Sunday, January 8, 2012

GDP is Gross

No, not the number which is bad enough, the actual equation. It supposedly tells us the health of the national economy but it does no such thing. And even worse is the unfortunate misconception it has created that 70% of the American economy is made up of consumer spending. That's just idiotic. But it has been repeated for so long that it's considered truth and even thick-skulled journalists repeat it back like parrots whenever they report on the economy.

It may also partly explain why so many Americans think we don't make anything here anymore. After all, if 70% of economic activity is consumer spending, there ain't much left. In addition to that, it has probably also led to the widespread condemnation of Americans as greedy, profligate consumers -- evidently raping the world of its treasure since we can't be bothered to make any of our own. It's all very unfortunate and unnecessary.

Left out of the equation is all the production going on to create the stuff that consumers buy. Of course, defenders of the GDP (Keynesians one and all) will tell you that to include production costs would be double-counting as those are wrapped up in the final sales prices of the consumer goods. It must be the case, they insist, because, of necessity, production costs have to be less than sales. No. They. Don't.

That is an example of the fallacy of composition that claims since each profit-making business's revenues exceed costs, the same is necessarily true for the the sum of all businesses. But let's work through a simple example to show just how false that assumption is.

Imagine a small country with a rubber ball industry. It's comprised of two businesses: a ball manufacturer (who, we shall assume, sells his product direct just to save complexity) and a rubber plant that turns out the sheets of rubber used to make the balls. The ball manufacturer buys the entire output of his supplier.

Last year on sales of rubber balls totaling $1 million, the ball factory paid $500,000 for rubber, spent $200,000 on labor, and had other expenses of $100,000. Its profit, therefore, was $200,000.

The rubber plant, which sold its entire output to the ball factory, therefore had sales of $500,000. Its raw materials costs amounted to $200,000. Labor ran $100,000 and capital and other expenses amounted to $100,000 for a profit of $100,000.

So, the rubber ball industry of our imaginary country had $1 million in consumer sales (finished rubber balls), but production costs totaled $1.2 million -- and both companies made a nice profit. It's counter-intuitive, I suppose, to people who have actually never thought about it. But we can see that it's not only likely, but probably necessary that an economy with an advanced division of labor and high ratio of capital to labor would spend more on production than on consumption.

If all the productive expenditures of American businesses were included in the GDP figures, the true composition of the economy would be much clearer. In good times, it would run about 40% for business-to-business (production) spending vs. around 30% for consumer spending. And when times turned bad, we would see much sooner where things were going wrong.

I doubt that our Keynesian-drenched government will soon consider such a simple and sensible suggestion because it would not enhance the mistaken theory that consumer spending drives all economic activity. But it would be the right thing to do if we want to understand how the entire economy is performing.

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