Wealth vs. Annual Output: It Depends on the Context to Know Which One Free Market Economists Support
Recently with the endorsements of the claim that hurricanes might be “good for the economy,” free market economists took to the airwaves to explain that this “broken window fallacy” foolishly focuses on the flow of output, while ignoring the stock of wealth. In other words, just because a natural disaster might boost official GDP, that is hardly an indicator of prosperity, because it’s simply replacing the portion of our accumulated wealth that had been destroyed.
In that context, I found it ironic when in our reading group tonight we covered this passage from Larry White’s The Clash of Economic Ideas:
Smith began The Wealth of Nations with the proposition that what matters for a nation’s well-being is not its hoard of accumulated treasure (as two centuries of mercantilist writers had believed), but its annual output or “produce,” the flow of goods and services, or what we today call national income or gross domestic product. It is this annual output that provides, either directly or by being traded for imports, “all the necessaries and conveniences of life which [the nation] annually consumes.” The Kingdom of Spain in Smith’s day had large hoards of gold and silver taken from the New World, but lower per capita consumption than Britain or the Netherlands. [White pp. 210-211]
Does everyone see the tension? White is literally saying that real GDP indicates prosperity; don’t get distracted by accumulated wealth, the way those silly mercantilists did.
Now to be sure, there’s not really any contradiction here. The mercantilists were wrong, and the people committing the broken window fallacy are indeed committing a fallacy. (Sometimes it’s possible that free market economists accuse someone unfairly of committing the fallacy.)
Even so, I thought it was ironic that the elevator pitches on both issues would end up yielding contradictory dicta for the layperson.
Also, even after we account for all of the subtleties, I now think it is flat out WRONG if free traders mock the accumulation of precious metals as foolish. To take Smith’s example (assuming White is presenting it fairly): The kingdom of Spain really is richer, if it has bigger stockpiles of gold and silver. For example, if there’s a bad harvest, the Spanish can use that stockpile of metal to import food from abroad.
Smith says what is prudence in the conduct of every family can scarce be folly in a great kingdom. Right, and every household maintains a checking account balance as well as cash in wallets and purses. If a households runs a trade surplus with the rest of the world and adds $1,000 to its checking account balance, nobody would say, “That will just raise prices, that’s dumb, that doesn’t actually make you richer.”
In general, I think free market economists need to just take a step back and reconsider their standard arguments more carefully. Don’t worry, you’re not going to end up endorsing tariffs. But some of our standard thought experiments don’t really prove what we claim, and it’s weird when our casual discussions (like the broken window fallacy and mercantilism) end up contradicting each other.
Adam Smith begins:
That’s not exactly a claim about “what matters for a nation’s well-being”, nor does Smith so much as mention “hoards of accumulated treasure” right at the beginning. It’s merely a starting point that labour is what creates things. The fifth paragraph then introduces the concept of capital accumulation:
So if you want to regard “hoard of accumulated treasure” as including all long-lived objects of value, then Smith certainly does not in any way suggest that such things can be ignored. Indeed he points out that there’s a very close link between capital stock and labour productivity (therefore total output, or maybe GDP if you prefer).
However, if you want to regard “hoard of accumulated treasure” as including only precious metals (treasure in the traditional narrow sense) Smith gets to that later in the context of why people use money as a medium of exchange:
So Adam Smith just matter-of-factly points out that humans tend to have a preference for using metal as money and it’s pretty much always been like that. It’s a huge stretch to somehow use Adam Smith as support for the claim that such things should be irrelevant in determining “what matters for a nation’s well-being”. Money is not quite the same as accumulated capital stock like mills, etc but Smith clearly recognizes that money serves a purpose and that people do tend to prefer precious metals.
Later on Adam Smith gets into fiat currency, bank notes, using gold and silver as backing for money and the expenditure of “treasure” during times of war. I won’t fill this up with quotes all over the place, but at any rate clearly this treasure holds some significant place in the whole economic operation.
So the simple answer is that White is wrong about Adam Smith.
https://www.gutenberg.org/files/38194/38194-h/38194-h.htm
Even if Adam Smith did understand the concept of GDP, it’s another huge stretch to claim that GDP maps directly onto Smith’s phrase, “all the necessaries and conveniencies of life” when you consider the amount of GDP that gets dumped into make-work projects and government inefficiency that do not appear to produce anything remotely necessary nor convenient.
In Victoria (Australia) they have started instructing the police to watch closely at gas stations and jump out an issue a fine should anyone fail to lock their car when they go in to pay for gas. This presumably provides jobs for police and much needed revenue for the state.
Bob,
You write, “Recently with the endorsements of the claim that hurricanes might be “good for the economy,”
Do you have cites. This time around, I haven’t found people making that claim. It’s possible I missed it. As you know, Dudley did NOT make that claim. Do you have anyone else in mind?
Eh, I think I saw people talking about commentators making such statements on CNBC or whatever. I don’t have a specific person in mind, though.
What claim did Dudley make, then? Here is a link:
https://www.cnbc.com/2017/09/08/feds-dudley-hurricanes-will-boost-economic-activity-over-the-long-run.html
He says he thinks it will “actually end up boosting the economy later this year.” Is that different from saying it is good for the economy?
Richie did you see this post? I walked through this controversy, including a link to David’s post where he defends Dudley.
Thanks, Bob. I did not see that. Clear now.
Yes, Richie. That is different.
My apologies, Mr. Henderson. I didn’t see Bob’s post from September 11. I read your post as well. I see the subtle difference now. Sorry for beating a fallen horse! Thanks.
You’re welcome, Richie.
I think both positions unhelpfully conceal some pretty important distinctions and so are misleading in their own right. They aren’t necessarily “net insight givers” without the appropriate caveats.
1) Yes, annual production is important, but in practice, the useful production is going to be *determined* by available wealth, since it can take the form of working capital.
2) And production can take many forms which may or may not add to the actual output or working capital that we really care about — consider an economy where 90% of the output is just legal services for indefinitely suing people. Determining what percent of GDP is win-win vs zero-sum is really important.
2a) So I don’t think it’s entirely pointless to look at gains in GDP after a disaster — after all, you could be asking the question, “are we still able to produce the stuff we need to rebuild” vs “are we so hosed we can’t rebuild at all”.
3) Accumulation of money only serves that hedging capacity a) in its capacity as money (not as metal) and b) only as long as *someone* can still produce the food; if everyone raids their food production capacity to horde gold/money, they’re all hosed during a drought. With that said, modern econ (IMHO) *severely* underemphasizes the private and social return to hedging against black swans by staying liquid.
Your point (1) is exactly what Adam Smith said.
Point (2a) fair enough… if the hurricane hit so hard that BOTH capital and production go backwards then it should be totally uncontroversial.
But wait! When the Tsunami hit Japan March 2011, they undoubtedly lost capital stock, but also the second quarter GDP of 2011 was down on the first quarter GDP (so their GDP went backwards). Krugman at the time claimed it was growing the economy, and he carefully compared the second quarter 2011 against the third quarter 2011 where the GDP was recovering again. So yeah, they went backwards, and did their rebuilding and got roughly back to where they were to begin with… but for some people that still counts as “growth”.
https://fred.stlouisfed.org/series/JPNRGDPEXP
Point (3) if you were paying an insurance company it would count towards GDP, but if you keep a store room with tins of beans and bottled water stacked up they don’t count that basically because the idea of people not depending on the state for everything gives them the willies.
Re point 1), I don’t think it is. Smith was saying that wealth is unrelated to production. I say it is, because there’s money-wealth, and working-capital wealth, and in practice they’re going to be deeply related.
Re (3), good point! lol
I put the links and the quotes from Adam Smith up above. His fifth paragraph from the introduction explains that capital improves the productivity of labour and then points to the second volume in his work which covers this in detail.
Unless there’s some other Smith somewhere…
I’m not really seeing any contradiction.
When people say that natural disasters that destroy wealth cause an increase in GDP they mean that people will temporarily work harder (and presumably wear down the remaining capital at a faster rate) as they go about rebuilding their lost wealth. When their wealth is fully rebuilt they will likely go back to enjoying the flow of services (GDP) that they did previously from this wealth.
This seems totally consistent with the view that While attributes to Smith – that what matter is not the wealth itself but the flow of services that if generates.
In this view wealth is accumulated capital. In modern times because of greater knowledge of productive techniques capital is generally represented by machines and other things that can increase labor productivity rather than in precious metals which (While claims) was the the case in earlier time. As a result the flow of services (GDP) from wealth is much greater now than then.
I should probably bring up my old post about surges in production after a negative shock: The reason GDP can grow faster after a natural disaster (sorry, tongue twister) is that they render it *obvious* what you need to do: get existing stuff back on line! This reduces the (normally expensive) “cost” of entrepreneurial insight.
That’s a very good point.
I would also add that after a disaster you get many people being paid overtime money at higher than normal rates plus travel costs and other such things so these people enjoy less time with their families, etc. Thus resources are getting redirected away from the things that economists steadfastly ignore (i.e. people enjoying their lives) towards the things that economists have a fetish about measuring (i.e. money changing hands).