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Why GDP Is A Flawed Economic Measure

This is a contrived example to illustrate the flawed nature of GDP as an economic measure. But more than that, it explains *why* GDP is a flawed measure.

Imagine that a new country called Delusia is created as an island nation in the middle of the Pacific Ocean. This new country is populated by a million people, all of them macro economists of neo-Keynesian, Keynesian, MMT, or monetarist schools. The economy there consists of two activities. Gambling and prostitution. Half the people work in the gambling industry, and half work in the prostitution industry. At the moment of creation, each prostitute has in their posession 100 rippawfs, the currency of Delusia. They spend the day gambling. On Delusia, there are rocks that are nearly flat, and the side facing the sun has had a patina of dark color added over time. Gambling consists of tossing the rock in the air and guessing which side will land facing up. There is an ante, so during the day all the money of the prostitutes becomes posessed by the gamblers. Every night the gamblers visit the prostitutes and spend all the money they've accumulated during the day.

It's obvious that Delusia has a positive GDP. And yet, if an auditing firm was to visit Delusia and create a balance sheet for Delusia, there would be no assets. Intuitively, all these macro economists can see that there is no wealth being created in Delusia, that this economy is illusory. But their economic theory says that Delusia is thriving. Suppose, over time, the 'productivity' grows at 10% per year, that the daily cycle speeds up continuously. The Wall Street Journal would be trumpeting the 'Economic Miracle of Delusia', and touts on CNBC and Seeking Alpha would be asking 'Should You Be Invested in Delusia's Growth?' and 'Delusia Returns Beat SP500!'.

So what's wrong here? It's obvious that this economy is a fantasy, and yet standard economic theory insists that it is a booming success. The problem is that standard economic theory values all economic activity equally. I'm not sure why this is, though I suspect it is for reasons of simplification. It's intuitively obvious that all economic activity *isn't* equal. Is using the resources that could grow a bushel of wheat or build an ipod to instead dig holes and fill them in equivalent? We understand that the former are productive, and the latter is not. The former leave a residue that can be consumed or invested, and the latter leaves nothing.

The two economic activities that I chose for Delusia exist in the real world. In fact, they are not insignificant components of economies in the world. If they provide no valid economic residue, why do they exist? A human economy, really a human society [1], is just a mechanism to allow the members of that society to maximize their utility. So, these activities exist because there are human beings that find utility in them.

Thus, the first thing I'm saying is that all utility is not equal. I propose that utility has measure corresponding to Maslow's heirarchy of needs. For instance, if someone is starving, they are not interested in gambling unless it provides a means for them to satisfy their hunger. That is, the utility of eating trumps the utility of pleasure from gambling for them. Perversely, economic utility is a hygiene factor; once it's satisfied, its motivational value diminishes. Once I have enough to eat, further food has less utility for me. Current economic theory doesn't take this heirarchy of utility into account. It assumes that *all* utility is equal. This distortion of utility creates distortion in policy.

The second thing I'm saying is that there is another measure of economic value that current economic theory doesn't even acknowledge. That is the thermodynamic nature of economic output. Here, it is clear that the oversight is due to ignorance on the part of economists. They aren't aware of the fundamental part that thermodynamics plays in economic activity, so they didn't include it in their theories. Would we let someone become a medical doctor without an understanding of biology? No. But we let someone become an economist without an understanding of thermodynamics. No economist should be able to graduate without passing a course that requires them to have a working understanding of thermodynamics. To illustrate, imagine that we take a weekend NASCAR race. If we look at the net residue of that economic activity it is zero [2]. That is, a measure of the balance sheet of the economy before and after that activity will show no gain in resources available for consumption. Imagine that all the energy expended on that activity went to producing actual economic residue. There would be a pile of goods available for consumption after the weekend instead of nothing. I'm not saying there shouldn't be NASCAR races, or other consumptive activities. After all, maximizing utility is the purpose of economic activity, and consumption is utility generating. What I'm saying is that economic theory has to include differentiation between economic activities based on thermodynamic category. There are consumptive activities, activities that are solely performed to generate utility, and there are productive activities, activities performed to generate assets, assets that can be consumed to generate utility or used to generate further assets. This lack of differentiation based on thermodynamic category also creates distortion in policy.

It is possible to use Delusia to view income tax and monetary theory as well, though the model is too simple to completely capture the necessary perspectives.

Suppose we introduce a 10% income tax in Delusia. What could the government purchase with the receipts of that income tax? The rippawfs they have can only be spent on the two activities available. And they thus add nothing to the economy already present. The GDP of this economy is the same before and after an income tax. However, all consumption by the government of Delusia using rippawfs generated from tax *has* to be created in the future. There is no pile of goods currently existing that can be transferred to the government for immediate consumption. The economic activity of Delusia leaves nothing in its wake, no residue. The government can achieve the same effect as an income tax by issuing rippawfs to itself in proportion to the GDP size of the economy. So, instead of a 10% income tax, they can create 10% more rippawfs than already exist and spend them. The participants of the economy, barring alternate currency systems, are helpless to oppose this. The tax will be borne by everyone who uses rippawfs.

Suppose the central bank of Delusia begins issuing rippawfs in order to stimulate the economy. Every year they issue an additional 10% of the current rippawfs in existence. What happens? The central bank extracts value from the participants in the economy on behalf of the government, assuming a central bank owned by the government. How so? As they purchase with their additional rippawfs, they are purchasing economic output, gambling and prostitutes, at the pre-issue rate. Once they have diluted the rippawf supply, prices will rise to reflect the lower purchasing value of a rippawf, but they have taken value from the participants in the transition. So the economic stimulus is equivalent to a tax on national income.

The rippawfs of Delusia can also be debt based. Here, the model of Delusia has almost broken down for use in analysis. Because debt based rippawfs allows Delusians to consume beyond their means, pushing the payments for current consumption they can't afford into the future. If Delusians anticipate that gambling and prostitution will grow 10% a year, they can consume some of that future productivity now. Of course, if the productivity then doesn't occur, debtors have no means to pay creditors the rippawfs they owe. Crisis!

1. While we can speak of an economy, there is really no way to separate an economy and a society. They are interwoven.

2. Actually, it is less than zero since it consumes resources, consumes wealth. After the weekend there will be less goods available for consumption than before the weekend.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.