How to Increase the Economy's Size by Fiat
The U.S. government has hit on a new solution to kick Carmen Reinhart and Kenneth Rogoff while they're down. Since their recently disputed paper makes so much of public debt-to-GDP ratios, one way to improve the situation is obviously to increase the size of GDP, ceteris paribus. But how do you accomplish that in an economy that requires the addition of a lot more than a dollar in new debt to produce a dollar of 'growth'?
Simple-- you just make stuff up. And so it has been decided to 'grow' the size of the U.S. GDP overnight by 3% by adding new items to it, some of which are so diffuse in their nature that they will be ideally suited to manipulating henceforth what is already the most manipulated economic statistic.
The relationship between the growth in total U.S. credit market debt to 'GDP' (from Dr. Marc Faber's presentation at the CFA Society Vancouver in March 2009).
According to press reports, this is how U.S. GDP will be grown overnight:
"The U.S. economy will officially become 3 percent bigger in July as part of a shake-up that will for the first time see government statistics take into account 21st century components such as film royalties and spending on research and development.
Billions of dollars of intangible assets will enter the gross domestic product of the world's largest economy in a revision aimed at capturing the changing nature of U.S. output.
In an interview with the Financial Times, Brent Moulton, who manages the national accounts at the Bureau of Economic Analysis, said the update is the biggest since computer software was added to the accounts in 1999.
"We are carrying these major changes all the way back in time – which for us means to 1929 – so we are essentially rewriting economic history," said Mr Moulton. The changes will affect everything from the measured GDP of different U.S. states to the stability of the inflation measure targeted by the U.S. Federal Reserve. They will force economists to revisit policy debates about everything from corporate profits to the causes of economic growth.
The revision, which is equivalent to adding a country as big as Belgium to the estimated size of the world economy, will make the U.S. one of the first adopters of a new international standard for GDP accounting.
"We're capitalizing research and development and also this category referred to as entertainment, literary and artistic originals, which would be things like motion picture originals, long-lasting television programs, books and sound recordings," said Mr Moulton.
At present, R&D counts as a cost of doing business, so the final output of Apple iPads is included in GDP but the research done to create them is not. After the change, R&D will count as an investment, adding a bit more than 2 percent to the measured size of the economy.
GDP will soar in small states that host a lot of military R&D, but barely change in others, widening measured income gaps across the U.S. R&D is expected to boost the GDP of New Mexico by 10 percent and Maryland by 6 percent while Louisiana will see an increase of just 0.6 percent. Creative works are expected to add another 0.5 percent to the overall size of the U.S. economy. Around one-third of that will come from movies, one-third from TV programs, and another one-third from books, music and theater.
The changes are in addition to a comprehensive revision of the national accounts that takes place every five years based on an economic census of nearly 4 million U.S. businesses.
Steve Landefeld, the BEA director, said it was hard to predict the overall outcome given the mixture of new methodology and data updates. "What's going to happen when you mix it with the new source data from the economic census … I don't know," he said."
It is quite stunning – or at least it should be – that these numbers will affect everything, including "the stability of the inflation measure targeted by the U.S. Federal Reserve." and that they will allegedly "force economists to revisit policy debates about everything from corporate profits to the causes of economic growth."
How can something that has just been made up out of whole cloth possibly influence everything from policy decisions to economic debates about the 'causes of economic growth'? Especially knowing that absolutely nothing has changed in reality, since the economy is still exactly the same it was before. What changes is how it is 'measured', but that 'measurement' was a complete nonsense number even before these recent changes. No wonder we are lurching from one boom-bust cycle to the next: the state's 'policy' minions and the econometricians populating modern economics all seem to believe that these numbers actually mean something. The problem is, they don't.
The Many Deficiencies of GDP
In 1975, Oskar Morgenstern warned his colleagues in the economics profession about using the --already back then-- completely useless 'GDP' accounts as the basis for policy recommendations. Almost needless to say, since Morgenstern delivered his lecture, the numbers have been 'improved' to the point of becoming a complete mirage.
As Morgenstern pointed out – and in part it turns out his objections were almost prophetic, since every bad idea that could possibly be incorporated into the calculation of 'GDP' has since then indeed been assiduously added to it – GDP incorporates a great many things that have obviously nothing to do with welfare-enhancing growth; in fact, many of these items actually reduce welfare:
"Anything that leads to a transaction in monetary form, which is where goods and services change hands against money, is recorded as positive, no matter what is being sold, it enters GNP. It may have been sales of goods already stocked, it may have been a car just coming out of a factory: it does not matter. Neither does it matter what it is: Atomic bombs, drugs, cars, food, aesthetic pollution by new billboards, you name it. Clearly that goes against common sense. Why should all goods and services be treated alike? If I don't like more nuclear weapons, why should I accept a measurement that includes them as part of the 'growth' of the economy? Of course once could argue that one is only interested in transactions. But then one would have a great deal of explaining to do how more transactions can possibly be related to 'welfare'. Does the uncontrolled increase of cancer cells in a child mean 'growth'? There are other equally well-known difficulties. Many services are rendered and many goods produced that never enter a market. Thus they escape GNP. As has been noted by many, if housewives were being paid by their husbands, GNP would rise although there would not be one iota of difference in production or services. There are many other similar situations.
Another trouble with the GNP concept is that it measures, or rather expresses, as positive also the malfunctions of the economic system or society. To wit: if we are stuck in one of the thousands of traffic jams, if airplanes are stacked and cannot land on schedule, if fires break out and other disasters occur that require repair – up goes the GNP. More gasoline is used, fares go up, overtime has to be paid, and so on. It would be difficult in any other science to find a 'measure' which tells simultaneously opposite stories if the functioning of a complex system in one single scalar number! If we merely improve the scheduling of airplanes and stagger the times of automobile traffic, and nothing else is changed – down goes the GNP! It goes up, on the other hand, if industry pollutes the air and we create other industries which remove the polluting substances.
So we see that there is real trouble with the basic underlying notion of GNP. It is not an acceptable scientific concept for the purposes it is used."
(emphasis added, italics in the original)
Morgenstern then went on to show that the measurements that are used to put together GDP are themselves deeply flawed ('the numbers are all laundered'). These measurements and actual reality were already shown by Kuznets to have a variance of up to 20%. And yet, the numbers are always presented to us as if they were exact. Nowhere does it say: "GDP was X, plus/minus 20%".
The above also explains why hobby economists like Paul Krugman (we will forever remain mystified how this guy won a Nobel prize for economics) are so deeply in love with the broken window fallacy. Every time a catastrophe strikes, GDP subsequently goes up! Instead of noting how this shows how fallacious it is to 'measure' economic growth in this manner, Krugman and his many fellow travelers are usually besides themselves with the anticipation of 'growth' every time windows get broken in great numbers (the WTC attack of 2001, the destruction of New Orleans by hurricane Katrina and the tsunami that devastated Japan were all hailed as 'growth boosters' by them). Krugman even thinks it would be a good idea if we could go to war with aliens from Rigel 2, since that would surely boost GDP as well, on account of increased government spending.
As we have pointed out previously, a major problem is also that GDP only adds up spending on final goods – the entire production structure of the economy (apart from investment in 'fixed' capital) is simply left out. This leads to a great many misconceptions, such as the well-known adage that the 'consumer is 70% of the economy'. This is balderdash. If one looks at the gross domestic income accounts published by the department of commerce with a delay every three years, it becomes clear that the biggest slice of economic activity in the U.S. is actually represented by the manufacturing sector – the very sector everyone believes to be in perpetual decline, and which according to the official GDP statistic allegedly represents only '12% of the economy'! In reality, spending by the manufacturing industries exceeds that of every other economic sector, including consumer spending.
Moreover, government spending is added to GDP as a positive factor. It seems hardly necessary to explain how ludicrous it is to assume that government consumption somehow represents a 'growth factor' for the economy. In actual fact, it represents an unadulterated burden on the economy. It creates not one iota of wealth – on the contrary, it wastes existing wealth and creates obstacles in the way of genuine wealth creation, as it competes for the same finite pool of economic resources the private sector needs to employ in its wealth creation activities.
Similarly, as Morgenstern points out, the 'malfunctions' of the economy are counted as a 'positive' factor in GDP. During the housing boom, all the construction activities that took place were regarded as a positive contribution to the economy – in spite of the fact that in reality they represented egregious malinvestment of scarce resources. To illustrate this point a bit further with an example that should make the problem abundantly clear: if the government were to start building a giant pyramid tomorrow, it would be regarded as contributing to 'economic growth' in the GDP, although economic logic and common sense should immediately tell us that it is the exact opposite: a waste of valuable scarce resources. Krugman would no doubt like it, though.
It should also be noted here that much of what enters so-called 'real GDP' are in fact completely imaginary numbers. In Oskar Morgenstern's time the main worry was that every monetary transaction, regardless of whether it was sensible, was regarded as contributing to GDP growth. The extent to which he criticized the 'laundering of numbers' was largely confined to 'seasonal adjustments' and the arbitrary measurement of the 'GDP deflator' (all of these remain with us of course).
Today, statistical fata morganas are included in GDP which Morgenstern probably couldn't have imagined even if someone had spiked his drinks with lysergic acid. Monetary transactions have long ceased to be necessary in order to add monetary numbers to 'GDP'!
There are for one thing so-called 'imputations'. These represent the 'imputed value' of services consumers get for free even though they apparently shouldn't. For instance, if checking services are offered for free by banks to customers opening a current account with them, then the government adds the supposed value of these free services to GDP. Note here that no money has actually changed hands, but what is added to GDP are in fact money terms. Obviously, the choice of what should be 'imputed' is completely arbitrary, with the decisions left to bureaucrats. We are not very far from what Morgenstern still thought of as an utterly absurd example, namely of housewives being paid by their husbands for their housewife-type services in imaginary dollars. These imputations are in fact the equivalent of this idea. They open vast vistas of statistical shenanigans to the government.
Another area in which imaginary numbers play an ever bigger role is the 'hedonic indexing' applied to all sorts of goods, something that has an especially large effect on all things to do with information technology. Here is an example from the second quarter of 2003 illustrating the effect (we have chosen this time period randomly, mainly because we happen to have the exact data at our fingertips. It should be pointed out though that the error in this data series compounds over time).
In Q2 of 2003, actual spending on computers increased by $6.3 billion, from $$76.3 billion to $82.6 billion. If simply 'every monetary transaction' were added to GDP, then this is the number that would have been added, and thereafter it would have been massaged by the 'deflator'. If not for hedonic indexing, that is. Before we tell you, try to guess how big an increase in spending on computers the government actually added to GDP in this instance. Was it 20% larger? 30%? Maybe even 50%? Hold on to your hat.
The number added by government to GDP instead of the $6.3 billion in actual additional spending was $38.2 billion. In other words, almost $32 billion in completely imaginary money that no-one ever spent or received, with the total number used by the government amounting to more than 6 times the actual spending growth was used for the calculation of 'real GDP'. It should probably be renamed 'unreal GDP'.
One could easily throw a 'growth' party with such methods in the middle of a depression. If only FDR had known, he could have created a more convincing illusion of recovery during the Great Depression. This is also one of the reasons why we have 'jobless recoveries' these days. Most likely there really is no recovery at all – it is a government-produced mirage of imaginary numbers.
We are very curious how the government will value 'original creative works' and the 'research that went into the iPad'. Obviously, there is a lot of room for inventiveness there. Perhaps we should add the creativity expended in making up these numbers to GDP as well? Back in 2008 we joked that we would like to get access to the Fed's discount window when it became known that the Fed accepted practically any type of asset; we proposed to offer our unfinished symphony for discount, without a doubt a work of great value. Somehow we were unable to convince the powers-that-be that they should accept it for the $20 million discount loan we had in mind, in spite of our assurances that we would provide the economy with a badly needed 'shot in the arm', but now it may at least end up as a contribution to GDP.
Regarding the idea of adding R&D spending to GDP: the cost of R&D (and yes, it is a cost to business) is already reflected in the products that spring from applying its results. Even the spending of those that are paid to perform R&D flows into GDP already, so this is simply double-counting the same money over and over again. At any given time, there are numerous technological 'recipes' on the shelf that entrepreneurs can choose from when engaging in production processes. These are by themselves not a 'cause' of economic growth. It is their application when the production structure is lengthened or widened that brings about growth. In fact, Apple's (NASDAQ:AAPL) iPad is a good example; not one of the major technological features of the device was actually a new invention. The first tablet PCs were a product of Microsoft (NASDAQ:MSFT), which introduced the term 'tablet' itself back in 2001. Apple simply took existing technological recipes and improved on them, applying them in the production of a device that finally managed to do what previous tablets failed to do, namely resonate with the consumer.
Finally, it should be noted in this context that there is a lot of R&D spending that fails to produce economically viable results. Take, for instance, the billions spent on the development of drugs that then fail to gain approval as commercial products because clinical tests disprove their efficacy or show that their side-effects are intolerable. Will such wasted R&D spending also be added to GDP now? Should it not instead be subtracted?
And so the global economy 'grows' overnight, adding the equivalent of the entire annual output of Belgium by government fiat. Soon we may have a veritable virtual boom. After all, why not add the value of the millions of tweets that appear on twitter every day, to name just one example? Surely they improve growth by disseminating information more quickly than was possible previously. For instance, how would you have learned that there were 'smiles all around as Justin Bieber leaves his Stockholm hotel' if not for a timely tweet?
We are sure many more things can be thought of. Carmen Reinhart and Kenneth Rogoff clearly have no leg to stand on anymore. Undoubtedly we can now 'grow' GDP a whole lot faster than the public debt. The only limit is our imagination.
The trajectory of U.S. public debt versus GDP (indexed to 1 as of 2007).
Charts by Marc Faber, St. Louis Fed