GDP Provides a False Reading of the State of the Economy

by
Frank Shostak
My articles My booksMy videos
Follow on:

Most economists see GDP as a snapshot of the performance of the economy. However, it is better understood as a misleading statistic which fails to accurately describe what really is happening economically.

Original Article: “GDP Provides a False Reading of the State of the Economy”

The GDP (gross domestic product) statistic portrays a view that the key driving factor of economic growth is not the production of wealth but rather its consumption. Instead, it is a calculation of the value of final goods and services produced during a particular time interval, usually a quarter or a year. Since consumer outlays are the largest part of the overall demand, it is held by many commentators that consumer spending is the key driver of economic growth.

All that matters in this view is the demand for goods and services, which in turn will give rise almost immediately to their supply. Because the supply of goods is taken for granted, this framework ignores the various stages of production that precede the emergence of the final good.

In the GDP framework goods emerge because of people’s desire to purchase goods. However, it is not enough to have demand for goods—one must have the means to accommodate purchases. The means are various final consumer goods that are required to sustain individuals in the various stages of production.

The key source for the means of sustenance is individuals’ savings. For instance, John the baker produces ten loaves of bread and consumes two loaves of bread. The unconsumed eight loaves of bread constitutes savings. John the baker could exchange the saved eight loaves of bread for the services of a technician in order to improve his oven—i.e., the improvement of his infrastructure. With the help of an improved infrastructure, John could increase the production of bread—increasing economic growth. Note that the eight saved loaves of bread sustain the life and well-being of the technician while he enhances the oven.

Savings determine future growth. If a strengthening in economic growth requires a particular infrastructure while there are not enough savings to make such an infrastructure, then economic growth is not going to emerge. The GDP framework cannot tell us whether final goods and services that were produced during a particular period are a reflection of wealth expansion, or because of capital consumption.

GDP and the Real Economy: What Is the Relationship?

There are difficulties calculating real GDP. To calculate a total, several things must be added together, and 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. To overcome this difficulty, economists employ total monetary expenditure on goods, which they divide by an average price of those goods. It is however not possible to calculate the average price.

Suppose two transactions were conducted. In the first transaction, one TV set is exchanged for $1,000. In the second transaction, one shirt is exchanged for $40. The price or the rate of exchange in the first transaction is $1000/TV. The price in the second transaction is $40/shirt. In order to calculate the average price, we must add these two ratios and divide them by 2. However, $1000/TV cannot be added to $40/shirt, implying that it is not possible to establish an average price.

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 price deflators are meaningless, then so is the real GDP statistic.

Since it is not possible to quantitatively establish the status of the total of real goods and services, one cannot take seriously the various data like real GDP that government statisticians generate. The concept of GDP gives the impression that there is such a thing as the national output. In a market economy, however, wealth is produced by individuals and belongs to them independently. According to Ludwig von Mises, the idea that one can establish the value of the national output or what is called the GDP is farfetched:

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 at $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.

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 we can say is that this percentage has nothing to do with real economic growth and that it most likely mirrors the pace of monetary pumping. Since GDP is expressed in dollar terms, it is obvious that its fluctuations will be driven by the fluctuations in the amount of dollars pumped into the economy. From this, we can also infer that a strong real GDP growth rate likely depicts a weakening in the process of wealth formation.

Once one realizes that so-called real economic growth, as depicted by real GDP, mirrors fluctuations in the money supply growth rate, it becomes clear that an economic boom has nothing to do with real economic expansion. On the contrary, a boom leads to real economic contraction, since it undermines the pool of wealth, which is the heart of actual economic growth.

Since the GDP framework assumes the central bank can cause real economic growth, most commentators slavishly follow this narrative. Much of the so-called economic research produces “scientific support” for the viewpoint that monetary pumping can enable the economy to grow. What these studies overlook is that no other conclusion can be reached once it is realized that GDP is a close relative of the money stock.

Why Do We Need Information on Economic Growth?

One is tempted to ask why it is necessary to know the growth of the so-called “economy.” What purpose can this type of information serve? In a free economy, this type of information would be of little use to entrepreneurs. The only indicator that any entrepreneur would rely upon is profit and loss. How can information that the “economy” grew by 4 percent in a particular period help an entrepreneur generate profit?

What an entrepreneur requires is not general but rather specific information regarding the demand for a specific product, or products. The entrepreneur himself has to establish his own network of information concerning a particular venture.

Things are different, however, when the government and the central bank tamper with businesses. Under these conditions, no businessperson can ignore the GDP statistic since the government and the central bank react to this statistic by means of fiscal and monetary policies.

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 a growth path outlined by omniscient officials. Thus, whenever the growth rate 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” growth rate.

If the effect of these policies were confined only to the GDP statistic, then the whole exercise would be harmless. However, these policies tamper with activities of wealth producers and thereby undermine people’s well-being. Likewise, by means of monetary pumping and interest rate manipulation, the Federal Reserve doesn’t help generate more prosperity, but rather sets in motion “stronger GDP” and the consequent menace of the boom-bust cycle that results in economic impoverishment.

Conclusion

The GDP statistic provides an illusory frame of reference to assess the performance of government officials. Movements in GDP however, cannot provide us with any meaningful information about what is going on in the real economy. If anything, it can actually provide us with a false impression. A strong GDP growth rate in most cases is likely to be associated with the intensive squandering of the pool of wealth. Hence, despite “good GDP” data, many more individuals may find it much harder to make ends meet.

This Audio Mises Wire is generously sponsored by Christopher Condon.