Patterico's Pontifications

6/10/2014

Consumer Spending Is Not the Most Important Part of the Economy — Why Paul Krugman’s Love of GDP Is Wrong, Part Two

Filed under: General — Patterico @ 6:00 am

As I mentioned yesterday, I am spending time this week attacking GDP as the ultimate benchmark for measuring the strength of the economy. Yesterday, in Part One of the series, I noted that GDP includes government spending even though government spending does not necessarily benefit consumers.

Today, I want to address another problem with GDP: it overemphasizes consumer spending to the detriment of capital investment.

I am going to give you the same video I showed you yesterday, featuring Austrian economist Jeff Herbener, interviewed by Tom Woods. If you are short on time, skip to 4:55, where Prof. Herbener notes that GDP indicates only the value of the final goods and services produced.

GDP is generally defined as the market value of the final products of an economy, including goods and services. But GDP does not measure all economic production. There is an entire production process that goes into the production of any good, whether it be a consumer good or a capital good. This does not get included in the calculation.

For example, when a car is sold, the price of the car is included in GDP. Economists do not include, for example, the cost of the steps in the production process that provide the building blocks for the car — such as the mining of iron ore, the production of steel, or the machinery and computer modeling that serve to transform that steel into the skeleton of an automobile.

The reason is that the final price of the car is thought to represent the cost of all stages of production of the automobile, ideally together with a profit for the company. If one counted the value of the production process and the cost of the car, it is said, that would represent “double counting” of the costs of the production process.

That’s fine if your only goal is to learn the final value of the good. But leaving the production process out of the equation, and including only purchases of final goods and services, distorts the significance of the total. That’s because eliminating the work that goes into making the product gives an outsized significance to the act of purchasing that final product. As Professor Herbener has elsewhere explained:

If all one is interested in determining the the dollar value of all that has been produced in the economy, then, counting the steel, and other parts of the car along with the car would be double counting. But the dollar value of what has been produced in an economy is, perhaps, the least interesting thing we could know about it.

If we really want to understand an economy, we have to know how all the different resources people have get allocated into all the different production processes. The monetary value of all production tells us nothing about this.

. . . .

When we trace back the production of consumer goods to their sources, then, we see that the amount of demand entrepreneurs have for all the producer goods necessary to make some consumer good far outweigh the demand consumers have for it. In other words, the far greater portion of production in an economy is of producer goods, which is explained by entrepreneurial demands, which results in investment spending. Consumer demands and consumption spending are a far smaller portion of all demands and total spending and the production of consumer goods is a smaller portion of the production across the entire economy.

By excluding the cost of production processes from GDP, economists overemphasize the importance of consumer spending. Based on measures of GDP, we are told that consumer spending is 70% of the economy, and that investment is only 15% or even as little as 10%. But that is radically wrong. That may be true when it comes to the value of the final goods. But those goods did not come out of nowhere. They had to be produced.

Tom Woods recently interviewed an economist named Tim Delmastro who successfully lobbied the government to provide a number called “gross output.” This number measures spending at all stages of production — a concept central to Austrian economics. As Delmastro notes in the interview, the GDP number consists of consumer spending (70%) and government spending (20%) with business investment coming up as a distant third. This misleads people into thinking that increasing consumer spending is the most important thing to do in the economy. But when you measure “gross output” and get a more accurate picture of the economy, you learn that consumer spending is only about 30 to 40% of the economy, while business investment is actually over 50% of the economy. (The “gross output” number is actually quite poor under Obama, by the way. Shockingly.)

At 8:21 in the video below, Woods makes the killer point that drives this point home: we are always told we need more consumer spending. If we followed that advice and took it to its logical conclusion, everyone who receives money for a good or service should just go spend it on consumption. As Woods says:

But meanwhile, people are told, or are under the impression, that what we need is more consumer spending. Spend spend spend spend. But if we followed that advice . . . to a “T,” and everybody, as soon as he got money, just spent it on another consumer good . . . let’s say you buy ten gallons of milk from me, and I take that money and I buy a shirt, and the shirt guy buys a hat, and the hat guy buys a gallon of gas . . . then no wages get paid [and] all the production structure we just described grinds to a complete halt. But that would be Nirvana, because you have all the consumption you want!

Woo-hoo!

Tomorrow, in part three of the series, we identify the basic problem with GDP. Namely: it does not measure what we should be most interested in when we study economics: how to allocate scarce resources. See you then.

P.S. Once again: if you choose to sign up for Woods’s “Liberty Classroom” to learn more about concepts like this, please do so though this link. Do yourself a favor and at least check out Woods’s free samples to see what you think.

32 Responses to “Consumer Spending Is Not the Most Important Part of the Economy — Why Paul Krugman’s Love of GDP Is Wrong, Part Two”

  1. Excellent! Just shows how the government gives us a distorted view of the world.

    stmilam (770d4d)

  2. One thing: They used to use Gross National Product (GNP)

    Gross National Product was always considerd equal to Gross Natropnal Income (GNI) and it was in fact, GNI that was calculated, not GNP.

    When did the changeovere to GDP occur, and what was done different?

    Sammy Finkelman (2d4607)

  3. Sammy,

    GNP takes into account final goods and services produced by American nationals whether they are located within our territorial boundaries or not. GDP measures only production within our territorial boundaries.

    I’d like for people not to get too sidetracked by that small distinction, though. The point of this post is the overemphasis on consumer spending to the detriment of capital investment.

    Patterico (9c670f)

  4. stmilam,

    Thank you.

    Patterico (9c670f)

  5. Patterico 3. GNP takes into account final goods and services produced by American nationals whether they are located within our territorial boundaries or not

    But GNP doesn’t/didn’t do that at all. GNP is/was never calculated. It is actually Gross National Income, which is defined as equal to Gross National Product.

    They had to do something totally new to get GDP.

    It is important to know what they did or do to get some kind of an idea what kind of a figure this is.

    Sammy Finkelman (2d4607)

  6. you learn that consumer spending is only about 30 to 40% of the economy, while business investment is actually over 50% of the economy.

    In effect, a major part of the dynamics of an economy isn’t just predicated on the behavior of the consumer but on the behavior of the business builder.

    That’s apparent when one very talented, resourceful, ambitious person can create far more economic energy all around him (or her) compared with the effects from John and Mary Q. “Typical Shopper” Public.

    Even more misleading to reflecting the true nature of a society’s economy (etc) are unemployment rates, since official statistics indicate that Mexico has had unemployment of generally 3 to 4 percent (and rarely much above that) for over 30 to 40 years. So based on that type of statistic, our neighbor to the south looks like an economic nirvana.

    Mark (c63fba)

  7. “At 8:21 in the video below, Woods makes the killer point that drives this point home: we are always told we need more consumer spending.”

    Patterico – It’s a little like the chicken or the egg problem, which came first. I look at the macro economy and see a labor force which has not recovered to its pre-crash size since Obama took office, depressing potential consumer spending, and I see a number of major factors worthy of blame.

    I see business unwilling or unable to invest in their businesses due to a crushing and uncertain regulatory environment coming out of Washington. First, going after banks with torches and pitch forks dried up bank credit for businesses and continues to have an impact on the availability of credit for many businesses as banks are still worried about the government looking over their shoulder and questioning why loans were made (the DOJ’s current Operation Choke Point is a great example of the government trying to force banks out of lending to perfectly legal businesses). The lack of availability of credit limits capital investment and the need to hire additional labor.

    Uncertain potential tax and environmental regulations have been another hallmark of this administration, casting another pall over capital investment and expansion decisions.

    Obamacare represents a third major factor, with all its delays in actually providing guidance to employers after its passage in 2010 and then waivers in implementation.

    Uncertainty is a part of life, but when it is caused by an inexperienced, anti-business political team, that tends to make businesses cautious and scale back capital spending and hiring plans, which are some of the major reasons I believe this is the worst recovery we have seen since the Great Depression.

    daleyrocks (bf33e9)

  8. Mark (c63fba) — 6/10/2014 @ 7:43 am

    official statistics indicate that Mexico has had unemployment of generally 3 to 4 percent (and rarely much above that) for over 30 to 40 years. So based on that type of statistic, our neighbor to the south looks like an economic nirvana.

    If the unemployment rate was the only statistic that mattered.

    Mexico has a much lower minimum wage, which I think, in fact, is a minimum daily, not hourly, wage.

    And probably a big informal economy besides.

    Sammy Finkelman (2d4607)

  9. “At 8:21 in the video below, Woods makes the killer point that drives this point home: we are always told we need more consumer spending.”

    Patterico – A frequent criticism of the U.S. which is also made is that our savings rate is way below many other industrialized nations. Growing savings generates funds for capital investment. Growing spending does as well. Both, however are dependent on growing jobs, incomes and in the case of spending, the ability to incur debt. The willingness of businesses to make capital investments and expand workforces, in my opinion, is based upon their outlook of the future. Under Obama, not many sectors have been positive.

    daleyrocks (bf33e9)

  10. I think this is weak tea, particularly compared to part one which I agreed with completely (the economic profession should be ashamed of itself for its role in throwing gasoline on the growing government fire). Business investment doesn’t happen in a vacuum – it reflects future anticipated demand. Where does anticipated demand come from? To a great extent, the trend is your friend i.e. current spending is extrapolated. In the house example in the video, all the activities cited are all driven by one thing: anticipated future demand. If you know spending trends and inventory levels, you can predict business investment in the aggregate (though not timing).

    East Bay Jay (a5dac7)

  11. What you seem to be forgetting is that the only purpose of production is
    consumption. Money spent on mining iron and smelting it into steel is “wasted”,
    in a sense, because hardly anybody has any use for steel itself. If that steel
    were to be produced and then lie around in a warehouse forever, or if it were
    used to make something that nobody wants, then all the resources
    spent in producing it would indeed have been wasted. The reason it is worthwhile
    to produce steel is only because consumers want things that are made with it, and
    will ultimately buy those things. It’s that consumption that justifies the
    production, which if considered in itself would be of no value at all.

    I’ve written about this here before: When a farmer takes perfectly good seeds and
    buries them in the ground, where they rot away into nothing, he has destroyed value!
    He spent good money for that seed, and now what does he have to show for it?
    A naive observer would consider him a vandal, or an idiot. Nor is there any
    guarantee that a crop will result from his sowing; if it doesn’t, then he will
    indeed have wasted the seed, and his labor. Even if a crop does result, if the
    price drops the seed and labor may still have been wasted. It’s only when someone
    buys the crop at a good price that value retroactively attaches to all that went
    into producing it.

    Milhouse (b95258)

  12. PS: Mr Technical guy, this ultra-wide comment window is a pain.

    Milhouse (b95258)

  13. Same comment as before, properly formatted:

    What you seem to be forgetting is that the only purpose of production is consumption. Money spent on mining iron and smelting it into steel is “wasted”, in a sense, because hardly anybody has any use for steel itself. If that steel were to be produced and then lie around in a warehouse forever, or if it were used to make something that nobody wants, then all the resources spent in producing it would indeed have been wasted. The reason it is worthwhile to produce steel is only because consumers want things that are made with it, and will ultimately buy those things. It’s that consumption that justifies the production, which if considered in itself would be of no value at all.

    I’ve written about this here before: When a farmer takes perfectly good seeds and buries them in the ground, where they rot away into nothing, he has destroyed value! He spent good money for that seed, and now what does he have to show for it? A naive observer would consider him a vandal, or an idiot. Nor is there any guarantee that a crop will result from his sowing; if it doesn’t, then he will indeed have wasted the seed, and his labor. Even if a crop does result, if the price drops the seed and labor may still have been wasted. It’s only when someone buys the crop at a good price that value retroactively attaches to all that went into producing it.

    Milhouse (b95258)

  14. as of now, the comment window is correctly sized in FireFox, and in Internet Explorer version 9 (copyright 2011) at least when running under windows 7.

    The comment box is not properly sized and the comment boxes are also gone in Internet Explorer version 8 under XP unless things have changed since I last looked.

    Strikeout is gone, but some people seem to be using it.

    Sammy Finkelman (d22d64)

  15. It seems to alternate between posts. But I’ve sized my monitor so that the preview below is visible and I use that as a guide when the box runs on.

    nk (dbc370)

  16. Sammy, for strikeout, italicize and then replace the em inside the tags with strike.

    nk (dbc370)

  17. Further to the example of the farmer: it doesn’t stop when someone buys the crop. The consumer demand for raw wheat is almost nil, so even when the crop is bought, no value has yet been produced. If it’s made into baked goods that nobody likes, or if it catches fire and burns, it’s all the same: the economy is worse off than if the farmer hadn’t sowed the seeds in the first place. The seeds, labor, rent on the land, etc., will all have been wasted. It’s only when the final consumer buys what is made from the crop, and enjoys it, that the economy is suddenly better off.

    How much better off? To calculate that, the value of the consumer’s enjoyment must be offset against all that was spent on producing it. In other words, even in the final analysis, the seeds, labor, rent, storage, baking skills, etc, are all negatives, and only the consumer’s enjoyment is a positive. All those other things were costs paid to achieve the consumer’s enjoyment, and are justified only if they add up to less than the value of that enjoyment.

    The best measure we have of that enjoyment is what the consumer willingly paid for it. She might have misestimated it, perhaps even grossly so. It might look good but taste horrible, and she’ll spit it out and regret having bought it. But that’s an unusual case. We can safely assume that such errors don’t happen often. We can also safely assume that they’re offset by errors in the other direction, where the consumer under-estimated how much she would enjoy the goods. So we’re justified in ignoring it, not only because we have no other choice.

    Milhouse (b95258)

  18. Dear Mr. Demand,

    Thank you for your kind demand. You may have my production that you demand when you produce the price of my production.

    Your, etc.,
    Production

    The world is full of demand which will remain unfulfilled until the price for it has been produced. Production is the Alpha and the Omega.

    nk (dbc370)

  19. nk, the problem is the definition of “demand”. Demand doesn’t simply mean people’s uninhibited wishes, it means only those wishes that the wisher can pay for. As Adam Smith put it:

    The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labour, and profit, which must be paid in order to bring it thither. Such people may be called the effectual demanders, and their demand the effectual demand; since it may be sufficient to effectuate the bringing of the commodity to market. It is different from the absolute demand. A very poor man may be said in some sense to have a demand for a coach and six; he might like to have it; but his demand is not an effectual demand, as the commodity can never be brought to market in order to satisfy it.

    Milhouse (b95258)

  20. What you seem to be forgetting is that the only purpose of production is consumption.

    Not at all. I agree with your point: the only reason for the production of capital goods is to more efficiently produce consumer goods (or other capital goods that make production of consumer goods more efficient, etc.) That observation does not undercut my point: most of the economy is investment in capital goods, and it is important to know that — because it helps you understand why focusing on increasing consumption at the expense of capital investment can be counterproductive. What the Keynesians seem to be forgetting is that all consumer goods must be produced.

    FDR stumbled from one wrongheaded attempt to boost consumer spending after another, all the while conducting a war on business — and failing to see that his actions actually hurt consumers’ purchasing power. This is why the point of this post is actually not “weak tea” as East Bay Jay suggests, but a very important point that needs to be understood by those who would use government to tinker with the economy.

    Patterico (e369c3)

  21. Further insight into how government damages the economy can be attained by reading The Forgotten Man, by Amity Shlaes. A fairly conciseful accounting of the few highs, and many lows, of FDR’s attack on Capitalism – and its a good read.

    askeptic (8ecc78)

  22. Thanks. As personal wealth increases what was once a luxury, or unattainable, now becomes ordinary, even a necessity. So yes, I agree, in that sense “effectual demand” does drive production.

    nk (dbc370)

  23. 16.Sammy, for strikeout, italicize and then replace the em inside the tags with strike.

    That’s what doesn’t seem to work. At least when i used “strikeout” Is it just strike, now?

    strikeout Strike

    Maybe that works. It works in the Preview.

    But I can’t get a space character after the end of the strikeout.

    It looks alittle better with a period. strikeout . Strike

    I want something there.
    strikeout ^ Strike

    Sammy Finkelman (d22d64)

  24. Alt-256?

    strikeout ↓ Strike

    I can’t get a space. Some characters exit from the comment.

    Sammy Finkelman (d22d64)

  25. Alt-250 looks close to nothing. strikeout · Strike

    Sammy Finkelman (d22d64)

  26. That observation does not undercut my point: most of the economy is investment in capital goods, and it is important to know that — because it helps you understand why focusing on increasing consumption at the expense of capital investment can be counterproductive.

    The key phrase there is “at the expense of”. Boosting consumption is good. And without government intervention, any increase in consumption will naturally lead to a corresponding increase in production, and thus of capital investment. I don’t even understand what it would mean for the consumption to come at the expense of capital investment.

    Central planning changes all that. If the government forcibly controls all resources, and must approve all expenditures, then it can indeed prevent capital investment, and then wonder why the increased consumption it ordered only led to inflation. Or it can make the opposite mistake, and order lots of capital investment in things that there is no natural demand for. Get rid of central planning and nobody needs to worry about it. Consumption and production will adjust themselves.

    Milhouse (b95258)

  27. I don’t even understand what it would mean for the consumption to come at the expense of capital investment.

    To be precise, I didn’t say the consumption would come at the expense of capital investment. I said it can be counterproductive to focus on consumption at the expense of capital investment, which is not *quite* the same thing. I am not saying that the consumption itself detracts from capital investment, but that a misunderstanding of the economy can lead Our Betters to pass wrongheaded policies that purport to increase consumption, while forgetting that consumer goods must first be . . . produced.

    Here, I am obviously talking about government action, and I gave as my example FDR’s presidency. (It doesn’t take full central planning to screw up the economy, as FDR demonstrated quite effectively.) Let me flesh that out a bit.

    FDR mistakenly believed that the problem to solve was underconsumption, which he sought to fight by exhorting (and eventually forcing) businessmen to pay higher wages. Consumers have more money, so they can spend more! Woo-hoo! Of course, like most government tinkering with the economy, this had unintended consequences, largely in the form of increased unemployment. Meanwhile, the real problem of the Great Depression lay in a lack of capital investment — an outcome predicted by Austrian business cycle theory — yet FDR declared war on businesses. For example, he passed the only tax on undistributed corporate profits in the world, which cut into business’s ability to purchase capital equipment.

    These are some of many examples.

    And the culprit is an emphasis on GDP, which is the root of the problem with Keynesian theory.

    Patterico (9c670f)

  28. Boosting consumption is good.

    Yes, if it occurs in the unhampered market economy.

    But if government distorts the economy to artificially boost consumption at a time when people would normally be saving more, that creates less savings, which means that investment is more difficult.

    Patterico (9c670f)

  29. I hope this is fleshing out for East Bay Jay why this is all important.

    Patterico (9c670f)

  30. I hope so too. But I still think we have a tiny point of disagreement. The problem is not the emphasis on GDP. The problem is government intervention. You seem to be saying that the problem with FDR is that he was trying to achieve the wrong goal. I say the problem was that he was trying to achieve any goal. Trying to boost consumption while steering investment away from production is silly, but the opposite policy would be just as bad. I think GDP is a very useful measure of how much an economy produces, and that the higher the GDP the better off the economy and everyone in it is. But it’s a measure, not the thing itself, so trying to artificially boost it just throws it off. It’s like trying to gain weight by weighing oneself with a rock in ones pocket. And no matter what measure you pick instead, trying to artifically boost it will be just as bad.

    In general I think you’ve been paying too much attention to Rothbard. I remember reading years ago, I don’t remember by whom, that Libertarian philosophers think Rothbard was a good economist and historian, though he was no philosopher. Meanwhile Libertarian economists think he was a good philosopher and historian, who blundered when he tried to write on economics. And Libertarian historians admire him as a philosopher and economist, while dismissing his historical writing.

    Milhouse (b95258)

  31. 28. Patterico (9c670f) — 6/10/2014 @ 5:42 pm

    FDR mistakenly believed that the problem to solve was underconsumption,

    That was more Herbert Hoover, who got behind or sponsored a “Buy Now” campaign in 1930 and bla,ed everythong on a failure of “confidence” and kept on asserting, or so the legend goes, that “Prosperity is just around the corner.”

    which he sought to fight by exhorting (and eventually forcing) businessmen to pay higher wages.

    But more than that, and coming earlioer, was an attempt to keep prices high.

    And where wqere people going to get the money to pay these high prices?

    They weren’t monetarists.

    Consumers have more money, so they can spend more! Woo-hoo!

    I just read that this week in a letter to the New York Times, saying – once again – that Henry Fird raised wages around 1910 or so, to $5 a day, so that his workers could buy his cars – which somehow, I think, would not work as a business plan.

    Meanwhile, the real problem of the Great Depression lay in a lack of capital investment — an outcome predicted by Austrian business cycle theory — yet FDR declared war on businesses. For example, he passed the only tax on undistributed corporate profits in the world, which cut into business’s ability to purchase capital equipment.

    What would be the sense of capital investment if there were no buyers? But nevertheless you can say many upfront expenditures would create profitable busineses. TThe ral sticking point was lack of bank loans.

    Sammy Finkelman (2d4607)


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