Posts Tagged gdp
Sometimes a self-appointed economist gets it so wrong that their statement fails the laugh-out-loud test. Today’s subject is the fascinating world of national income accounting and the most recent NPR fail. Along the way we’ll learn how gross domestic product is measured. Even if you’re a real economist, I suspect you can learn a thing or two from this.
Why is this important? Because gross domestic product is equal to national income. When GDP rises, so does national income. Even if you don’t think GDP is important, I’m pretty sure national income matters to you.
Writer Dave Barry once famously said, “gross domestic product would be an excellent name for a band.” While that may be true, we’re going in a different direction today.
Background: NPR Strikes Again
Today’s egregious error is from Public Radio International’s The World. The segment was titled “How Should We Judge Our Economy.” And the guest clown pseudo-economist was “Eric Zencey, a political economist with the Gund Institute for Ecological Economics at the University of Vermont.” Forthwith, Mr. Zencey’s argument (lifted straight from the PRI page for this story).
“I think GDP should re-named, so that we don’t mistake it for a measure of well-being. I think we should call it gross domestic transactions,” said Zencey. “That’s all it is, it totes up the monetary value of all the transactions. And if it had that name that would help break the association people have with the idea that more GDP is better. It’s like hmmm, more transactions are better? Well it depends on what you’re transacting.” [All quotation marks and other punctuation unchanged from original story.]
The easy criticism is that, even if GDP equaled spending, it would not equal the total volume of transactions in the economy. For starters, GDP excludes transactions involving assets. If you buy or sell shares in a mutual fund, that is not included in GDP. Also excluded are transactions involving previously-owned items. That antique pepper mill you bought at a garage sale? Not in GDP. That car you bought from a soon-to-be-ex-friend? Also not included. So the total volume of transactions in any economy would be a huge multiple of GDP.
The more subtle issue is a complete misunderstanding of what GDP measures. Most principles of economics texts get this pretty much: gross domestic product is the market value of all goods and services produced in a country during a calendar year. Read that again and see if you can find the words “spending” or “transactions.” You can’t because GDP measures neither of those. GDP measures production, not spending.
“Wait,” says the knowledgeable reader. “In macroeconomics I learned that GDP was the sum of consumption spending, investment spending, and government spending. Why isn’t GDP the same as total spending? What about C + I + G?”
Read on. The answer is far simpler than you can imagine.
GDP and Spending
Think carefully about what you learned in that economics course. In the definition of GDP wasn’t there something about exports and imports? And if you memory is better than mine, you may recall something about the net change in business inventories being part of gross private domestic investment (“investment spending”). Each of these three items is important in its own way. Let’s begin with a basic fact: C + I + G measures total domestic spending on newly-produced goods and services. Asset transactions and purchases of previously-owned goods are still excluded.
GDP, Domestic Spending, and Domestic Production
Let’s first discuss a country that operates in complete autarky. This lovely word autarky describes a country that does not interact economically with the rest of the world. In such a country, total domestic spending on domestically produced goods is, in fact, total spending. What happens if there is a difference between spending and production in such an economy?
This is actually pretty simple. John Maynard Keynes discussed it at length in his General Theory of Employment, Interest, and Money. When spending is less than production, business inventories rise. The unsold goods flow into inventories. And when spending is greater than production, business inventories fall. The only way businesses can sell goods they have not produced is to draw them from inventory.
A simple example may help. Consider a company that makes ordinary wooden pencils. They try to produce to meet demand. When thinking about how many pencils to produce in July (for example), they consult their economist who assures them that there will be demand for 5 million pencils in July. The company produces 5 million pencils in July. But the forecast was incorrect. Only 4.8 million pencils were actually sold. What happens to the remaining 200,000 pencils? They end up in inventory for the beginning of August.
Note the relationship here: output – sales = inventory change. We can rewrite this simply as output = sales + inventory change.
But wait – we’re trying to measure output (GDP). We start by adding up total spending: consumption plus government plus business fixed investment. We then correct for any output that was not sold by adding the net change in business inventories. Adding inventory change converts total spending into total output.
That was pretty easy. Believe it or not, the next section is even easier.
GDP, Domestic Spending, and Domestic Production in an Open Economy
Now let’s open our economy to international trade. Our GDP equation now becomes C + I + G + (X − M). Exports are X, imports are M. Together, X − M is called net exports.
If you read several principles textbooks you will find many convoluted explanations of why exports are added and imports are subtracted. That’s unfortunate because the explanation is very easy. Exports are goods and services produced in our country and sold elsewhere. We add exports to domestic spending because those goods and services are not included in domestic spending but they are included in domestic production. Workers producing those exports earn income even though the products they are producing are not sold within the country where they are produced.
What about imports? Goods and services that are produced in other countries but sold in our country fall into this category. Therefore, those goods and services are part of domestic spending. But they are not part of domestic production. Imports are subtracted to correct domestic spending into domestic production.
Consider a couple of examples. Suppose you buy a new BMW for $50,000. The car was produced in Germany. But it’s sold here, which means domestic spending rises by $50,000. But domestic production has not changed. We need to subtract that $50,000 from domestic spending to move the total in the direction of domestic production.
Similarly, consider German tourists visiting the U.S. They are buying tourism services from the U.S. which count as exports. The services are produced here but sold (in effect) in another country. Therefore we must add the value of those exported services to total spending to move the total in the direction of domestic production.
So here’s the story. We begin with domestic spending (roughly C + I + G ignoring the fact that inventory change is included in I). We then add the net change in business inventories to this total to correct for any difference between domestic spending on domestically produced goods and domestically produced goods sold within the country. Next we add exports, products that are produced here but sold in other countries. Finally we subtract imports, products that are produced in other countries but sold here. Remember, the central idea is to convert domestic spending into domestic production.
At its most basic, this stuff is not difficult. It’s always been a mystery to me why economists insist on making it difficult. I hope this explanation has been helpful. Please feel free to ask questions in the comments.
 Please don’t quibble. I know there are differences between GDP and national income. This is a blog, not the American Economic Review.
 No one has yet figured out how to sell previously-owned services, so we don’t have to worry about that.
 From the ancient Greek autarkeia: self-sufficiency, or nonattachment. See this page from Britannica online for more details.
 Consistent with national income accounting assumptions, I continue to exclude spending on assets and previously-owned goods.
The second estimate is in for the third quarter and — no surprise — GDP growth was revised down. The preliminary estimate had been 2.5 percent, but the revised estimate is 2.0 percent. Remember, you read it here first.
Happy talk media today are whooping it up because real GDP grew by 2.5% in the third quarter. News flash: it’s the advance GDP estimate, stupid!
Don’t take my word for it. Read the first two paragraphs of the press release from the Bureau of Economic Analysis:
“Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 2.5 percent in the third quarter of 2011 (that is, from the second quarter to the third quarter) according to the “advance” estimate released by the Bureau of Economic Analysis. In the second quarter, real GDP increased 1.3 percent.
The Bureau emphasized that the third-quarter advance estimate released today is based on source data that are incomplete or subject to further revision by the source agency (see the box on page 3). The “second” estimate for the third quarter, based on more complete data, will be released on November 22, 2011.”
Prediction: this estimate will be revised downward twice — once at the end of November and a second time just as we’re about to welcome in 2012.
Friday the Bureau of Economic Analysis released the preliminary estimate of the first quarter, 2010, U.S. gross domestic product. The good news is that total production of goods and services grew 3.2% in that quarter (seasonally adjusted at an annual rate). For better or worse, nearly half that growth (1.57%) was caused by expansion of business inventories. I’m going to dig into the GDP numbers, an exercise that often puts readers to sleep. Hang in there – I promise it will be worth the effort.
Before I begin, there’s one important point to be made. This is the preliminary estimate for the first quarter. There will be two revisions released near the end of the next two months. Revisions are often significant. As several writers have discovered, basing significant economic analysis on the preliminary estimate can lead to wildly incorrect conclusions.
Caveat emptor. You have been warned. Read on at your own risk!
Far and away the most interesting data for the first quarter comes from the B.E.A.’s table 1.1.2 (“Contributions to Percent Change in Real Gross Domestic Product”). From that we learn that 2.55% of the 3.24% growth came from consumer spending. About 40% of that (1.15%) was attributed to growth in consumer spending on services. This is actually a good sign. It means that consumers are, among other things, going out to restaurants and beginning to purchase services they might have performed themselves a year ago. Not surprisingly durable goods spending contributed 0.79%, down sharply from the 2009 second quarter of 1.36%. The “cash for clunkers” program did exactly what economists predicted. It shifted consumer spending from future quarters into the second quarter of 2009. Mind you, this is a good thing. The economy needs more spending sooner.
Gross Private Domestic Investment
Far more problematic is the behavior of gross private domestic investment. Consumer spending stimulates output this year. Investment spending creates the new physical capital to increase output in the future. The overall contribution of gross private domestic spending was 1.67%. However, only 0.1% was from business fixed investment. The remaining 1.57% was growth in business inventories. Let’s dissect those numbers.
Business fixed investment includes nonresidential structures, nonresidential equipment and software, and residential construction. Nonresidential and residential constructions together reduced GDP by 0.73%. That means spending to build new structures fell compared to the fourth quarter of 2009. Blame this on the first-time homebuyer’s tax credit which shifted demand for residential structures into the last two quarters of 2009. However, these decreases were more than offset by increased spending on nonresidential equipment and software which contributed 0.83% to GDP. The net change in gross private domestic investment masks larger changes in the underlying components.
The 1.57% contribution of inventory growth has been hailed by many economists as evidence that businesses are rebuilding inventories anticipating higher future sales. Not so fast, folks. Let’s review J.M. Keynes. He pointed out that there are two sources of inventory change: planned and unplanned. Economic analysts are assuming the inventory increase was intentional. But suppose the change was unplanned. That would mean production exceeded spending. Remember, businesses have to plan production in advance of spending. When their demand forecasts are too high, production will exceed spending and inventories will rise. But that’s not a positive sign for the economy – in fact, it’s a negative because businesses will have to liquidate those inventories in future quarters.
Was the inventory increase planned or unplanned? I don’t know and I suspect many of the economists mentioned in the previous paragraph don’t know, either.
However, another B.E.A. table contains some valuable insights. Table 5.6.6B is the “Change in Real Private Inventories by Industry, Chained Dollars.” This table is in billions of constant 2005 dollars, not percentages. The growth in business inventories was $31.1 billion. As always, inventories in some industries grew while others shrank. The main positive contributions came from Manufacturing, nondurable goods industries ($10.3 billion), Wholesale trade, nondurable goods industries ($10.3 billion, no this is not a typo), and Motor vehicle and parts dealers ($23.1 billion). In other words, nondurables and vehicles were the source of the inventory growth. The growth in motor vehicle inventories is nothing more than rebuilding depleted inventories after the end of the cash for clunkers program. Don’t expect that to continue into future quarters. The two nondurable increases are largely a result of the increased consumer demand for services. (Remember, consumer spending on services includes meals eaten away from home. Restaurants hold inventories just like most businesses that make something. Consider this a bit of an anomaly in the national income accounts.)
Let’s not bother with foreign trade since exports and imports are mainly included to convert total spending into production. Instead, take a look at government spending.
The contribution of government spending to first quarter growth was -0.37%. You read that correctly. Government spending was actually a drag on the economy.
“Wait,” you’re saying. “What happened to the government stimulus program?”
Good question. Once again we can look at the details to see what happened. Federal government spending contributed +0.11% to GDP growth. But state and local government spending dragged GDP growth down by 0.48%. This lends support to the calls by several economists for the federal government to bail out state governments.
That’s the story. The news is good, but perhaps not as good as the media would have you believe.
 See, for evidence, the failure to spend economic stimulus funds from the ARRA program at a fast enough rate.
 I believe Paul Krugman has advocated this position, but I’m too lazy to look up the citation.