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US economy: Wall Street, GDP and wingnuts

Gerard Jackson

Monday 14 August 2006

In my article on Why Wall Street keeps getting it wrong on the US economy I pointed out that GDP is not gross at all because it leaves out spending on intermediate goods. This approach conveys the false impression that consumer spending is the real driving force in the economy because it comes to 66 to 70 per cent of GDP. However, when we use a genuine gross-expenditure approach the situation changes radically with business spending dwarfing consumer spending.

Even I was surprised at the response to my article. I certainly didn’t expect to be called a “wingnut” and “nut case” just for pointing out the obvious, or at least what should be obvious. One poor soul called me an “ignorant nutmeg” for not realising that “GDP does include spending on intermediate goods”. It never occurred to this learned gentlemen that net means that deductions have been made. In the case of GDP these reductions are what firms have spent on their inputs, i.e., circulating capital.

This person obviously thinks that because GDP includes expenditures on fixed capital this must also include circulating capital. How he could arrive at this conclusion when every text book stresses the fact that spending on intermediate goods is definitely not included in GDP beats me. (Paul Samuelson Economics, McGraw-Hill Book Company, 10 edition, 1976, p. 185).

I received a sneering email from some chappie called Mike who said he stopped reading my article when he reached the part on GDP “because it is obvious you don’t know what you’re talking about”. Well I just love an open-minded person, don’t you? According to Mike “to include spending on intermediate goods would be double counting”. There were a number of other emails trying to make the same point. Clearly we are dealing with a text book mentality here.

First things first: I did not say anything new. If Mike had persevered further he would have learnt that in 1928 a certain Mr M. W. Holtrop made the same point when he calculated that consumer spending in the US was about 8.3 per cent of what was spent on producer goods, which also included intermediate goods. Friedrich von Hayek made exactly the same point and explained the danger in overlooking this vitally important fact. (Prices and Production, Lecture II pp.32-68, Pub. Augustus M. Kelley 1967, first published in 1931).

Furthermore, Hayek returned to this subject in his essay The Paradox of Saving, (see Profits, Interest and Investment, Augustus M. Kelley Publishers, 1975). He used a table to illustrate the importance of spending on intermediate goods, describing in great detail how interfering with this spending can deform the capital structure and cut living standards. But perhaps Mike thinks that this Nobel Prize-winning economist was also a “nut case”. Taking what one can call the Mises-Hayek approach Murray N. Rothbard also stressed that the text-book approach leads to the fallacy

…that the important category of expenditures in the production system is consumers’ spending. Many writers have gone so far as to relate business prosperity directly to consumers’ spending, and depressions of business to declines in consumers’ spending”…. it is clear that there is little or no relationship between prosperity and consumers’ spending; indeed almost the reverse is true. (Man, Economy and State, Nash Publishing, Los Angeles, 1970).

Stressing this point further Rothbard tells us

that what maintains capital is gross expenditures and gross investment and not net investment….The fallacies of the net product figures have led economists to include some “grossness” in their product and income figures. At present the favorite concept is that of the “gross national product” and its counterpart, gross national expenditures...Current “gross” figures, however, are the height of illogicality, because they are not gross at all, but only partly gross. They include only gross purchases by capitalists of durable capital goods and the consumption of their self-owned durable capital, approximated by depreciation allowances set by the owners….it is inadmissible [italics added] to leave the consumption of nondurable capital goods out of the investment picture. (Ibid.)

Mark Skousen also exposed this fundamental flaw in GDP and explained how it should be treated. He came up with the concept of “gross outlays”. Using the Mises-Hayek approach Skousen concluded that

...GNP violates the basic principles of business accounting,...businesses must be able to raise sufficient capital...to pay for the gross outlays, not just the value-added portion of doing business….Business cannot ignore the aggregate costs of doing business; therefore, why should economists do so in figuring national output? It is national folly indeed...That by omitting intermediate business input, GNP greatly underestimates actual spending by firms. In sum, GNP does not reflect total spending in the economy. (Economics on Trial: Lies, Myths and Realities, Business One Irwin, 1991. There is also his Economic Logic, Capital Press).

In his monumental Money, Bank Credit, and Economic Cycles Jesüs Huerto De Soto used figures and charts to describe in considerable detail the nature of production, and explain why it is a dreadful error to omit from the national accounts spending on intermediate goods (published by the Ludwig von Mises Institute, 2006).

What my critics failed dismally to grasp is that I was using production-structure analysis, an approach that ineluctably leads to the rejection of the deeply flawed GDP concept as providing an accurate picture of total spending. As I have already said, there is nothing new in any of this. In The Theory of Political Economy, first published in 1871, William Stanley Jevons developed a similar concept. Hayek then used — in homage to Jevons — what he called Jevonian triangles to illustrate the shape of the production structure.

However, it was Eugen von Böhm Bawerk rather than Jevons who treated in greater depth the successive stages of capital goods that form the capital structure. (Capital and Interest, Vol II The Positive Theory of Capital, Chap. V, Libertarian Press, first published in 1888). Unfortunately, instead of using a triangle to illustrate his thesis he opted for the clumsy use of concentric circles. Nevertheless it was a groundbreaking work.

The stages-of-production approach was once a common feature of textbooks. A good example being The Social Framework of the American Economy: An Introduction to Economics by the eminent economist J. R. Hicks and Albert G. Harcourt (Oxford University Press, 1945). Like the Austrians these authors concluded that

The consumers’ good is the end of the whole process; producers’ goods are stages on the road towards it.

Rather than treat the economy as consisting of successive stages the orthodox approach of ignoring spending on intermediate capital goods is basically assuming, though tacitly, that the economy only consists of two stages: the first stage being consumption spending and the second stage being the aggregate of capital goods.

One part of the problem is that income is treated as a circular flow resulting in the assumption that everything happens simultaneously. In other words, the circular flow concept of income expels time from the economy. I believe this error can be directly traced to John Bates Clark who thought of the economy as being in a timeless state where production and consumption happened simultaneously.

This view leads to the assumption that even if savings fell to zero consumers’ spending will be sufficient to maintain the quantity of capital. In my opinion this is why so many economists ascribe the business cycle to changes in consumption. Frank H. Knight continued with this approach and assumed that once capital is produced it multiplies itself in some mysterious way.

How else can his theory be interpreted once we recognise that it is based on the idea of a timeless economy in which time preference cannot influence production? It is both safe and fair to therefore conclude that the Clark-Knight view of capital as something permanent results in capital being treated as an independent aggregate and thus a separate factor of production. Moreover, the permanency theory of capital has to deny the obvious fact that production takes place through complex stages production and hence through time.

Although I feel I shouldn’t have to stress my point further I still think it necessary to emphasise that once one applies production structure analysis to the economy it becomes necessary to take in to account spending on intermediate goods. Once this is done a very different and more accurate picture of the economy emerges.

It’s a great pity that my critics saw fit to cease reading when they did.

Gerard Jackson is Brookes’ economics editor

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