Economic Growth Is Not GDP Growth

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GDP is a monetary measure and is largely a measure of monetary inflation.

As personal consumption expenditures make up by far the biggest component, GDP is primarily a measure of money-inflated consumer spending.

Since the prime drivers of GDP growth are monetary inflation and increased consumption, an increase in GDP should not be confused with economic growth.

GDP is arguably the most followed measure of "aggregate output" in any nation. The US. Bureau of Economic Analysis (BEA), which compiles the aggregate for the U.S., defines GDP as "…the market value of the goods and services produced by labor and property located in the United States" [1] and refers to it "…as the primary measure of U.S. production." [2] It is measured as the sum of personal consumption expenditures, gross private domestic investment, net exports of goods and services, and government consumption expenditures and gross investment. Since the value of government output is measured by the cost of inputs, [3] GDP is a blend of consumer spending, business and government investment, and government running costs. Basically, it is all the money changing hands for these categories added up plus net exports (the value of exports minus the value of imports).

As what is spent by someone must be received by someone else, GDP can be measured both in terms of expenditures (the expenditures approach) and income (the income approach). It is an estimated number, that is, reported GDP will deviate from the actual number it is meant to represent. Some of the items included in GDP are not even real, [4] while others not included previously are later added. [5] GDP as a quantity, therefore, changes over time as some of the components and the value attached to them, change over time. Furthermore, the estimated numbers are seasonally adjusted and this adjustment process is also changed from time to time. [6] The challenges in estimating such a complex number are endless and ever-changing, a primary reason why reported GDP is revised many times. As such, it is important to actually treat reported GDP numbers as estimates.

Since GDP excludes intermediate purchases of goods and services by business, [7] it is a measure of the amount of money changing hands at the "end user" stage only, i.e. "final" goods and services. This means GDP does not account for the market value of transactions of the entire production structure. For example, GDP in the U.S. currently amounts to only about 58% of Gross Output (GO), an output measure which includes intermediate outputs as well, i.e. it includes the market value of output at all stages of production and not just the final stage. GO is therefore a more complete measure of total economic activity and demonstrates that business spending is in fact almost double the size of consumer spending. [8]

Many things have been written about GDP so there's little need to revisit more of them here. Instead, we'll focus on some of the perhaps less frequently discussed and sometimes forgotten aspects of GDP. Firstly, GDP is a monetary measure; it is a price-times-quantity figure. It, therefore, does not measure the physical volume of final goods and services purchased during a period, but rather their market value as quoted in money terms. That is why this "gross" GDP number discussed until here is referred to as Nominal GDP. It is, however, the physical quantity of goods and services produced and available, and not their market value in money terms, which affects people's standard of living.

Now, if we for a moment take for granted that nominal GDP is an accurate measure of total expenditures on final goods and services in an economy, we're still left with the problem that it is a monetary measure. That is to say, nominal GDP may increase solely due to price increases, and not due to an increase in the amount of final goods and services exchanged during a period. Since it is a monetary measure, GDP will almost automatically increase with an increase in the amount of money in the economy, at least over the longer term. Deflating GDP with the GDP deflator (officially named the Implicit Price Deflator) is an attempt by the BEA to remove price effects with the goal of ending up with a number unaffected by price inflation. This number is then meant to indicate the level of actual physical output as defined by the GDP convention. The resulting measure is the so-called Real GDP.

Estimating the deflator though is at least as challenging as measuring nominal GDP. [9] The additional complexity added to the calculation means that real GDP is an even more elusive number than nominal GDP. Furthermore, there are good reasons to suspect that the GDP deflator underestimates the actual price changes of the items included. Given the effect an expanding money supply has on prices in general, it is hard to take seriously the consistently low price inflation numbers reported by the BEA in recent years relative to the vast increase in the money supply.

The longer-term trends in the three data series depicted above show a significant increase in the money supply growth rate (M1 and M2) while the reported price inflation heads in the opposite direction. In fact, the spread (chart below) between the M1 and the GDP deflator has never been higher than it is today (based on data since 1969), while the spread between the M2 and the deflator is now back at a level last seen at the end of the 1960s.

These developments are especially suspicious as the demand for money to hold, as measured by the personal saving rate, remains relatively low in a historical perspective. [10] Additionally, it is unlikely that output in physical terms has increased enough to offset the current spread between the two of 9.1% (the highest percentage point difference based on data since 1969). [11] This suggests that the GDP deflator is likely underestimated which means that real GDP is likely overestimated. Certainly, this also suggests that real GDP does not measure what it sets out to do: an inflation-adjusted estimate of production (i.e. the level of actual physical output) as price inflation is only partly removed.

But GDP, nominal and real, is not only a monetary measure. More importantly (especially nominal GDP), it is largely a measure of monetary inflation. As any broad economic aggregate measured in money terms simply cannot grow over the longer term absent monetary inflation, GDP tends to increase in tandem with the ever-inflating money supply.

The chart shows that there is a near perfect positive correlation between GDP and the money supply over longer periods, in this case ten years. As access to money is needed before it can be spent, there is a causal relationship between the two where the money supply is the causal factor. An increased quantity of money therefore eventually affects all the four major components of GDP in one way or another. As GDP therefore only can more or less ceaselessly expand over the longer term if the money supply increases, and since the only way the money supply can grow under the existing monetary system is through an increase in debt, it follows that the only way GDP can ever increase year in and year out is through the issuance of more debt.

Finally, as personal consumption expenditures make up by far the biggest component, GDP (especially nominal GDP) is primarily a measure of money-inflated consumer spending.

As GDP (nominal as well as real) at the end of the day is primarily a measure of monetary inflation and consumer and government spending, it should be readily obvious that GDP is an inadequate measure of economic growth. For example, GDP will increase whenever consumers or the government borrow more or save less to fund spending.

Herein of course we can find the root cause of the great policy mistake aiming to increase GDP: "spend more to help the economy." Many economic policies today are geared toward achieving exactly that, instead of pursuing policies supportive of increased production (here), to the great detriment of increased prosperity for most. Sadly, GDP therefore tells little about the accumulation of savings, a crucial component for increased investment, production, and hence economic growth.

The above does not render GDP useless, though. Given its close relationship with the money supply, GDP can be used to track the business cycle. As the demand for money to hold tends to increase quite dramatically during downturns and banking crisis, GDP also does a relatively good job of demonstrating this as consumer spending and especially business investments decline as a result.

The greatest value of GDP may yet be found in the significant importance many attach to it. The financial media focuses extensively on GDP, and investment banks and money managers apply it in their valuation models and asset allocation strategies. GDP is in many ways the great anchor for financial pundits and the investment industry. This psychological importance of GDP must therefore never be underestimated. For example, you might sit on information that the economy is heading for disaster while GDP continues to expand. As long as the majority of investors will continue to act as if the economy is heading in the right direction when it is not, chances are they will be correct and you will be wrong, at least for a while.

In conclusion, GDP is more of an indicator of current economic activity in money terms than it is an indicator of economic growth. Moreover, as it is mostly an indicator of monetary inflation, sharp increases in GDP over time most likely signal increased overconsumption and malinvestments rather than a general improvement in living standards. Given that the prime drivers of GDP growth are monetary inflation and increased consumption, an increase in GDP should not be confused with economic growth, but instead be referred to what it actually is: an increase in GDP.

[1] (US. Bureau of Economic Analysis, p. 5).

[2] (US. Bureau of Economic Analysis, 2016)

[3] (US. Bureau of Economic Analysis, p. 9).

[4] E.g. "net rental income of owner occupants of farm and nonfarm dwellings" is an imputed number (US. Bureau of Economic Analysis, p. 11) while even some services people get for free are also imputed and added to GDP (Man, 2015).

[5] E.g. as of Q2 2013, the BEA began including the amount of money businesses invest in the production of intellectual property while also changing the way it counts defined benefit pension plans (US. Bureau of Economic Analysis, 2013). One estimate suggests this new GDP number will be about 3% higher than the old (Advani, 2013). An example from the UK: In 2013 an EU agreement on GDP standards, for example, included income from selling recreational drugs and paid sex work. In Britain, the changes added 0.7% to GDP (The Economist, 2016).

[6] E.g. see (US. Bureau of Economic Analysis, 2015).

[7] (US. Bureau of Economic Analysis, p. 8).

[8] (Skousen, 2016).

[9] Some challenges involve what items to include or not to include, their weights and calculation methods. Even an assessment of quality changes are incorporated into the deflator ("hedonic quality adjustment").

[10] As of Q3 2016, the 10-year average personal saving rate is 5.5% compared to an average of 6.9% since 1982 based on data published by the BEA. As addressed in the chapter on the purchasing power of money, increases in the money supply and decreases in the demand to hold drive price increases.

[11] An increase in physical output exerts downward pressure on prices as explained in the chapter on the purchasing power of money.

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