Is the economy really twice as large as we thought?

Since the mid-20th century, economists, governments, businesses, and just about everyone else has used gross domestic product (GDP) to measure the size of the economy. But is it thebest metric for the job? Some economists are saying no.

GDP is a measure of the level of spending on finished goods in the economy. It is a measure of final production. If a pencil sells for 50 cents, it increases GDP by 50 cents. But a good deal more spending tends to occur in the process of making a pencil. At the very least, the manufacturer has to acquire resources to make the pencil — someone must harvest the wood, someone must harvest the rubber, someone must mine the graphite. Under GDP, that spending is not directly included. It is only counted implicitly when the finished pencil is produced and purchased by a consumer or business.

Some economists, such as Chapman University’s Mark Skousen, argue that the intermediate stages of production lower down the production chain should also be included in measurements of output. While they recognize that including them again explicitly can mean double counting or triple counting, they argue that there are “several reasons why double counting should not be ignored and is actually a necessary feature to understanding the overall economy.” After all, lots of businesses deal solely in intermediate goods. Intermediate producers buy partial products, add a “bell and a whistle,” and pass them on. At Forbes, Skousen argues that “no company can operate or expand on the basis of value added or profits only. They must raise the capital necessary to cover the gross expenses of the company — wages and salaries, rents, interest, capital tools and equipment, supplies, and goods-in-process.” To Skousen that means that a measurement of output should take all this spending into account.

Perhaps taking heed of some of these arguments, the Bureau of Economic Analysis starting on April 25 will release each quarter a measure called gross output that includes total sales from the production of raw materials through intermediate producers to final wholesale and retail trade. 

Read More At TheWeek.com

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How saving endangers the economy — and what to do about it

An impressive video featuring former Treasury Secretary Larry Summers has been making the rounds.

Summers makes the case that the United States and other Western nations may have reached a state of permanent stagnation in growth and employment. In Japan, per capita incomes grew strongly until the 1990s, and since then they have been growing very weakly and intermittently. Summers cites Japan as an early example of what might occur elsewhere.

Japan’s stagnation is shocking — today, the Japanese economy is only half the size economists in the 1990s predicted it would be if it had continued on its pre-1990s growth trend. As Summers notes, in the U.S., growth is also well below its pre-crisis trend, and unemployment remains persistently high. More than 12 million people who want work and are actively looking cannot find it. That’s a very ugly situation.

Under normal conditions, central banks can lower interest rates on lending to banks as a way to encourage activity and fight unemployment. Lower rates make business projects easier to afford, and more business projects should mean more jobs. If an economic shock pushes the unemployment rate up, central banks can lower lending rates to ease conditions. And conversely, if economic conditions are overheating and inflation is pushing up above the Federal Reserve’s target of 2 percent, interest rates can be hiked to encourage saving and discourage spending.

Yet in the current slump, unemployment has remained elevated even while interest rates have been at close to zero for four years while inflation has remained contained. This suggests that the interest rate level required to bring employment down significantly is actually below zero. Summers agrees:

Suppose that the short-term real interest rate that was consistent with full employment had fallen to negative 2 percent or negative 3 percent sometime in the middle of the last decade.

But central banks can’t lower interest rates below zero percent because people can just hold cash instead. Why invest if you’re going to lose money doing so?

Read More At TheWeek.com

Of Krugman & Minsky

Paul Krugman just did something mind-bending.

KrugMan-625x416

In a recent column, he cited Minsky ostensibly to defend Alan Greenspan’s loose monetary policies:

Business Insider reports on a Bloomberg TV interview with hedge fund legend Stan Druckenmiller that helped crystallize in my mind what, exactly, I find so appalling about people who say that we must tighten monetary policy to avoid bubbles — even in the face of high unemployment and low inflation.

Druckenmiller blames Alan Greenspan’s loose-money policies for the whole disaster; that’s a highly dubious proposition, in fact rejected by all the serious studies I’ve seen. (Remember, the ECB was much less expansionary, but Europe had just as big a housing bubble; I vote for Minsky’s notion that financial systems run amok when people forget about risk, not because central bankers are a bit too liberal)

Krugman correctly identifies the mechanism here — prior to 2008, people forgot about risk. But why did people forget about risk, if not for the Greenspan put? Central bankers were perfectly happy to take credit for the prolonged growth and stability while the good times lasted.

Greenspan put the pedal to the metal each time the US hit a recession and flooded markets with liquidity. He was prepared to create bubbles to replace old bubbles, just as Krugman’s friend Paul McCulley once put it. Bernanke called it the Great Moderation; that through monetary policy, the Fed had effectively smoothed the business cycle to the extent that the old days of boom and bust were gone. It was boom and boom and boom.

So, people forgot about risk. Macroeconomic stability bred complacency. And the longer the perceived good times last, the more fragile the economy becomes, as more and more risky behaviour becomes the norm.

Stability is destabilising. The Great Moderation was intimately connected to markets becoming forgetful of risk. And bubbles formed. Not just housing, not just stocks. The truly unsustainable bubble underlying all the others was debt. This is the Federal Funds rate — rate cuts were Greenspan’s main tool — versus total debt as a percentage of GDP:

fredgraph (18)

More damningly, as Matthew C. Klein notes, the outgrowth in debt very clearly coincided with an outgrowth in risk taking:

To any competent central banker, it should have been obvious that the debt load was becoming unsustainable and that dropping interest rates while the debt load soared was irresponsible and dangerous. Unfortunately Greenspan didn’t see it. And now, we’re in the long, slow deleveraging part of the business cycle. We’re in a depression.

In endorsing Minsky’s view, Krugman is coming closer to the truth. But he is still one crucial step away. If stability is destabilising, we must embrace the business cycle. Smaller cyclical booms, and smaller cyclical busts. Not boom, boom, boom and then a grand mal seizure.

Hurricanes and Broken Windows

It is relatively easy to debunk the Broken Window fallacy, the idea that hurricanes or more generally the destruction of capital may be a tragic economic stimulus. Indeed, much has already been written on the opportunity cost of the new spending that may be unleashed by a natural disaster — in the last few days by Robert Murphy and Jim Quinn (and many others) and historically by Henry Hazlitt and Fredric Bastiat. When a window is broken, and money is spent on a glazier, the labour, capital and resources is only moving the economy back to where it was, and it has an opportunity cost — whatever might have been purchased with the labour, capital and resources had the window not been broken.

A Krugmanite might respond to this with the idea that when an economy is in a depression state, where vast quantities of labour and capital are idle, then this opportunity cost is less relevant. But this is not so.

A natural disaster will undoubtedly result in new economic activity that would not have taken place otherwise. Undoubtedly, labour, capital and resources that may n0t have been employed otherwise will be employed because of an earthquake, or a flood or a fire. But believers in the Broken Window fallacy are looking at the economy through a distorted lens. What they define as “activity” (i.e. GDP) is only one side of the picture. Yes, a major hurricane like Sandy might require $100 billion or more spent to repair the damage. Yet to only look at spending is to only look at one side of the picture — the flow. An economy is both stock and flow. That $100 billion of spending is flow to replace damaged and destroyed capital stock (houses, factories, roads, etc).

To grasp the full picture we have to look at both sides of the equation. If a hurricane like Sandy causes $100 billion of damage requiring $100 billion of spending to fix, then after that spending we are in aggregate no better off than we were before the storm. Without the storm, resources would surely have been deployed differently. But without the preceding hurricane damage, all spending is a gain because the spending is not replacing capital stock that has been destroyed. Let us assume that Sandy had blown herself out without making landfall, and that without the need for a major reconstruction, only 10% ($10 billion) of the $100 billion necessary to repair the damage was deployed in the economy. In aggregate, we are $10 billion better off than with the $100 billion of spending in the wake of the storm, because that $100 billion was merely making up for losses via destruction.

I hope that we can put the Broken Window fallacy to bed at last and agree that the “stimulus” effect of natural disasters, is merely a transitory illusion based on flow, while ignoring that that flow is merely compensating for loss in stock. There are benefits to natural disasters — like learning not to build in areas prone to flooding or volcanism, or developing building materials and techniques or other innovations robust to earthquakes or flooding, or the concept of natural-disaster preparedness and survivalism — but these are informational and not an economic “stimulus”.

And certainly, unemployment is a tragedy. But there are far better ways to reduce unemployment — like slashing red tape and cutting taxes for small businesses and startups  — than the destruction of capital.

Wealth Inequality in America

Plenty of talk has gone into the rising income inequality that America has experienced since the early 1970s. But income is merely a wealth flow, and the truer measure of equality is the distribution of net worth and financial wealth (the wealth stock).

The historical change is clear: the bottom 80% have gotten considerably poorer both in financial wealth and in terms of total net worth:

This widening gap between the rich and everyone else is not a case of people being rewarded for their talents. Some income and wealth disparity is an inevitable effect of the market process. But the reality of today is more of a case of oligarchs harnessing the power of government bailouts, monetary policy, corporate subsidies, pork, quantitative easing, barriers to entry, favourable regulation, SuperPACs, Citizens United, lobbyists, market-rigging (etc, etc, etc) to get whatever they want.

Are Cameron’s Economic Policies Working?

Britain has returned to growth:

But compared even to the USA — which has huge problems of its own — Britain is still mired in the depths of a depression:

An Olympic bounce does not constitute a recovery. As I noted in March, Britain is under-performing the United States — in GDP and in unemployment. Although Cameron and Osborne keep claiming that they are deficit hawks who want to cut the government deficit, the debt keeps climbing.

Defenders of Cameron’s policies might claim that we are going through a necessary structural adjustment, and that lowered GDP and elevated unemployment is necessary for a time. I agree that a structural adjustment was necessary after the financial crisis of 2008, but I see little evidence of such a thing. The over-leveraged and corrupt financial sector is still dominated by the same large players as it was before. True, many unsustainable high street firms have gone out of business, but the most unsustainable firms that had  to be bailed out — the banks and financial firms who have caused the financial crisis — have avoided liquidation. The real story here is not a structural adjustment but the slow bleeding out of the welfare state via deep and reaching cuts.

Britain has become welfare-dependent. Britain’s welfare expenditure is now over 25% of its total GDP. Multi-billion pound cuts in that figure are going to (and have) hurt GDP.

I believe countries are better with small governments and a larger private sector. The private sector consists of many, many individuals acting out their subjective economic preferences. This dynamic is largely experimental; businesses come and go, survive, thrive and die based upon their ability to stay liquid and retain a market, and this competition for demand forces innovation. The government sector is centrally directed. Governments do not have to behave like a business, they do not have to innovate or compete, as they have the power to tax and compel. (The exception to this is when governments become overrun by the representatives of private industries and corporations, who then leverage the machinations of the state to benefit corporations. When this occurs and markets become rigged in the favour of certain well-connected competitors, it matters little whether we call such industries “private sector” or “public sector”).

So I am sympathetic to the idea that Britain ought to have a smaller welfare state, and fewer transfer payments than it presently does. But the current and historical data shows very clearly that now is not the time to make such an adjustment. The time to reduce the size of the welfare state is when the economy is booming. This is the time that there is work for welfare claimants to go to. Cutting into a depressed economy might create a strong incentive for the jobless to work, but if there is little or no job creation for the jobless to go to, then what use are cuts? To reduce government deficits? If that’s the case, then why are British government deficits rising even though spending is being reduced? (The answer, of course, is falling tax revenues).

An alternative policy that would reduce unemployment and raise GDP without increasing the size of government is to force bailed-out banks sitting on huge hoards of cash to offer loans to the jobless to start their own private businesses. The money would be transferred to those who could be out working and creating wealth, but who cannot get credit through conventional channels, unlike the too-big-to-fail megabanks who are flush with credit but refuse to increase lending to the wider public. Even if the majority of these businesses were to fail, this would ensure a large boost in spending and incomes in the short run, and the few new businesses that succeed would provide employment and tax revenues for years to come. Once there is a real recovery and solid growth in GDP and in unemployment, then the government can act to decrease its size and slash its debt. Indeed, with growing tax revenues it is probable we would find that the deficit would end up decreasing itself.

Chart of the Decade

This chart tells millions of stories. I’m trying to get my head around its implications.

That’s right: since 1984 (surely an appropriate year) while the elderly have grown their wealth in nominal terms, the young are much worse off both in inflation-adjusted terms, as well as nominal terms (pretty hard to believe given that the money supply has expanded eightfold in the intervening years). So why are the elderly doing over fifty times better than the young when they were only doing ten times better before?

Are young people a stupefied generation coddled by parents and government, addicted to welfare, junk food, drugs and reality TV?

To some extent, but are they any less fiscally and morally responsible than the marijuana-smoking, free-love-embracing, national-debt-accruing baby boom generation? That’s a matter of opinion, but my answer is probably not. Baby boomers hate Ron Paul, while the under-35s seem to love him.

Is it due to government policies that favour the elderly and screw the young?

America is suffering from excessive consumer debt:

Net worth is calculated by subtracting debt from assets. The biggest debt for most people is a mortgage. So having more mortgage debt or less mortgage debt tends to be a pretty good determinant of net worth. (And no — unlike in the United Kingdom and Australia which have a severe problem with housing affordability — housing in the USA is still cheap today priced in wages)

The elderly have very often already paid off their mortgages — no doubt helped by the 1980s and 1990s where both stock prices and house prices grew rapidly. And why did rise so rapidly?

Some say that it came on the back of excessive expansion of the money supply beyond the economy’s productive capacity. But that doesn’t seem quite true:

The money supply grew in tandem with industrial production. This was no bubble, but organic growth (albeit as I have shown before on the back of cheap Chinese goods and cheap Arab energy).

My hypothesis is that the present situation is a product of government expansion.

Here’s government expenditure as a proportion of GDP:

Government spending in democracies very often tends to constitute a transfer of wealth from non-voters to voters (as well as groups that can’t afford lobbyists to groups that can afford lobbyists — perhaps that is one reason why corporate profits are soaring while youth unemployment remains elevated, and why Wall Street banks get bailed out, but delinquent small businesses do not).

Here’s the voter turnout by age in the 2004-2008 Presidential elections:

Older people vote in droves. Politicians want their votes and therefore promise them more free stuff — medicare, medicaid, services — and they vote for whoever offers them the most.

The biggest issue though, is this:

Keynesians may say that this reflects a government’s failure to create jobs for young people. They claim that the problem is that there is not enough money circulating in the economy, and that government can “raise demand” by pumping out more cash. But there is plenty of money in the economy; so much money that Apple have built up a $90 billion cash pile. So much that China has built up a $3 trillion cash pile. So much that banks are holding $1.6 trillion in excess reserves below fractional lending requirements.

More likely is the reality that overregulation and barriers to entry are preventing the unemployed from picking up the slack in the jobs market. As John Stossel reveals in a recent documentary film,  in New York City it costs $1 million to get a licence to drive a taxi. Anyone who wishes to operate a food cart, or run a lemonade stand has to traverse reams of bureaucracy, acquire health and safety certificates, and often pay huge fees  to receive the “necessary” accreditation. While some barriers to entry are necessary (e.g. in medicine), in other fields it is just an unnecessary restraint on useful economic activity. In many American cities it is now illegal even to feed the homeless without government certification and approval. Citizens who defy these regulations face fines, arrest, and even imprisonment.

In a recent article, the Economist noted:

Two forces make American laws too complex. One is hubris. Many lawmakers seem to believe that they can lay down rules to govern every eventuality. Examples range from the merely annoying (eg, a proposed code for nurseries in Colorado that specifies how many crayons each box must contain) to the delusional (eg, the conceit of Dodd-Frank that you can anticipate and ban every nasty trick financiers will dream up in the future). Far from preventing abuses, complexity creates loopholes that the shrewd can abuse with impunity.

The other force that makes American laws complex is lobbying. The government’s drive to micromanage so many activities creates a huge incentive for interest groups to push for special favours. When a bill is hundreds of pages long, it is not hard for congressmen to slip in clauses that benefit their chums and campaign donors. The health-care bill included tons of favours for the pushy. Congress’s last, failed attempt to regulate greenhouse gases was even worse.

Complexity costs money. Sarbanes-Oxley, a law aimed at preventing Enron-style frauds, has made it so difficult to list shares on an American stockmarket that firms increasingly look elsewhere or stay private. America’s share of initial public offerings fell from 67% in 2002 (when Sarbox passed) to 16% last year, despite some benign tweaks to the law. A study for the Small Business Administration, a government body, found that regulations in general add $10,585 in costs per employee. It’s a wonder the jobless rate isn’t even higher than it is.

The truth may be that the inability of the unemployed to become self-employed is the force that is squeezing the jobless most. Certainly, job migration overseas has changed America, but why should it mean continued elevated unemployment? There is enough money to keep the economy flowing so long as there are opportunities for people to make themselves useful in a way that pays. With the crushing burden of overregulation and the problem of barriers to entry, these opportunities are often restricted to large corporations.

These issues of youth unemployment and growing inequality between the generations are critically important. Unemployed and poor swathes of youth have a habit of creating volatility in response to restricted economic opportunity.