We should ditch GDP as a measure of economic activity

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by Alasdair Macleod, GoldMoney:

This article exposes the false economic concepts behind GDP, which is only the visible tip of a large iceberg of economic deceit. Describing an increase in GDP as economic growth owes its meagre validity to imprecise definition. An economy does not grow, only the quantity of fiat currency deployed grows. A successful economy progresses our condition, our wealth, our standards of living. The evolution of misleading statistics such as GDP to their current condition is only governed by their usefulness to governments, not as an objective development of sound theory by seekers of truth.

There are perhaps two plausible reasons for producing the GDP statistic, other than employing statisticians, and both have nothing to do with economics. By compiling the figures, a government keeps track of its tax base, and it can enter into the game of my-country-is-bigger-than-yours.

In international comparisons of economic performance, gross domestic product adjusted for price inflation is the most common metric used. Countries are ranked by size, and success is measured by the rate of growth in GDP. This is important to the political class.

About two years ago, I was told that the Indonesian central bank had a plan to do away with cash entirely, because it would bring unrecorded transactions into Indonesia’s GDP, promoting it from sixteenth to perhaps the thirteenth largest nation measured by GDP. I have no idea if this was true, but allegedly, this was important to the Indonesian government.

We should not be surprised if going cashless is partly motivated to give the illusion of GDP growth, in the same way that in 2014 the EU decided to add in estimated contributions from prostitution and drug dealing. These are examples of why and how GDP is manipulated to produce a goal-sought answer.

As a widely-accepted measurement of economic activity GDP is a fairly recent introduction, dating from the 1990s. Before GDP, we used gross national product (GNP) which was introduced following the Second World War. And before that we had national income, a theoretical concept that goes back to Sir William Petty in the seventeenth century.[i]

The more you examine the history of attempts to define national income, the more you see that it has been adapted to suit the mathematical economists of the last century in their statist objectives. While attempts are made to include or estimate black market activities, second hand goods are excluded, which make up a significant part of our economic activity. In its construction and purpose GDP has amounted to compromise heaped upon compromise. That notwithstanding, it is now the principal method of comparing the economy of one country with another.

The relative status in a table of size measured by GDP is always rationalised into US dollars as the common reserve currency, along with the implied rate of comparative growth. This cuts across domestic prices, which corrected for purchasing power parity gives completely different answers. The rate of growth from one year to the next is adjusted by the rate of price inflation in the underlying currency to come up with “true” GDP growth. One wonders at the purpose of it all, given, as Petty points out in his Political Arithmetick, the size of a country is immaterial to its wealth, which is better judged on a per capita basis. The Indonesians in the example above would be better off considering how to promote individual wealth than to manipulate statistics to enhance their international standing.

This article looks at the principal deficiencies of the GDP statistic, and why it is more misleading than useful. Erroneous beliefs that GDP records economic reality could make the task of central banking’s crisis management more destructive than it would otherwise be, a looming issue given that the global credit cycle is moving closer to an inflection point triggered by rising interest rates.

This article questions the legitimacy of inflation-adjusting, the diversion of attention from the importance of payments in the production process and makes the case for excluding the government sector entirely. It also shows why it is wrong to make any association between an increase in GDP and economic progress.

The senselessness of inflation adjustment

In an inflationary economy, official government price statistics routinely under-record the true rate of price increases approximated by raw data. By this simple device a GDP increase is registered when the economy might be going nowhere or even regressing.

The exaggeration of real GDP growth is greatest in a high-inflation economy, but it is also evident when there is greater price stability. US Nominal GDP in Q2 2018 grew by 7.6% annualised, while the CPI is recorded as rising at an annual rate of 3.2%. Therefore, the official growth rate of the US economy for that quarter was 4.2%.

Independent sources agree the rate of price inflation in the US is closer to 10%.[ii], in which case adjusted for true consumer price inflation, GDP contracted by approximately 5.8% annualised instead of increasing. This may be difficult to comprehend, because we are so conditioned to official statistics that always say otherwise. Yet we are prepared to accept black market prices as the true indicator of the rate of inflation in high-inflation economies, such as Venezuela or Argentina, because official statistics paint too rosy a picture. But it cannot be one rule for the reserve currency and another for some of the others, because that is simply inconsistent.

Assuming the independent estimators of US price inflation are correct, it also throws the whole basis of monetary policy into doubt. If in Q2 2018 real GDP contracted by 5.8%, it implies to policy-makers that interest rates are far too high to stimulate the economy and should be cut sharply. Yet, if the Fed is targeting price inflation, interest rates are far too low and should be increased to 10% just to be neutral.

The answer to this conflict is straight-forward. The real world works on nominal prices, not inflation-adjusted ones. A businessman constructing a business plan will consider known factors in calculating his returns. He starts with an assumption of the volumes he can expect to sell based on known market prices. He then estimates the costs involved. From these costs and the market value of his anticipated production, he can work out the expected return on his capital. Very rarely do these estimates incorporate some form of price indexation, unless prices are inherently unstable. And even then, rather than indexing future prices between the business planning process and eventual production output, he is more likely to increase the hurdle rate for returns on capital.

It is nominal prices that matter. Economists are mistaken in their attempts to adjust GDP by price inflation, not least because today’s price inflation is the result of monetary expansion long ago. But there is also a fundamental misconception of what GDP actually represents, which is easy to demonstrate.

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