Weapons
of Economic Misdirection
By John Mauldin
“Measurement
theory shows that strong assumptions are required for certain statistics to
provide meaningful information about reality.
Measurement theory encourages
people to think about the meaning of their data. It encourages critical
assessment of the assumptions behind the analysis.
“In
‘pure’ science, we can form a better, more coherent, and objective picture of
the world, based on the information measurement provides. The information
allows us to create models of (parts of) the world and formulate laws and
theorems. We must then determine (again) by measuring whether these models,
hypotheses, theorems, and laws are a valid representation of the world.”
–
Gauri Shankar Shrestha
“In
science, the term observer effect refers to changes that the act of
observation will make on a phenomenon being observed. This is often the
result of instruments that, by necessity, alter the state of what they
measure in some manner.
“It
was, perhaps, the most unusual episode in the long running duel between the
two giants of twentieth century economic thought. During World War Two, John
Maynard Keynes and Friedrich Hayek spent all night together, alone, on the
roof of the chapel of King’s College, Cambridge. Their task was to gaze at
the skies and watch for German bombers aiming to pour incendiary bombs upon
the picturesque small cities of England….
“Night
after night the faculty and students of King’s, armed with shovels, took it
in turns to man the roof of the ornate Gothic chapel, whose foundation stone
was laid by Henry VI in 1441. The fire watchmen of St. Paul’s Cathedral in
London had discovered that there was no recourse against an exploding bomb,
but if an incendiary could be tipped over the edge of the parapet before it
set fire to the roof, damage could be kept to a minimum. And so Keynes, just
short of sixty years old, and Hayek, aged forty-one, sat and waited for the
impending German onslaught, their shovels propped against the limestone
balustrade. They were joined by a common fear that they would not emerge
brave nor nimble enough to save their venerable stone charge.”
–
Nicholas Wapshot in Keynes Hayek: The Clash That Defined
Modern Economics
This
week’s letter will deal with the problems of determining what GDP really is …
and isn’t.
But
first, I’m having a free online Q&A session on Tuesday, Aug. 23 at 2:00
PM Eastern time. We’ll discuss some of the macro issues I’ve been pondering
in recent newsletters.
Joining me will be Patrick Watson, whose “World
Gone Backwards” article I featured in this space two weeks ago, and
our Mauldin Economics Senior Equity Analyst, Robert Ross.
Patrick
and Robert co-edit our Macro
Growth & Income Alert premium service. As I’ve explained
before, for regulatory reasons (since I am registered) I do not discuss
specific stocks or other securities in this letter, tending instead to stick
to macroeconomic and other big-picture concepts. Patrick and Robert face no
such limitations, so after we discuss the macro world, I will drop off and
they will talk about how to turn our macro views into real-world investment
ideas. I am proud of the team we have assembled here at Mauldin Economics and
appreciate the hard work and experience they bring to our readers.
You
can register for the Q&A session and submit questions by clicking here. I
hope you’ll join us. And now to the letter.
The
problem we have today in economics is that many people, and not a few
economists, seem to regard economics as “pure science,” as described above by
Gauri Shankar Shrestha. If you delve deep into measurement theory, you find
that all too often the way in which you measure something determines the
results obtained from your experimental model. How you measure the
effectiveness of a drug can sometimes determine whether it gets approved –
apart from whether it actually does any good. The FDA actually works rather
hard at measurement theory.
And
if you’re using models, as we do in economics, to determine policies that
govern nations, your efforts can result in economic misdirection that seems
for a time to work but that all too often can lead to a disastrous Endgame. A
shortsighted economic policy is not unlike a drug that makes one feel good
for a period of time but ultimately leads to further weakness or collapse.
In
this week’s letter we look at the construction of gross domestic product
(GDP). As we will see, GDP is a relatively late-to-the-party statistic,
thoroughly malleable in its construction and often quite contentious in its
application. Yet the mainstream media regularly releases GDP numbers with the
implicit assumption that they are in fact an accurate reflection of the
general economy. We shall soon see that GDP is instead a fuzzy reflection of
the economy, derived from a model that is continually readjusted in a
well-intentioned effort to understand the scope
of the economy.
GDP
is one economic model among several that could serve the purpose, but its use
conveniently leads to policies that reflect the thinking of a particular
school of economic monetary and fiscal policy advocates.
We
all know that in operating a business we need to be able to measure the
profits of our company and then adjust our prices and production to make sure
that there are enough profits to adequately fund the company. That is a
relatively straightforward process, since the amount of money in the bank at
the end of the month is a real number.
When
most people see the release of the GDP number, they equate the precision of
that statistic with the bottom right-hand number in their bank accounts. And
news anchors and journalists rarely acknowledge the rather significant
caveats that the Bureau of Labor Statistics publishes along with that data.
What
we are going to find is that developing the concept of gross domestic product
was more than a dry economic and accounting undertaking. At its very core,
GDP is John Keynes versus Friedrich Hayek writ large. And their debate
explains a great deal of the current tension between those who would make
final consumption – or what we call consumer spending – the be-all and
end-all of economic policy, and those who feel that productivity and income
should instead be the focus. The very act of measuring GDP as we do gives the
high and easy intellectual ground to those of the Keynesian persuasion.
Let
me hasten to note that I have no problem with the concept or the calculation
of GDP in general. It is absolutely a number that we need to have in order to
understand the workings of a part
of the economy. But it is just one tool in the economic toolbox. If the only tool
you use to affect (determine, guide – choose your word) economic growth and
the creation of jobs is the hammer of GDP, the world ends up being a very
strange-looking, rather deformed nail, bent time and time again by the
imprecise blows of those wielding the hammer.
GDP
is an important concept, perhaps one of the more important that we have
looked at in quite a few years. I urge you not to roll your eyes at the
attempt to understand yet another dry economic statistic, but instead to look
deeply at how the attempt to measure GDP affects everything in our lives.
The
subtitle above is taken from the title of a recent book by Diane
Coyle. (For economics wonks, she writes an interesting blog at http://www.enlightenmenteconomics.com.)
GDP: A Brief But Affectionate History
is a fascinating 140-page book that I cannot recommend highly enough. This is
simply the best book on GDP that I’ve ever seen. You can read it on a few
hours’ plane ride or a lazy Sunday afternoon. And Ms. Coyle actually makes a
relatively dry subject interesting and at times a page-turner. She has a true
gift.
(Now that she has conquered the GDP mountain, might I suggest she move
on to CPI?)
Ms.
Coyle starts with the predecessors to Adam Smith and takes us through the 17th
century right up until today with the development of GDP, so we see the ebb
and flow of ideas through time. Who knew the early developers of the model
did not want to include defense spending, as they saw it as a wasteful,
nonproductive activity? Or that Adam Smith thought the inclusion of services
in the concept was misleading. “The provision of more services was a cost to
the national economy, in his view. A servant was a cost to his employer, and
did not create anything. Importantly, money spent on warfare or the interest
on government debt was also being used unproductively. The nation’s wealth
was its stock of physical assets less the national debt. National income was
what derived from the national wealth.”
(I
read this book on my iPad using my Kindle app, an extremely useful tool. As
it turns out, if you highlight passages in the book you read [and even make
notes and comments], you can go to your Kindle web page and see all the
passages you highlighted. I regularly do that now and find it an extremely
useful exercise, one that I would suggest to any serious researcher, as notes
in a book tend to get buried and lost; and often you just can’t quite (at
least at my age) remember those connections five or ten years later,
especially if you’re reading more than a few books a year. Now my notes are
in the cloud. Wow. And when I access the notes, I can touch a link to go back
to the original passage in the book, making sure I have the context. How cool
is that?
I
found myself highlighting more than the normal number of passages, as
seemingly every page had something I wanted to be able to remember for future
use. Just for fun I cut and pasted my highlights into a Word doc and found
that they ran to some 15 pages, or more than 10% of the book.)
And
while I would suggest you read Coyle’s book, I know that many of you don’t
have the time or inclination, so I’m going to try to summarize the highlights
and arguments and quote somewhat freely from the text here and there. (Unless
otherwise noted, all quotations below are from the book.)
Let
me note up front that Ms. Coyle takes us through not just the development of
GDP but also the problems inherent in the concept. She delves into its misses
and its misfires, some regularly discussed in public circles and a few new to
me.
There
is no such entity out there as GDP in the real world, waiting to be measured
by economists. It is an abstract idea…. I also ask whether GDP alone is still
a good enough measure of economic performance – and conclude not. It is a
measure designed for the twentieth-century economy of physical mass
production, not for the modern economy of rapid innovation and intangible,
increasingly digital, services. How well the economy is doing is always going
to be an important part of everyday politics, and we’re going to need a
better measure of “the economy” than today’s GDP.
GDP
is a huge undertaking, full of rules, with almost as many exceptions to the
rules, changes, fixes, and qualifications, so that, as one Amazon reviewer
noted, GDP is in reality so complex there are only a handful of people in the
world who fully understand it, and that does not include the commentators and
politicians who pontificate about it almost daily. The quarterly release of
GDP statistics is more akin to a religious service than anything resembling a
scientific study. The awe and breathlessness with which the number is
discussed is somewhat amusing to those who understand the sausage-making
process that goes into producing the number. Whether the GDP reading is
positive or negative, it often changes less in a given quarter than the
margin of error in the figure itself, and it can be and generally is revised
significantly – often many years later when almost no one is paying
attention. When’s the last time the mainstream media reported a five-year
-old revision?
If
you pay someone to mow your lawn and report wages paid, that adds to GDP. If
you pay that person under the table, it doesn’t. If you pay your maid to
clean your house, it adds to GDP. Except if you marry her, then it doesn’t.
Unless of course she gets access to the credit card, in which case spending
probably increases GDP dramatically. In England, sex with your wife does not
add to GDP, but sex with a prostitute does – even if it is unreported. Go
figure. There are so many jokes and one-liners that I could add to this
litany, but I’m going to resist. Okay, just one. Can you imagine the
reception if you came home with a blonde hair on your dark suit and your
excuse was, “Honey, I was just doing my bit for the national economy. We all
have to make sacrifices.”
Housekeeping,
cleaning, cooking, and other such duties do not get counted in GDP, although
without them GDP would suffer significantly. Perhaps that is because when the
original discussions about what constituted GDP were underway, “woman’s work”
was significantly undervalued.
But
we are getting ahead of ourselves. Before we discuss how GDP is constructed
(and abused), let’s take a look at the history of how it came about. It will
not surprise most readers to know that governments decided they need to know
what the gross domestic product of the country was in order to be able to
both tax that productivity and decide about a nation’s capabilities to wage
(and pay the wages of) war.
Ms.
Coyle starts her book with the rather dramatic story of the calculation (or
rather the miscalculation) of Greek GDP upon that country’s entry into the
European Union. The Greek group responsible for creating such numbers worked
in a dusty old apartment without any computers and seemingly engaged in
little activity. The real work was done by politicians, who did not appear to
feel the need to be burdened by anything so aggravating as actual numbers.
When the European Commission and the IMF decided to send someone to create an
actual statistical agency in Greece, they selected a well-respected Greek
economist, who within a year was charged by the Greek government with the
crime of betraying the national interest, an offense that theoretically
carries a life sentence. Essentially, he was charged for not cooking the
books, which the Greeks had perfected as an art form.
Evidently, in Greece
economics is a full-contact sport, and the “calculation” of G DP had
real-world implications for whether the government would get desperately
needed money from its Eurozone lenders and for how many government workers
would lose their jobs, not to mention the impact it would have on the living
standards of millions of Greeks.
GDP
is the way we measure and compare how well or badly countries are doing. But
this is not a question of measuring a natural phenomenon like land mass or
average temperature to varying degrees of accuracy. GDP is a made-up entity.
The [current] concept dates back only to the 1940s….
According
to Benjamin Mitra-Kahn, “The
Wealth of Nations introduced a new idea of the economy, and
through the effort of Adam Smith’s students and admirers, it was adopted
almost instantly.” In Smith’s own words: ‘There is one sort of labour which
adds to the value of the subject upon which it is bestowed: There is another
which has no such effect. The former, as it produces a value, may be called
productive; the latter, unproductive labour.
Thus the labour of a
manufacturer adds, generally, to the value of the materials which he works
upon, that of his own maintenance, and of his master’s profit. The labour of
a menial servant, on the contrary, adds to the value of nothing…. A man grows
rich by employing a multitude of manufacturers: He grows poor, by maintaining
a multitude of menial servants.’ The idea of a distinction between productive
and unproductive activity, adopted by Adam Smith, dominated economic de bate
and measurement until the late nineteenth century.”
(A
side note: Karl Marx agreed with Adam Smith, and up until the collapse of
communism in 1989, the Soviet Union’s economic statistics ignored service
activities. Go figure.)
Simon
Kuznets was a Russian-American economist and a true giant in the field.
Much of what we regard as economics today was developed under his aegis.
Wikipedia notes: “His name is associated with the formation of the modern
economic science … as an empirical discipline, the development of statistical
methods of research, and the emergence of quantitative economic history.
Kuznets is credited with revolutionising econometrics, and this work is credited with fueling
the so-called Keynesian revolution” (even though Kuznets had
significant disagreements with Keynes). Kuznets himself was influenced by
Schumpeter, Pigou, and Pareto; and he early on introduced Kondratiev to the
West.
Kuznets,
when he originally developed an approach for measuring GDP for the American
economy, did not want to include expenses on “… armaments, most of the
outlays on advertising, a great many of the expenses involved in financial
and speculative activities, and much of government activity,” including the
building of subways, expensive housing, etc.
Such
thinking could not stand the scrutiny of politicians, however:
With
this aim, in fact, Kuznets was out of tune with his times. Welfare was a
peacetime luxury. This passage [and his early work on GDP] was written in
1937, when his first set of accounts was presented to Congress. Before long,
the president would want a way of measuring the economy that did indicate its
total capacity to produce but did not show additional government expenditure
on armaments as reducing the nation’s output. The trouble with the prewar definitions
of national income was precisely that, as constructed, they would show the
economy shrinking if private output available for consumption declined, even
if the government spending required for the war effort was expanding output
elsewhere in the economy. The Office of Price Administration and Civilian
Supply, established in 1941, found that its recommendation to increase
government expenditure in the subsequent year was rejected on this basis.
Changing the definition of national income to the concept o f GDP, rather
than something more like Kuznets’s original proposal, overcame this hurdle.
There
was a “heated debate between Kuznets and other economists, especially Milton
Gilbert of the Commerce Department, about the right approach. The discussions
were highly technical, but the underlying issue was profound: what was the
meaning of economic growth and why were statisticians measuring it?
Gilbert
and his colleagues were clear that the aim was to construct a measurement
that would be useful to the government in running its fiscal policy.”
The
inclusion of business taxes and depreciation [in GNP measured at market
prices] resulted in a production measure that was more appropriate for
analysis of the war program’s burden on the economy. Kuznets was highly
skeptical: “He argued that Commerce’s method tautologically ensured that
fiscal spending would increase measured economic growth regardless of whether
it actually benefited individuals’ economic welfare.” In the policy tussle in
Washington, Kuznets lost and wartime realpolitik won. [And that those arguing
against Kuznets were heavily influenced by Keynes is rather difficult to
deny. –JM]
…
This decision was a turning point in the measurement of national income, and
it meant that GNP (or later GDP) would be a concept strikingly different from
the way the economy had been thought about from the dawn of modern industrial
growth in the early eighteenth century until the early twentieth century. For
two centuries, “the economy” was the private sector.
Government played a
small role in economic life, and featured mainly because it looked to raise
taxes to pay for wars. Its role expanded steadily over the centuries,
however. In Victorian times this began to extend to the provision of other
services, those we take for granted now such as roads and water as well as
the historic government roles of defense and justice.”
Keynes
himself, on the other side of the Atlantic, was arguing for an extended role
for statistical analysis in government planning. He set forth his case in a
1940 pamphlet called How to
Pay for the War.
Coyle
notes:
Crucially,
the development of GDP, and specifically its inclusion of government
expenditure, winning out over Kuznets’s welfare-based approach, made Keynesian macroeconomic theory
the fundamental basis of how governments ran their economies in the postwar
era. The conceptual measurement change enabled a significant
change in the part governments were to play in the economy. GDP statistics
and Keynesian macroeconomic policy were mutually reinforcing. The story of
GDP since 1940 is also the story of macroeconomics. The availability of
national accounts statistics made demand management seem not only feasible
but also scientific.
Understand
what this means. One thing that Paul Krugman and I can agree on (and I say
this with utmost confidence) is that we both believe that real economic
growth is necessary to get us out of our current situation. (I am sure there
are some other things that we could agree on, such as our mutual love for
science fiction, but nothing else leaps to mind right now.)
However,
if your measure of economic growth overweights the contribution of government
spending to growth and underweights private production by focusing on final
consumption, then when you are looking for “policy dials” to turn on the
economic control panel in order to increase growth, the dials you reach for
will be the two largest ones in your equation for measuring success: final
consumption and government spending.
Coyle
underlines the inherently political nature of GDP measurement:
We
are now awash with macroeconomic models and forecasts, published by official
agencies and central banks, by investment banks, by think tanks and
researchers, as well as by commercial forecasters such as DRI’s successors.
Indeed, the idea of the economy as a machine, regulated by appropriate policy
levers, took firm hold….
Debate
rages in particular about the multiplier, because the issue of whether extra
government spending or tax cuts (a “fiscal stimulus”) will boost GDP growth
turns on its size. If it is greater than one, a stimulus will help growth,
while austerity measures will hurt it. Its actual size is hotly contested
among macroeconomists, especially in the context of the present political
debate about how much “fiscal stimulus” the government should be applying to
get the economy growing faster.
There
is an unsurprising alignment in the “multiplier wars” between
macroeconomists’ answer to the technical question about the size of the
multiplier and their political sympathies….
It
will be clear by now that the ambition of measuring national income has a
long history, with correspondingly many changes in how people have thought
about it. As Richard Stone put it, national income is not a “primary fact”
but an “empirical construct”: “To ascertain income it is necessary to set up
a theory from which income is derived as a concept by postulation and then
associate this concept with a certain set of primary facts.” There is no such entity as GDP out
there in the real world waiting to be measured by economists. It is an
abstract idea, and one that after a half century of international discussion
and standard-setting has become extremely complicated. [emphasis
mine]
Today,
as Coyle notes, the process of comprehending GDP is somewhat akin to what
happens when my kids play a videogame. The basic concepts are simple, but as
you master each level and move on to the next, complexity increases almost ad
infinitum. There is now an entire international community of statisticians (a
surprisingly small one at that) that actually determine what is accepted as
statistically relevant to GDP. The first United Nations guide on national
accounts was 50 pages. The latest edition has 722.
It
should not surprise readers that every few years new rules are created for
the figuring of GDP. British statisticians just this year declared the UK
economy to be 5% bigger than previously thought. What brought about this
magical boost in productivity? There was no discovery of buried treasure
hidden away in the vaults of the Bank of England. Instead, statisticians
turned to counting the economic contribution of prostitution and illegal
drugs (along with a few other odds and ends). If you are borrowing money and
your creditworthiness depends on cash flow and your debt-to-GDP ratio, you
tend to look for sources of income that weren’t previously accounted for.
Did
the size of the US economy increase by 3% last summer? According to the
statisticians it did. They decided to include music and entertainment and
make adjustments to how we deal with investments. These changes were then
calculated for all previous years, and suddenly the economy was 3% bigger!
Small positive annual changes can add up over 40 years.
GDP
has always been a political construction, subject to the ebb and flow of the
intellectual and political climate, the need to raise taxes, and the military
needs of the day. It is also a tool used to argue for or against income
inequality (depending on what country you’re in).
GDP
is particularly bad at detecting innovation, as George Gilder’s powerhouse
work Knowledge and Power
explains. There is a clear consensus emerging in economic circles about that
weakness in the formula for calculating GDP, but there is nothing approaching
consensus on how you might actually measure the contribution of innovation to
GDP.
How do you measure the value of Google maps? The voice recognition
software that I’m using right now has made me significantly more productive,
but how do we measure that?
And
somewhat provocatively, there is growing disagreement over the contribution
of the financial services sector. Depending on how you measure it, you can
even determine that the actual contribution of the financial services sector
is negative, although I would not make that argument. But was the
contribution of financial services in 2005-2006 as positive as their impact
on GDP suggests? Or was it part of the destructive process?
If I
purchase a solar energy system for my home, that purchased immediately adds
its cost to GDP. But if I then remove myself from the power grid I am no
longer sending the electric company $1000 a month and that reduces GDP by
that amount. Yet I am consuming the exact same amount of electricity! My
lifestyle hasn’t changed and yet my disposable income has risen.
Black
markets? The sharing economy? The new gig jobs which are off the radar? So
much of our economy doesn’t easily fit into neat financial models.
GDP
is a financial construct at its heart, a political and philosophical
abstraction. It is a necessary part of the management of the country,
because, as with any enterprise, if you can’t measure it you can’t determine
if what you are doing is productive. That said, the act of measuring GDP
precipitates the observer effect writ large.
But
as we will see next week, there are additional (note, I am not saying alternative)
ways to measure growth and the size of the economy. Those measures would
actually lead to policies more favored by Hayek, as the largest “dials” on
the control panel would become productivity and income rather than consumer
spending and government.
Stay
tuned as next week we ponder the question of “How in the name of all that is
righteous and holy could Hayek lose the argument?” His proponents are right
to argue that the match was rigged and the judges were bought. If you have a
few minutes, watch these two brilliantly done, hilarious, and instructive
YouTube videos, here
and here.
I think you will come away smiling but also gain an understanding of the true
terms of the debate. At the end of the day, I keep coming back to how central
the arguments between Hayek and Keynes are to almost every economic discussion.
I
will be in Denver on September 14 for the S&P
Dow Jones Indices Denver Forum. If you are an advisor/broker and are
looking for ideas on portfolio construction, I will be there along with some
friends to offer a few suggestions. Then I will stay in Denver for the next
few days to give the closing keynote at the Financial Advisor magazine’s 7th
annual Inside
Alternatives conference, where I will again share my thoughts on how to
construct portfolios that are designed to have the potential to get us to the
other side of the problems I see coming in the macro world. Bluntly, I think
that portfolios constructed along the traditional 60/40 model are going to
cause their owners significant pain in the future. And if you think the
recovery has been slow this time, then you will not appreciate the snail’s
pace of the n ext recovery.
Sometime
in the fourth quarter I will go public with what I think is an innovative way
to approach portfolio construction and asset class diversification.
I’ve
been thinking about this new “Mauldin Solutions” portfolio model for a very
long time, and now we are putting the final touches on the project. While the
investment model itself is relatively straightforward, all of the details
involved with making sure that the regulatory i’s and business t’s are
crossed – the stuff that has to happen behind the scenes – are far more
complex. Plus, as you might guess, there are white papers to write and web
pages to construct.
It
is a little ironic that I put together this letter on productivity and
GDP during a week when I have been about as unproductive as I have been in a
very long time.
My computer crashed Monday morning while I was in Montana,
and let us just say that the efforts to get it back up have been frustrating.
I am operating in a very reduced and unproductive writing environment, which
will hopefully change in the next day or so. It has allowed me to get a lot
of reading done while people work on the computer and backups.
And
with that I will go ahead and hit the send button. And hope that we are all
more productive next week.
Your
did not add much to GDP this week analyst,
John Mauldin |
miércoles, 24 de agosto de 2016
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