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!
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.