Rocking the Henry Hazlitt t-shirt en route to my 9th place finish in Event #35 at the 2011 World Series of Poker!


Debunking the importance of GDP

What is GDP and why is it so important? From investopedia.com:

The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country's economy. It represents the total dollar value of all goods and services produced over a specific time period - you can think of it as the size of the economy.

How GDP is measured from www.bea.gov:
First, GDP can be measured as the sum of expenditures, or purchases, by final users. This is known as the expenditures approach (and is illustrated by the formula familiar to students of economics: GDP = Consumption + Investment + Government Spending + eXports – iMports)

I hope to demonstrate that the components used in the GDP formula to represent the total dollar value of all goods and services produced in an economy are, in fact, disconnected from the underlying value that they are purporting to reveal.

I've never been a fan of the GDP statistic as an accurate indicator of the health of an economy. Ignoring the quite valid reason that the statistic itself may be manipulated by the reporting agency, there has always been what appears to be a structural flaw in its very nature.

The component which I have always held as being suspect is government spending (G). Previously my criticisms of this G component in the GDP equation was that it did not accurately represent wealth as government spending is arbitrary and oftentimes used for destructive ends such as wars etc. However, this objection can be somewhat countered by the claim that government spending provides public goods (such as national defense etc.) that do in fact increase the wealth of an economy.

Now to counter this claim by attacking the notion that military spending increases the wealth of the economy as a whole, implicitly suggests that G would be an accurate indicator of increased wealth if its underlying actions were wealth-creating. While this is still a very valid criticism of government spending, there remains an additional and perhaps even more fatal critique of the quality of G in the G + I + C = GDP formula. This critique being that G itself, by definition, is not analogous to C (consumer spending) as an indicator of wealth.

To see why, we first have to understand why spending at all can be considered a measure of wealth. Upon reflecting on this matter, we realize it has to do with prices (specifically market prices) and the information that they convey. Whereas one finds his lot improved by the purchase of 5 wheelbarrows at the market price of 10 dollars a wheelbarrow, we can conclude the individual, and thus the economy as a whole, is wealthier to the tune of the utility that 50 dollars in spending has granted him, specifically the subjective value of the additional 5 wheelbarrows. Moreover the spending of 50 dollars represents the creation of these 5 wheelbarrows and of course the additional utility they grant, hence why they were purchased. This is the key. Wealth is not measured simply by the dollar amount of spending. Wealth comes from the goods and services provided in exchange for money. This is why spending matters and is accurate as an indicator of wealth. If any part of this process is diluted, the quality of spending as an accurate indicator of wealth diminishes greatly.

So why does consumer spending work well in this regard, where government spending fails? The answer lies in the prices. In a free market, all participants are subject to the profit and loss test. Namely, if one consistently spends more than he earns, he eventually becomes bankrupt and removed from the market altogether. In order to prevent this "death by free-market" one must learn to generate a profit; which is done by allocating resources efficiently. As all market participants engage with one another in this task, prices emerge for all the various goods and services within the economy that reflect their valuation to the economy as a whole (the price of course being derived both from the subjective valuation of the good as measured against the scarcity of the good, put more simply: supply versus demand).

This is precisely what gives prices such significance in the measuring of value. They have emerged organically as beacons of information about both the relative scarcity of the good contrasted with the market's intensity of demand. Thus, when we look at all of the spending that has occurred within an economy, we are provided with an aggregate of the wealth or utility that is gained precisely because the prices used to comprise "C", are prices that emerged from the free market and under the profit and loss test.

Government spending is a measure of spending that occurs outside of this profit and loss test. Since government and only government is in the unique position of being able to exist via taxation and the printing of money, it is not constrained by the profit and loss test and thus routinely overbids for goods. This results in government spending being less accurate as a measure of true wealth and value of the underlying goods purchased as the prices paid tend to be always higher than the existing market prices. Some examples include paying 200k to design a website and so on. I'm sure everyone has their own favorite anecdote of absurd government spending.

Consequently, all the interwoven factors that result in the prices that emerge within the free market and enabling spending to be an accurate measure of wealth, are completely manipulated if not outright destroyed under government spending. This inherent nature of government spending and its direct contrast with all that makes consumer spending meaningful in the first place is why G is a corrupted and inaccurate measure of wealth, and consequently the GDP = G + I + C formula is invalid when used as such.

Said another way, consumer spending is meaningful because it is very closely, if not exactly, accurate as a reflection of the underlying value of the goods purchased (produced). Conversely, government spending is significantly less accurate as a measure of wealth because its correlation to the underlying value of goods purchased is much weaker due to the lack of a constraint on spending and thus a tendency to overpay (sometimes quite drastically!) for goods and services.