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Is GDP an economic fallacy?
Dr Frank Shostak
To ascertain the state of an economy most analysts rely on a statistic called GDP (Gross Domestic Product). This statistic is constructed in accordance with the view that what drives an economy is not the production of wealth but rather its consumption. In short, what matters here is demand for final goods and services. Since consumer outlays are the largest part of overall demand, it is consumer demand that sets in motion economic growth — so it is held. The GDP framework pays attention to the value of final goods and services produced during a particular time interval, usually a quarter, or a year.
By focusing exclusively on final goods and services the GDP framework lapses into a world of fantasy where goods emerge because of people’s desires. This is in total disregard to the facts of reality i.e., the issue of whether such desires can be accommodated. All that matters on this view is the demand for goods, which in turn will give rise almost immediately to their supply. Because the supply of goods is taken for granted this framework completely ignores the whole issue of the various stages of production that precede the emergence of the final good.
In the real world it is not enough to have demand for goods, one must have the means to accommodate peoples desires. Means i.e., various intermediate goods that are required in the production of final goods, are not readily available — they have to be produced.
Thus in order to manufacture a car there is a need for coal that will be employed in the production of steel, which in turn will be employed to manufacture an array of tools. These in turn are used to produce other tools and machinery and so on until we reach the final stage of the production of a car. The harmonious interaction of the various stages of production results in the final product.
The GDP framework gives the impression that it is not the activities of individuals that produce goods and services, but something else outside these activities called the “economy”. However, it must be realised that at no stage does the so-called “economy” have a life of its own independent of individuals. The so-called “economy” is a metaphor — it doesn’t exist.
Through lumping the values of final goods and services together government statisticians concretise the fiction of an economy by means of the GDP statistic. Furthermore, by regarding the “economy” as something which exists in the real world mainstream economists reach a bizarre conclusion that what is good for individuals might not be good for the “economy” and vice versa. Since the “economy” cannot have a life of its own without individuals obviously what is good for individuals cannot be bad for the economy.
The GDP framework cannot tell us whether final goods and services that were produced during a particular period of time are a reflection of real wealth expansion, or on account of capital consumption.
For instance, if a government embarks on the building of a pyramid, which adds absolutely nothing to the well being of individuals, the GDP framework will regard this as economic growth. In reality however, the building of the pyramid will divert real funding from wealth generating activities thereby stifling the production of wealth. Because the GDP framework completely disregards the intermediate stages of production it can be of little help in the assessment of boom-bust cycles. It is little wonder then that mainstream economists are forced to conclude that recessions are in response to a sudden fall in consumer spending. Consequently, it is quite logical within the GDP framework to advocate loose monetary policies to revive the “economy”.
The whole idea of GDP gives the impression that there is such a thing as the national output. In the real world however, wealth is produced by someone and belongs to somebody. In other words, goods and services are not produced in totality and supervised by one supremo. This in turn means that the entire concept of GDP is devoid of any basis in reality. It is an empty concept. According to Mises the whole idea that one can establish the value of the national output is somewhat farfetched.
The attempt to determine in money the wealth of a nation or the whole mankind is as childish as the mystic efforts to solve the riddles of the universe by worrying about the dimension of the pyramid of Cheops. ( Human Action, 3rd revised edition, Henry Regnery Company, p.217)
Furthermore:
If a business calculation values a supply of potatoes at $100, the idea is that it will be possible to sell it or replace it against this sum. If a whole entrepreneurial unit is estimated $1,000,000 it means that one expects to sell it for this amount… the businessman can convert his property into money, but a nation cannot. (Ibid.)
In addition to all these issues there are serious problems regarding the calculation of the GDP statistic. To calculate a total, several things must be added together. To add things together they must have some unit in common. However, it is not possible to add refrigerators to cars and shirts to obtain the total of final goods. Since the total real output cannot be meaningfully defined, obviously it cannot be quantified. To solve this problem economists employ total monetary expenditure on goods which they divide by an average price of those goods. There is however, a serious problem with this. What is price? It is the rate of exchange between goods established in a transaction between two individuals at a particular place and a particular point in time.
The price or the rate of exchange of one good in terms of another is the amount of the other good divided by the amount of the first. In the money economy, price will be the amount of money divided by the amount of the first good. Suppose two transactions were conducted. In the first transaction one TV set is exchanged for $1000. In the second transaction one shirt is exchanged for $40. The price or the rate of exchange in the first transaction is $1000/1TV set. The price in the second transaction is $40/1shirt. In order to calculate the average price we must add these two ratios and divide them by 2. However, $1000/1TV set cannot be added to $40/1 shirt, implying that it is not possible to establish an average price. It is interesting to note that in commodity markets prices are quoted as Dollars/barrel of oil, Dollars/ounce of gold, Dollars/tonne of copper, etc. Obviously it wouldn't make much sense to establish an average of these prices. On this Rothbard wrote:
Thus, any concept of average price level involves adding or multiplying quantities of completely different units of goods, such as butter, hats, sugar, etc., and is therefore meaningless and illegitimate. (Murray N. Rothbard Man, Economy and State, Nash Publishing 1970, p.734)
The employment of various sophisticated methods to calculate the average price level cannot bypass the essential issue that it is not possible to establish an average price of various goods and services. Accordingly, various price indices that government statisticians compute are simply arbitrary numbers. If, however, price deflators are meaningless so is the real GDP statistic. So what are we to make out of the periodical pronouncements that the economy, as depicted by real GDP, grew by a particular percentage? All that we can say is that this percentage has nothing to do with real economic growth and it most likely mirrors the pace of monetary pumping.
As a rule the more money is created by the central bank and the banking sector, the larger the monetary spending will be. This in turn means that the rate of growth of what is labelled as the “real economy” will closely mirror rises in money supply. So it is no wonder that in the GDP framework the central bank can cause real economic growth, and most economists who religiously follow this framework believe that this is so. Much so called economic research produces “scientific support” to popular views that by means of monetary pumping the central bank can grow the economy. It is overlooked by all these studies that no other conclusion can be reached once it is realised that GDP is a close relative of the money stock.
The question one is tempted to raise is why it is necessary to know the growth of the so-called “economy”? What purpose can this type of information serve? In a free unhampered economy this type of information would be of little use to entrepreneurs. The only indicator that any entrepreneur relies upon is profit and loss. How can the information that the so-called “economy” grew by 4 per cent in a particular period help an entrepreneur to make profit? What an entrepreneur requires is not general information but rather specific information regarding the demand for his specific product, or products. The entrepreneur himself has to establish his own network of information concerning a particular venture.
Things are, however, quite different when the government and the central bank tamper with businesses. Under these conditions no businessman can ignore the GDP statistic since the government and the central bank react to this statistic by means of fiscal and monetary policies.
Likewise participants in financial markets also closely follow the GDP statistic in order to assess the likely responses of the central bank. The entire army of economists is busy guessing whether the central bank will lower, or raise, interest rates. Moreover, to provide a rationale for all this a new form of economics labelled “Macro-economics” was invented. Needless to say this type of economics doesn’t deal with the real world but rather with a non-existent entity called the “economy”. By means of the GDP framework government and central bank officials generate the impression that they can navigate the “economy”. According to this myth the “economy” is expected to follow the growth path outlined by omniscient officials.
Thus, whenever the rate of growth slips to below the outlined growth path, officials are expected to give the “economy” a suitable push. Conversely, whenever the “economy” is growing “too fast” the officials are expected to step in to cool off the “economy’s” rate of growth. If the effect of these policies were to be confined only to the GDP statistic then the whole exercise would have been harmless. However, these policies tamper with activities of wealth producers and thereby undermine people’s well being.
To take a particular instance, by acting to make the non-existent entity the “economy” more efficient US government officials tried to destroying a major wealth generator — Microsoft. Likewise, by means of monetary pumping and interest rates manipulations the Federal Reserve doesn’t help to generate more prosperity, but rather sets in motion a “stronger GDP” and the consequent menace of the boom-bust cycle i.e. economic impoverishment.
We can thus conclude that the GDP framework is an empty abstraction devoid of any link to the real world. Notwithstanding this, the GDP framework is in big demand by governments and central bank officials since it provides justification for their interference with businesses. It also provides an illusory frame of reference to assess the performance of government officials.
Dr Shostak is a former Professor of economics who now works in the private sector
BrookesNews.Com
Monday 3 September 2007