#Answer: GDP Leads To Bad Policy
Spending doesn’t happen in a vacuum, but that’s what GDP tells us.
GDP often gets a bad rap. Similar to hardhearted statistics like income per capita, real GDP can increase following an increase in divorces and natural disasters. But besides its heartlessness, isn’t it a useful measure of how productive an economy is?
A Short Segue Into How GDP Is Calculated…..
There are three ways of calculating GDP, which are theoretically equal. Countries can choose any combination of the income, expenditure or value added approach.
The US chooses the expenditure approach; it only adds the sales price of finished products. This is based on the premise that consumption, not production, tells us about an economy’s value.
If we believe our GDP metric, consumer spending is the largest contributor to economic value, followed by government spending. Investment is a distant third. Altogether, spending contributes 70% to GDP.
But instead, let’s look at a metric like Gross Domestic Expenditure (GDE). It includes some intermediate consumption, and shows that consumer and government expenditure only contribute around 40% of economic value. Without getting too technical about GDE, this dramatic drop tells us two things; first, the ‘make’ economy, or the economy involved in production, is far larger than we previously thought. Second, productive or capital expenditure, rather than consumer or government expenditure, is what is driving a lot of spending.
So what? It’s just a metric, right?
If only. GDP isn’t just the metric du jour in the media, it drives government and Federal Reserve policy.
Take a look at the Taylor Rule, a Fed favorite, which tells us what an economy’s interest rate (i) should be:
(Yt — [bar]Yt) is the difference between Current Real GDP and Potential GDP. This is GDP targeting, albeit with a few other metrics like inflation and unemployment.
Now take a look at the Personal Saving Rate from 1960 to 2007. Although the Taylor Rule was only formalized in the 1990's, the Fed states that policy from 1970 onward, a period called the ‘Great Moderation’, was broadly consistent with the Taylor Rule:
You can see there was nothing ‘moderate’ about household spending after 1970 — the decline in personal savings relative to GDP was about 7 percentage points.
Why Save?
Saving isn’t just non-spending. Productive expenditure, a bulk of Gross Domestic Expenditure discussed previously, requires a high rate of savings.
Households save less when it looks like better times are ahead. It could indeed look that way: real GDP will continue to inch upwards. But all that GDP projections tell households is that they will consume more, not that they will have the means to consume more.
Ultimately, Congress, businesses, journalists, and the Fed have these facts before them: spending, whether consumer or government, accounts for two-thirds of GDP, and GDP measures an economy’s productivity. Therefore, an increase in spending will lead to an increase in productivity. That’s a bad metric leading to bad policy.
