26 Sep 2017

Wealth vs. Annual Output: It Depends on the Context to Know Which One Free Market Economists Support

Trade 16 Comments

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.

16 Responses to “Wealth vs. Annual Output: It Depends on the Context to Know Which One Free Market Economists Support”

  1. Tel says:

    Adam Smith begins:

    The annual labour of every nation is the fund which originally supplies it with all the necessaries and conveniencies of life which it annually consumes, and which consist always either in the immediate produce of that labour, or in what is purchased with that produce from other nations.

    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:

    The causes of this improvement in the productive powers of labour, and the order according to which its produce is naturally distributed among the different ranks and conditions of men in the society, make the subject of the first book of this Inquiry.

    Whatever be the actual state of the skill, dexterity, and judgment, with which labour is applied in any nation, the abundance or scantiness of its annual supply must depend, during the continuance of that state, upon the proportion between the number of those who are annually employed in useful labour, and that of those who are not so employed. The[Pg 2] number of useful and productive labourers, it will hereafter appear, is everywhere in proportion to the quantity of capital stock which is employed in setting them to work, and to the particular way in which it is so employed. The second book, therefore, treats of the nature of capital stock, of the manner in which it is gradually accumulated, and of the different quantities of labour which it puts into motion, according to the different ways in which it is employed.

    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:

    In all countries, however, men seem at last to have been determined by irresistible reasons to give the preference, for this employment, to metals above every other commodity. Metals can not only be kept with as little loss as any other commodity, scarce any thing being less perishable than they are, but they can likewise, without any loss, be divided into any number of parts, as by fusion those parts can easily be re-united again; a quality which no other equally durable commodities possess, and which, more than any other quality, renders them fit to be the instruments of commerce and circulation. The man who wanted to buy salt, for example, and had nothing but cattle to give in exchange for it, must have been obliged to buy salt to the value of a whole ox, or a whole sheep, at a time. He could seldom buy less than this, because what he was to give for it could seldom be divided without loss; and if he had a mind to buy more, he must, for the same reasons, have been obliged to buy double or triple the quantity, the value, to wit, of two or three oxen, or of two or three sheep. If, on the contrary, instead of sheep or oxen, he had metals to give in exchange for it, he could easily proportion the quantity of the metal to the precise quantity of the commodity which he had immediate occasion for.

    Different metals have been made use of by different nations for this purpose. Iron was the common instrument of commerce among the ancient Spartans, copper among the ancient Romans, and gold and silver among all rich and commercial nations.

    Those metals seem originally to have been made use of for this purpose in rude bars, without any stamp or coinage. Thus we are told by Pliny[6], upon the authority of Timæus, an ancient historian, that, till the time of Servius Tullius, the Romans had no coined money, but made use of unstamped bars of copper, to purchase whatever they had occasion for. These rude bars, therefore, performed at this time the function of money.

    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.

  2. David R Henderson says:

    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?

    • Bob Murphy says:

      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.

    • Richie says:

      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?

      • Bob Murphy says:

        Richie did you see this post? I walked through this controversy, including a link to David’s post where he defends Dudley.

        • Richie says:

          Thanks, Bob. I did not see that. Clear now.

      • David R Henderson says:

        Yes, Richie. That is different.

        • Richie says:

          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.

          • David R Henderson says:

            You’re welcome, Richie.

  3. Silas Barta says:

    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.

    • Tel says:

      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.

      • Silas Barta says:

        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

        • Tel says:

          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…

  4. Transformer says:

    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.

    • Silas Barta says:

      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.

      • Tel says:

        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).

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