Even Economists Should Check Out My GDP Article
I realized my last excerpt might not have alerted professional economists to the fact that I have some novel (I think?) points on GDP accounting in my latest EconLib piece. Some excerpts:
[S]uppose that one method of producing 1,000 cars draws down on the fixed stock of iron ore located in a country’s mines, while another method relies on only renewable resources. Again, standard GDP calculations would score the two methods as equivalent, ignoring the “deductions” from the wealth of the country in the form of mineral resources.
and
Our discussion of the bread industry revolved around intermediate versus final purchases. If a baker spends $120 buying flour that is used up during the year, then that expenditure does not count in GDP. On the other hand, if the baker spends $10,000 buying a brand new oven, then that is classified as a final good and does contribute $10,000 to that year’s GDP.
However, this distinction is somewhat arbitrary. Suppose that, instead, we calculated GDP over the entire lifespan of a new oven rather than over one year. In that case, the $10,000 spent on the oven in the beginning of the period would be economically equivalent to the $120 spent on the flour; all of these resources would be “used up” in the production of final loaves of bread for consumers. Therefore, the GDP calculation is sensitive to the time period chosen, even though this shouldn’t be relevant to economic well-being.
Also, I clarify why Mark Skousen (among others–including Rothbard in Man, Economy, and State) doesn’t appreciate the emphasis on consumption that the U.S. GDP figures give. My clarification:
To reiterate our earlier discussion, the conventional GDP approach doesn’t include these expenditures by the businesses at each stage in the bread industry because they represent spending on intermediategoods, not final goods. There is a reason for this decision: we want to avoid double counting, so, for example, we don’t want to count the $120 spent by the baker on flour if we’re already counting the $200 spent by consumers on the final loaves of bread. However, the danger here is that the GDP concept gives an exaggerated importance of consumer spending in the overall economy. In particular, even though the $120 spent by the baker on flour doesn’t add anything to the GDP calculation, it is certainlyeconomically critical. If all of the bakers suddenly decided to refrain from reinvesting their revenues in buying more flour, then the output of bread would pretty quickly come to a screeching halt. No matter how much money the final consumers were willing to offer the grocery store owner, she couldn’t sell them any bread if the bakers had previously stopped the gross reinvestment of their proceeds.
Your last excerpt is so critically important it should be in the introductory chapters of every economics textbook.
A healthy, growing economy does not have 70% of all expenditures on consumer goods. It is such a silly statement to make, on multiple levels.
For one thing, if 70% of all spending really were consumer spending, then the implied aggregate profitability in the economy would be higher than it really is. For consumer expenditures are pure revenues, they are not costs to business firms. If 70% is consumer spending, then 30% would be investment spending. Only 30% of the expenditures would show up on anyone’s profit and loss statement as costs. If all expenditures in the economy were presented by 1000 units of money, where each unit can be however many billions or trillions in dollars, then out of 1000 total revenues each year, only 300 will be deducted to calculate profits. 700 profit on 300 investment (ignore depreciation for simplicity) is 233% profit. In reality however profits are what, 10%, 20%, 30%? Certainly not triple digits.
For another thing, if double counting really were a principle to exclude certain expenditures, then ALL investment spending should be excluded, since all investment is made to eventually produce and offer consumer goods. Even including the 30% would be double counting, since whatever that 30% is supposed to represent, all of it is intended to eventually, at some point, bring about consumer goods and services. Every economy should therefore be 100% consumer based. Reporting GDP in this way would not be MUCH more silly than reporting 70%.
And if it couldn’t get worse, it does, for even the current accounting method consists of double counting! The argument that flour should be excluded because the final bread is included, is tantamount to arguing that flour is the bread. That the wheat is the flour, and the bread.
Bob. Your points:
1. Correct. But well-known I think. Depends on what you want GDP for. Also, once you start subtracting used up natural resources, you need to include in newly-discovered resources, and resources that become useful when technology changes. Gets very fuzzy.
2. Correct. Not widely understood I think. That’s why Net DP would be better (subtracts depreciation). But measuring depreciation gets tricky.
3. You lost me a bit. Does it matter, for example, if all the firms producing intermediate goods vertically integrate?
On 3 I think Rothbard said such monopolies would face a socialist calculation problem.
On 3, I assume that if the wheat farm, the mill, the baker and the bread store all vertically integrated – then there would be no transactions in intermediate goods so nothing to double count – and it would be clearer that the whole production process was just aimed at producing a good (bread) that gets consumed.
Nick,
Point (3) is admittedly tricky, and when I was at Hillsdale I spent a couple of weeks trying to nail it down (for a journal article) with someone who really knew GDP accounting, but we got busy and never came back to it.
But, to answer your question: I don’t think it affects official GDP if the miller, baker, grocer etc. all integrate, so long as we’re just absorbing what are originally considered intermediate goods.
However, if a firm that normally sells ovens periodically to the baker is bought by the baker, then yeah, that reduces GDP in that first year, right? (If originally, the new oven would get counted in GDP.)
Bob: assuming ovens are a capital good?
Hmmm. Firms make their own capital goods for their own use, will those new capital goods be counted as investment? They should be (assuming they are durable), but will they? I don’t know. Tricky one. You might (or might not) be onto something.
I think unsold goods count towards GDP. It seems likely that capital goods made by a company for its own use would be counted in the same way.
that is: I think the capital equipment would count as a final good even if not sold.
Dr. Murphy said:”However, if a firm that normally sells ovens periodically to the baker is bought by the baker, then yeah, that reduces GDP in that first year, right? (If originally, the new oven would get counted in GDP.)”
No. If the oven firm continues to make ovens at the same rate then then there would be no change in GDP. This should be obvious if you think about GDP being measured by the factor income method. The oven operation continues to buy the same value of production factors so, no GDP change. Factor incomes equal production expenditures so, either GDP method will give the same result.
I, like Nick Rowe, don’t.quite get point 3. Intermediate goods aren’t counted at the full market exchange price because that would double count (or multiply count) some of the value of the intermediate good. But, standard GDP accounting does in effect include the value added of every intermedite good. So, the value added output of all the intermediate suppliers isn’t being ignored.
Does it matter if the consumer also vertically integrates?
I grow my own limes, and brew my own beer. So if I want to get fancy and offer a bit of service, I can pull a cold beer out of the fridge and put a wedge of fresh lime in the top then slide it across the bar to myself, maybe even hand them out to a few friends.
Sounds like a boost to economic productivity. Fortunately the authorities don’t know I’m having a good time, otherwise they’d be searching for more ways to tax me over it.
Its not quite clear to me why its felt that ‘the GDP concept gives an exaggerated importance of consumer spending in the overall economy’. In the example given , assuming the bread is eaten during the period in question, then the $200 spent on it really does represent stuff that has been consumed – including all the intermediate goods that make up the $200. What is being exaggerated ?
Tranformer, assume we’re in a stationary equilibrium. Then people would report, “This economy is driven 100% by bread consumption, and 0% by investment.”
That might lead people to think that business investment is not relevant to economic outcomes, when of course that’s not true.
If no investment goods were being produced it would be an accurate statement to say that 100% of output went on consumption.
If however 20% of output was of investment goods used in the manufacture of consumption goods then it would be accurate to say only 80% of output went on consumption.
In both cases it seems reasonable to say that the economy is ultimately driven by consumption – what would be the point of economic activity otherwise ?
One could also say that the economy is actually ultimately driven by investment.
If 100% of all spending went to consumption, what would happen? If the economy were really “driven by consumption”, then doing this would drive to the maximum the economy could get. But in reality the economy would collapse.
Consumption is what every human must do to live. It is virtually automatic that consumption of some kind takes place. Investment on the other hand is not something that any human can do virtually automatically.
Investment is just consumption deferred.
Better consumption is just investment caused.
Key word is “represent”.
In any one year the quantity of investment spending in a developed economy drastically outweighs the quantity of consumer spending, and the ratio of investment spending to consumer spending gives a clearer picture of what is going on.
The “70%” consumer spending this year is actually accompanied by far more investment spending than 30% of all spending.
In principle, there is no necessary reason why we should consider the $200 of consumer spending as “representing” a series of prior investment expenditures, rather than the other way around. If I said “the $1000 of investment spending this year “represents” a future series of consumer expenditures that when added up over the entire life of the investment become equal to a total of $1100″, then I am using the term “represent” in as fuzzy a manner.
Capt. Parker, Transformer, and Nick:
I re-read my EconLib article and remembered that I had weakened the claim, to be surer that it was correct. I wrote:
“Suppose that, instead, we calculated GDP over the entire lifespan of a new oven rather than over one year. In that case, the $10,000 spent on the oven in the beginning of the period would be economically equivalent to the $120 spent on the flour; all of these resources would be “used up” in the production of final loaves of bread for consumers.”
So in the above, I wasn’t actually claiming that GDP statisticians *would* change how they scored it, rather I meant that they *should* change it. (It’s possible that they *would* change it too, but I’m not as confident of that.)
So let me turn it around on you: If we are calculating GDP over a 5-year span, and a new oven lasts 5 years, then during that 5 years when the oven does nothing but contribute to bread output, why would you:
(a) Not count expenditures on flour because the bread purchases capture them, but
(b) Count expenditures on the oven?
If we are calculating GDP over a 5-year span, and a new oven lasts 5 years, then during that 5 years when the oven does nothing but contribute to bread output, why would you:
(a) Not count expenditures on flour because the bread purchases capture them, but
(b) Count expenditures on the oven?
Well, the answer is: you.wouldn’t.count the expenditure on the oven because the entire expenditure on the oven is now, under a 5 year accounting period, captured by 5 years of bread purchases. If the oven is fully consumed in the current period it’s not really an investment. If the oven lasts 5 years but the accounting period is 1 and you value the new oven at only the value added it provides for 1 year of bread output then you have a problem that in that first year factor incomes exceed production outputs. Y>C+I for the period. You need to add back in the other 4 years worth of oven value for the identity to hold. Or, you are throwing out the assumption that markets clear in the 1 year accounting period
If the business is writing off depreciation of assets against a tax deduction (many do it that way) and if government statisticians puzzle through those tax deductions and actually subtract them out of GDP then your method would work.
With thousands of bakery businesses they won’t all buy an oven on the same day so it will probably even out. Get the total of all ovens purchased that year, subtract the total of all business depreciation against ovens in the same year… should come to pretty close to zero in a steady state economy, meaning that the capital base is neither growing nor shrinking.
I should also point out that GDP is a scalar and therefore cannot possibly represent any economic structure whatsoever. Thus, even the basic split between capital and non-capital must necessarily be ignored so no matter what you do the answer will be somewhat questionable.
Hmmm, if this is correct then GDP does not subtract depreciation, but NDP does. The problem being that those depreciation figures are a bit unreliable so neither number is strictly correct.
https://www.quora.com/Why-is-capital-depreciation-deducted-from-GDP-when-calculating-national-income-even-though-its-restoration-constitutes-income-to-some-people
Anyhow, at least government statisticians do recognize the issue of how to count capital goods compared to consumable goods, they just don’t have a real good method of handling that.
I think I partially agree.
If to produce bread in one year you use
– 1/5 of the machine
– all the wheat
– some additional labor to make rthe bread
Then the wheat and the 1/5 machine are both inputs and can’t be double counted.
But I suspect that the 1/5th of a machine counts as depreciation while the wheat counts as an input, so its OK to count the production of investment goods as part of GDP (but not the wheat) without double-counting.
One thing I have never understood about GPD is how they decide what is a capital good and when its a consumer good. What if someone bought the bread and made it into bread pudding and then sold that? How would/could they differentiate customers buying them for pure consumption vs making it into something else.
Bingo.
Or a pickup truck. One guy buys it to drive himself to work at the office, another guy buys it for use in his construction business.
List goes on and on.
Mainstream national accounting practises are based on such fundamental economic fallacies that it is inevitable people will run into problems like this.
Generally if the person buys bread and then sells bread pudding they would register as a business and fill in a bunch of paperwork identifying how much they buy, how much they sell, what their profits are, etc.
Admittedly, the church bake sales probably just get ignored. Amongst professional accountants this is known as “bucket chemistry”.