not poverty that is the chief evil but inequality.

All schemes for redistributing or equalizing incomes or wealth must undermine or destroy incentives at both ends of the economic scale. They must reduce or abolish the incentives of the unskilled or shiftless to improve their condition by their own efforts; and even the able and industrious will see little point in earning anything beyond what they are allowed to keep. These redistribution schemes must inevitably reduce the size of the pie to be redistributed. They can only level down. Their long-run effect must be to reduce production and lead toward national impoverishment.

The problem we face is that the false remedies for poverty are almost infinite in number. An attempt at a thorough refutation of any single one of them would run to disproportionate length. But some of these false remedies are so widely regarded as real cures or mitigations of poverty that if I do not refer to them I may be accused of having undertaken a book on the remedies for poverty while ignoring some of the most obvious.

The most widely practiced „remedy“ for low incomes in the last two centuries has been the formation of monopolistic labor unions and the use of the strike threat. In nearly every country today this has been made possible to its present extent by government policies that permit and encourage coercive union tactics and inhibit or restrict counteractions by employers.

As a result of union exclusiveness, of deliberate inefficiency, of featherbedding, of disruptive strikes and strike threats, the long-run effect of customary union policies has been to discourage capital investment and to make the average real wage of the whole body of workers lower, and not higher, than it would otherwise have been.

Nearly all of these customary union policies have been dishearteningly shortsighted. When unions insist on the employment of men who are not necessary to do a job (requiring unneeded firemen on diesel locomotives; forbidding the gang size of dock workers to be reduced below, say, twenty men no matter what the size of the task; demanding that a newspaper’s own printers must duplicate advertising copy that comes in already set in type, etc.), the result may be to preserve or create a few more jobs for specific men in the short run, but only at the cost of making impossible the creation of an equivalent or greater number of more productive jobs for others.

The same criticism applies to the age-old union policy of opposing the use of labor-saving machinery. Labor-saving machinery is installed only when it promises to reduce production costs. When it does that, it either reduces prices and leads to increased production and sales of the commodity being produced, or it makes more profits available for increased reinvestment in other production. In either case its long-run effect is to substitute more productive jobs for the less productive jobs it eliminates.

A similar judgment must be passed on all „spread-the-work“ schemes. The existing Federal Wage-Hour Law has been on the books for many years. It provides that the employer must pay a 50% penalty overtime rate for all hours that an employee works in excess of 40 hours a week, no matter how high the employee’s standard hourly rate of pay.

This provision was inserted at the insistence of the unions. Its purpose was to make it so costly for the employer to work men overtime that he would be obliged to take on additional workers.

Experience shows that the provision has in fact had the effect of narrowly restricting the length of the working week…. But it does not follow that the hour restriction either created more long-term jobs or yielded higher total payrolls than would have existed without the compulsory 50% overtime rate.

No doubt in isolated cases more men have been employed than would otherwise have been. But the chief effect of the overtime law has been to raise production costs. Firms already working full standard time often have to refuse new orders because they cannot afford to pay the penalty overtime necessary to fill those orders. They cannot afford to take on new employees to meet what may be only a temporarily higher demand because they may also have to install an equivalent number of additional machines.

Higher production costs mean higher prices. They must therefore mean narrowed markets and smaller sales. They mean that fewer goods and services are produced. In the long run, the interests of the whole body of workers must be adversely affected by compulsory overtime penalties.

All this is not to argue that there ought to be a longer work week, but rather that the length of the work week, and the scale of overtime rates, ought to be left to voluntary agreement between individual workers or unions and their employers. In any case, legal restrictions on the length of the working week cannot in the long run increase the number of jobs. To the extent that they can do that in the short run, it must necessarily be at the expense of production and of the real income of the whole body of workers.

Ten Fundamental Laws of Economics

Reprinted from the Mises Institute.

In the midst of so many economic fallacies being repeatedly seemingly without end, it may be helpful to return to some of the most basic laws of economics. Here are ten of them that bear repeating again and again. 

1. Production precedes consumption

Although it is obvious that in order to consume something it must first exist, the idea to stimulate consumption in order to expand production is all around us. However, consumption goods do not just fall from the sky. They are at the end of a long chain of intertwined production processes called the “structure of production.” Even the production of an apparently simple item such as a pencil, for example, requires an intricate network of production processes that extend far back into time and run across countries and continents.

2. Consumption is the final goal of production

Consumption is the objective of economic activity, and production is its means. The advocates of full employment violate this obvious idea. Employment programs turn production itself into the objective. The valuation of consumption goods by the consumers determines the value of production goods. Current consumption results from the production process that extends to the past, yet the value of this production structure depends on the current state of valuation by the consumers and the expected future state. Therefore, the consumers are the final de facto owners of the production apparatus in a capitalist economy.

3. Production has costs

There is no such thing as a free lunch. Getting something apparently gratis only means that some other person pays for it. Behind every welfare check and each research grant lies the tax money of real people. While the taxpayers see that government confiscates part of one’s personal income, they do not know to whom this money goes; and while the recipients of government expenditures see the government handing the money to them, they do not know from whom the government has taken away this money.

4. Value is subjective

Valuation is subjective and varies with the an individual’s situation. The same physical good has different values to different persons. Utility is subjective, individual, situational and marginal. There is no such thing as collective consumption. Even the temperature in the same room feels differently to different persons. The same football match has a different subjective value for each viewer as can be easily seen the moment when a team scores.

5. Productivity determines the wage rate

The output per hour determines the worker’s wage rate per hour. In a free labor market, businesses will hire additional workers as long as their marginal productivity is higher than the wage rate. Competition among the firms will drive up the wage rate to the point where it matches productivity. The power of labor unions may change the distribution of wages among the different labor groups, but trade unions cannot change the overall wage level, which depends on labor productivity.

6. Expenditure is income and costs

Expenditure is not only income, but also represents costs. Spending counts as costs for the buyer and income for the seller. Income equals costs. The mechanism of the fiscal multiplier implies that costs rise with income. In as much as income multiplies, costs multiply as well. The Keynesian fiscal multiplier model ignores the cost effect. Grave policy errors are the result when government policies count on the income effect of public expenditures but ignore the cost effect.

7. Money is not wealth

The value of money consists in its purchasing power. Money serves as an instrument of exchange. The wealth of a person exists in its access to the goods and services he desires. The nation as a whole cannot increase its wealth by increasing its stock of money. The principle that only purchasing power means wealth says that Robinson Crusoe would not be a penny richer if he found a gold mine on his island or a case full of bank notes.

8. Labor does not create value

Labor, in combination with the other factors of production, creates products, but the value of the product depends on its utility. Utility depends on subjective individual valuation. Employment for sake of employment makes no economic sense. What counts is value creation. In order to be useful, a product must create benefits for the consumer. The value of a good exists independent from the effort of producing it. Professional marathon runners do not earn more prize money than sprinters because running the marathon takes more time and effort than a sprint.

9. Profit is the entrepreneurial bonus

In competitive capitalism, economic profit is the extra bonus that those businesses earn that fix allocative errors. In an evenly rotating economy with no change, there would be neither profit nor loss and all companies would earn the same rate of interest. In a growing economy, however, change takes place and anticipating changes is the source of economic profits. Business that does well in forecasting future demand earn high rates of profit and will grow, while those entrepreneurs who fail to anticipate the wants of the consumers will shrink and finally must shut down.

10. All genuine laws of economics are logical laws

Economic laws are synthetic a priori reasoning. One cannot falsify such laws empirically because they are true in themselves. As such, the fundamental economic laws do not require empirical verification. Reference to empirical facts serve merely as illustrative examples, they are not statements of principles. One can ignore and violate the fundamental laws of economics but one cannot change them. Those societies fare best where people and government recognize and respect these fundamental economic laws and use them to their advantage.