The GDP Equation
I read a rather remarkable memo from Dr. Woody Brock on GDP this week and it triggered several thoughts. First, I want to discuss how the GDP number is actually created, then look at length at Woody's insights and then offer some of my own.
GDP, or Gross Domestic Product, is one way of measuring the size of a country's economy. The GDP of a country is defined as the total market value of all final goods and services produced within a country in a given period of time (usually a calendar year). The most common approach to measuring and understanding GDP is the expenditure method:
GDP = consumption + investment + government spending + net exports
Consumption is simply what we spend on goods and services. Investment can be said to have two components, residential and nonresidential investment. The investment part of the equation does not include what we normally think of as investments, such as stocks or bonds. It is business investments in capital, such as building a new mine, buying software, purchasing machines and so on. When you buy a stock, you are not adding to GDP. Residential investment is new home construction and adds to GDP. Buying an existing home does not add to GDP, as it does not produce anything new.
Net exports are really exports minus imports. Wikipedia has a good illustration of the process. If you buy a chandelier for your house from China, it is included in imports and subtracted from GDP. If you make a chandelier to be installed in a foreign country it would count as an export and add to GDP. Remember, what we are trying to do is measure domestic production. If you buy a chandelier made in the US for your house it would be accounted for in the consumption part of the equation.
Government spending is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.
There are some problems with comparing the GDP of different countries. Among other things, currency fluctuations will change the relative value. European GDP has risen by over 50% in dollar terms with the rise of the euro in the last five years, but would anybody contend that Europe is 50% bigger? Of course not. GDP is only really useful for looking at your own country's growth. Purchasing power parity and standard of living may make a more reasonable basis for comparison of actual economies.
GDP does not measure the standard of living of a country. A country may produce oil and other commodities and thus have a large GDP, but if the money is kept in a few hands it does not really raise the standard of living except for a few. (Think Nigeria.)
There are some other issues. The work to re-build New Orleans after Katrina counted in GDP, but would anybody contend that the US was better off as a result? If a company opens a division in Ireland and sells it products (say software) to the division at a low cost and then sells the product in Europe at a much higher price, keeping the profit in lower corporate tax Ireland, it adds the profit to the GDP of Ireland and does not add as much as it should to the US.
But with those and a few other caveats, GDP does help us understand whether the economy is growing or shrinking, and thus helps us get a handle on the business climate, where employment is headed, etc.
Now, I readily admit to being surprised that GDP for the second quarter was 3.8%, having been 0.6% the previous quarter. The economy certainly seemed to be slowing. And then along came Woody Brock's client memo, and the light came on. Woody is one of my favorite economic thinkers. His work is not standard issue economics that I so often read.
(Woody, through his firm Strategic Economic Decisions (SED), publishes memos like the one we are going to discuss as part of their excellent research service available by annual subscription. You may learn more about Dr. Brock, his research company, and how to subscribe to their publications by visiting their website at www.SEDinc.com. And I want to thank him for letting me use his work in this letter.)
The Key Variable Problem
Let's return to our equation but expand it a little given the discussion above.
GDP = consumption + (residential and nonresidential investment spending) + government spending + (exports - imports)
What Woody pointed out that most of us focus on consumer spending, which we all know is over 70% of GDP. But consumer spending is remarkably stable over time. The other components, though, can be very volatile.
First, let's look at this table labeled Figure 1.
Quoting from his memo:
"The Essence of the Key Variables Error: What we see here is that, whereas consumption growth fell in half from the first quarter to the second quarter of this year, GDP growth itself increased six-fold--surprising almost all investors. Moreover, the Fed had nothing to do with these changes in growth rates insofar as Fed policy had not changed at all for over a year. The essence of the Key Variables Error is thus to overlook the role played by other lesser variables that impact GDP.
"More specifically, and more analytically, a sound forecast of GDP should take into account (i) the variability (e.g., standard deviation) of each of the components adding up to GDP, and (ii) the covariances between all these components. Why? Suppose that three non-consumption terms swing much more than consumption does and are uncorrelated with consumption. Then in this case, we would expect the impact of consumption often to be offset by movements in the other terms. But is this generally the case? What do the data show?"
And that brings us to his second table.
Standard deviation measures the volatility of a series of numbers, whether consumption or mutual fund returns. The lower the standard deviation, the more stable is that series of numbers.
As it turns out, consumption is rather stable. But investment is not, and net exports from one quarter to the next can have very large swings. Woody goes on to show that there is almost no correlation between consumption and residential investment, net exports and government expenditures.
But as Woody points out, that means that quarterly predictions of GDP is more than simply difficult. Over a longer term, you may be able to make a reasonable forecast, but because of the volatility quarter to quarter of the three non-consumption components, you can see wide discrepancies, as we did last quarter. And to make investment decisions based upon one quarter of data would therefore be problematical.
Remember, the quarterly GDP recognizes the changes from quarter to quarter. So, even if exports continue to rise, we should not see such a large movement as we did in the second quarter. Investment spending is also not likely to rise by the fast pace in the second quarter. Similarly, government spending is not likely to grow at that pace, as the deficit is dropping each year.
The Importance of Fiscal Policy
This is a key point that Woody makes. We overestimate the importance of the Fed and monetary policy. And we underestimate the importance of fiscal policy. Let's quote Woody at length. This is going to be controversial to a lot of people. Please note that Woody is not arguing for deficit spending, just noting its effect upon the economy.
"The underestimation of the impact of fiscal policy along with the overestimation of the impact of monetary policy on GDP growth (discussed below) is the most surprising of the eight biases we are identifying in this essay. To begin with, monetary policy is a variable that does not appear anywhere in the GDP identities. Its influence on the real economy is thus indirect--and its impact on economic growth is significantly lagged, by the Fed's own admission.
"This is not the case with fiscal policy where the role of G (government expenditures) is explicit in the GDP identity, and where the lags between policy changes and response are much shorter. If policy makers wish to boost government spending tomorrow morning to offset a cyclical downturn, they can in principle do so. Analogously, they can slash taxes immediately, thus putting greater disposable income into consumers' pockets starting with next month's pay check.
"Are these points merely academic? Hardly. Consider the shock to many investors that no recession (defined here as two consecutive quarters of negative growth) accompanied the dual crashes of both capital spending and the stock market during 2000-2002. What saved the day? The answer is that the Bush administration managed to transform a Clinton fiscal surplus of 2.5% of GDP into a fiscal deficit of 3.4% between 2000 and 2003. This is a swing that pushed the level of GDP 6% higher than it otherwise would have been by the end of this period. This number reflected reduced tax revenues from decelerating income growth and policy-determined tax cuts and increased government spending.
"Yet this is rarely if ever cited when observers attempt to explain the events of this momentous period. Instead, economists erroneously attribute stability on Main Street to Greenspan's dramatic cut in the Fed funds rate to 1%. The reality is that the funds rate only reached 1% in June of 2003. Given the policy transmission lags involved, these lower rates cannot be said to have prevented recession in 2002. Fiscal policy played the key role here.
"In today's context, the federal deficit of the fiscal year ending October 2007 will have fallen to about 1.4% of GDP from 3.5% as recently as 2004. Moreover, without the war in Iraq, this year's deficit would be approaching 0%. Not only is today's US deficit much smaller than it was expected to be, but its contraction during past years has slowed GDP growth by as much as housing has. Yet this is never pointed out, partly because of our "key variables" bias, and partly because of the widespread belief that it is monetary policy alone that really matters.
