Lies, Damn Lies & GDP

Why GDP – gross domestic product – is in fact an economic lie...

GDP IS THE most commonly used measure of economic growth, writes Martin Hutchinson, global investing strategist for the Money Morning email service.

But GDP (gross domestic product) isn't just inaccurate and misleading – it's the contrivance of Keynesian economists seeking to push their own, big-government agenda.

Yes, GDP is a financial ruse – the biggest of the past half-century in fact. And it's time to move past it to another, more accurate measure of economic growth.

Keynesian economist Simon Kuznets designed GDP at the height of the New Deal era. Kuznets first revealed the measure in a report to Congress in 1934. GDP takes into account consumption, investment and government expenditure to create a measure of economic growth.

But the Keynesians employed some chicanery, or sleight-of-hand, to generate this statistic. A close look reveals the dirty little secret about GDP: It intentionally overplays the importance of government spending – and in doing so inflates the role that Washington plays in each of our lives.

And it's been doing this for 77 years.

Gross domestic product is supposed to be a measure of all the goods and services produced here at home. But there's a discrepancy.

You see, private-sector output is measured by the price people are prepared to pay for it. But government output is fudged: It's measured by its cost.

That means GDP increases any time the government spends money. It doesn't matter if that money is actually put to productive use or not – GDP rises nonetheless.

The bureaucrat devising regulations that damage business? His salary increases GDP. The $300 million Alaskan "bridge to nowhere" of a few years back? That was $300 million added to GDP. The jet-fighter project that costs billions, and is plagued by huge overruns that lead to its cancellation? Those billions add to GDP, too.

Even public-spending "stimulus" programs, however foolish, are always effective according to the GDP definition, because their cost is simply added to output.

It's obvious why big-government Keynesians would like this calculation: It substantiates their claim that government spending stimulates economic growth. In the real world, however, this makes no sense. Indeed, none of the examples above actually add to economic welfare.

Don't misunderstand – some government output is very valuable. We could not exist in a free society without a court system that protects our property rights and a national defense that protects our borders. In most other cases, however, if government output were truly cost effective, the private sector would've already taken the initiative (and probably done so at lower cost and greater impact).

So how can you get an accurate measure of economic growth?

Arithmetically, there's a simple solution: You take Line 1, "Gross Domestic Product," in the Bureau of Economic Analysis' GDP Table and subtract from it Line 21, "Government Consumption Expenditures and Gross Investment."

That gives you a net number, which we can call "gross private product", or GPP. It's a measure of all the output produced by the private sector. In general, it will underestimate national "welfare" unless government is really bad. But it will give you a much better idea of the output the market economy is producing.

Indeed, looking at GPP's past performance helps to explain some things that GDP doesn't.

Keynesians like to proclaim that World War II got America out of the Great Depression: Thus, if you make stimulus big enough, it will solve economic problems.

This is the biggest lie of the 20th century. If you look back through history, and look only at GDP, it seems correct. After all, GDP did increase sharply during World War II. But if you look at GPP, the real story becomes quite clear.

GPP declined somewhat more than GDP at the beginning of the Depression, as US President Herbert Hoover threw money about in a futile attempt to stop the horrific downturn.

Then it increased somewhat more slowly than GDP during the 1930s, falling back in 1937-38. GPP really took off after that, rising at more than 9% per annum in 1938-40. New Dealer losses in the midterm elections of November 1938 had put an end to some of the group's spending and most of their meddling.

When war came, GPP collapsed while GDP rose. By 1944, GPP was down to half its 1940 level, and 25% below where it was in 1932 at the trough of The Depression. Then when war ended, it took off. In 1946, while GDP fell, GPP more than doubled, as the economy was converted to peacetime. Overall, however, the GPP level in 1946-48 was about 10% to 12% lower than it would have been had the 1938-40 recovery continued – or had the economy continued steady growth after 1929.

By the GPP measure, the US economy was recovering quickly by 1940. The war caused a huge downturn, but postwar reconstruction saw it bounce back, although not quite to the level it would have reached had the war not happened.

That narrative makes far more sense than the conventional Keynesian fable – that the manufacture of guns, tanks, uniforms and other instruments of war alone led to an economic revival.

The ultimate fallacy of Keynesian analysis was demonstrated last weekend, when Nobel Prize-winning economist Paul Krugman claimed that an excellent solution to our economic problems would be to stage an imaginary invasion by space aliens.

Under Keynesian analysis, all the money spent making weapons and munitions to fend off aliens would boost the economy, as it allegedly did during World War II.

But by using GPP analysis, we can be smarter than that. We know a major anti-alien war effort would damage private output, and potentially push the US Treasury into bankruptcy.

Gross private product also tells us a couple of other things. To begin with, the federal government's $800 billion-plus in stimulus spending didn't work. The quarters in which government spending increased the most saw sharp declines in GPP. Conversely, the best quarters of growth since 2007 were in the two winter quarters of 2009-10, when government growth stopped and even shrank slightly (mostly at the state and local level).

Of course, there's also some good news. GDP in the first half of 2011 expanded at a lousy 0.8% per annum, slower than population growth. However, GPP did significantly better, growing at a rate of 1.9% – as the government once again shrank somewhat.

That doesn't guarantee we won't have a "double-dip" recession, but it does indicate that if we keep government spending under control, and stop Federal Reserve Chairman Ben Bernanke from throwing money at the economy (which simply causes speculative bubbles, and does no good), then a real, healthy recovery is possible.

The private sector creates jobs, and pays for government. We need to keep track of its output through GPP, and run the economy to put GPP on a healthy long-term growth path.

No alien invasion, real or imaginary, is called for.

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Now a contributing editor to both the Money Map Report and Money Morning, the much-respected free daily advisory service, Martin Hutchinson is an investment banker with more than 25 years’ experience. A graduate of Cambridge and Harvard universities, he moved from working on Wall Street and in the City, as well as in Spain and South Korea, to helping the governments of Bulgaria, Croatia and Macedonia establish their Treasury bond markets in the late '90s. Business and Economics Editor at United Press International from 2000-4, and a BreakingViews editor since 2006, Hutchinson is also author of the closely-followed Bear's Lair column at the Prudent Bear website.

See full archive of Martin Hutchinson.

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