Why GDP Metrics Won’t Tell Us Much about the Post-COVID Recovery

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Alasdair Macleod
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In seeking to measure everything, econometricians gave us the dubious gift of gross national product and gross domestic product, the latter being in fashion today and the former in times past. Although there are different ways of measuring it, GDP is commonly taken as a measure of spending, comprised of household spending, government spending, investment spending, and net exports. The Bank of England’s guide says that it is a measure of the size and health of the economy. And the US’s Bureau of Economic Analysis similarly says, “the growth rate of GDP is the most popular indicator of the nation’s overall economic health”.

Although GDP is a measure of the size of an economy, it is an error to describe it as a measure of the economy’s health. Economic theory and empirical evidence are clear on the matter: an economy dominated by government spending is not a healthy economy, compared with one dominated by private spending; yet these two different models can produce the same total consumption figures. When Gordon Brown was Britain’s chancellor of the exchequer at the turn of the millennium, he consistently delivered GDP growth greater than forecast by independent economists. But when you took the numbers apart, it was achieved not by a private sector doing well, as everyone assumed, but by the government spending more than expected.

We must therefore disassociate changes in GDP from economic health, or put more specifically, changes in GDP tell us nothing about human progress or regress. GDP is simply a total of recorded transactions, a national but less accurate equivalent of a company’s turnover figure. We can go further. Let us assume that there is a fixed amount of money in the economy, which means that net exports must be zero, because the counterpart to an imbalance in trade is net money flows. That leaves the allocation of GDP free to adjust between nongovernment, government, and investment categories without any change in the GDP total.

Assuming there is no change in the ratio of recorded GDP transactions to unrecorded and excluded transactions, of which a total economy is always comprised, all individual actors in all GDP categories will rearrange their spending priorities within a fixed money total. There will be no increase or decrease in GDP, though the benefits to the human condition can increase or decrease.

In reality, the situation is complicated by large elements of transactions being excluded from GDP. The acquisition of securities and trade in secondhand goods are examples of exclusions. But for the moment let’s stick with the fiction that there’s no movement between GDP and its exclusions. Now let us further assume that there is an increase in the quantity of money emanating from the central bank. The extra money will flow into both GDP and excluded categories. The extent to which the extra money affects both categories is simply additional. In other words, GDP, being the total of recorded transactions, increases exactly by the extra money spent on items within the statistic. Other than the distortions solely connected with the absorption of additional money as it filters into the economy, there is more money being spent on the same quantity of goods. It is just that after a period of adjustment each monetary unit buys on average proportionately less.

We can confirm this by referring back to Say’s law, which posits that we divide our labor, specializing in what we are good at in order to buy the things we need and want. Money is just the commodity we use to turn our own production into consumption, allowing us to evaluate and compare different goods. The quantity of money and its purchasing power are immaterial to its function as a transaction medium in this respect. The point can be made in a different way: a consumer in Europe, India, or America uses the local currency to facilitate the division of his or her labor: whether it is euros, rupees, or dollars does not matter, so long as it is accepted as a medium of exchange.

Therefore, an increase in GDP does not reflect the health of an economy but only the extra money inflated into it as a category of economic measurement. And for those seeking to estimate how much of the extra money has gone into included transactions over a period of time, all they need to do is measure the difference between the more recent GDP figure and the former, adjusted for any change in net exports.

In the monetary conditions we face today, that is to say a sharply accelerating rate of monetary inflation, after a brief period allowing for its absorption into general circulation, nominal GDP will rise at an increasing rate. But, as we have seen, those who take it as indicating a healthy economy will be badly misled.

Armed with this knowledge, we know that economies that collapse their currencies through monetary inflation will exhibit high levels of growth in the nominal GDP statistic. But can we find examples to prove it? It is difficult to do so for two reasons. Firstly, the statistics available are so inaccurate as to be even more meaningless than those produced by nations with more moderate rates of monetary inflation; and secondly, statisticians in international bodies abandon domestic currency measures, replacing them with dollar equivalents at official exchange rates.

Using an official rate of exchange or the black market rate, which is always the more accurate of the two, will produce wildly different results. But that is ignored by government statisticians. And we have found from examples of high monetary inflation that the inadequacy of statistical analysis and misconceptions over GDP are confirmed by econometricians discarding the principals behind their method in these extreme cases. But we are all becoming extreme cases now.

High-spending governments are facing a period of accelerating monetary inflation for the dollar as their international currency as well as for their own, driven by an imperative to rescue their economies from the crises they were mainly responsible for in the first place. Only this week the Atlanta Fed forecast a 41.8 percent collapse in America’s GDP in the current second quarter, admittedly the immediate consequence of lockdowns. There will be a statistical recovery as lockdown rules are withdrawn.

Beyond that, there can be no doubt that the transmission to GDP constituents of the rapid increase in the quantity of money issued by the Fed in recent weeks takes time, not least due to the commercial banks’ reluctance to lend and because the downturn in consumption and product supply is both current and severe. But we know that the quantity of money included in the GDP statistic will increase through government spending and helicopter money. The nominal GDP statistic will recover, but the recovery will simply reflect the amount of new money, even though economic activity will likely remain badly depressed.

The extra money will be reflected in the prices of the goods and services upon which it is spent. But the consequences for prices are not so straightforward. Changes in supply and demand factors for individual goods will have their own effect on individual prices, while the increased quantity of money as it is absorbed into the economy will have another. Equally important are the different choices people make in these changed circumstances. And this is where disregarding Say’s law really undermines the relevance of the statistical approach.

Since the virus lockdown, what people desired beforehand bears little relation to their needs and wants in the coming months. Meanwhile, the assumption behind GDP is that what was desired yesterday will also be desired tomorrow, any adjustments to outcomes being made in retrospect. The monetary expansion, insofar as it is spent in the nonfinancial GDP economy, lends support to yesterday’s production. The reallocation of capital in all its forms, of money, labor, establishments, and product inputs to respond to change, is thereby discouraged and restricted.

Furthermore, the debasement of people’s earnings and savings impoverishes them even further. Inflation of the quantity of money always transfers wealth and earnings from savers and individuals to borrowers. And with governments being the largest borrowers for increasing amounts, they are the largest beneficiaries of the wealth transfer and their electors are the losers. The impoverishment of the masses through monetary inflation guarantees that monetary policies touted as rescuing the nonfinancial economy will fail.

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