Synopsis: The history, uses and problems with GDP.

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Discussion: This article discusses the origins and the appeals of Gross Domestic Product (GDP), as well as its major flaws.

Introduction

GDP is the sum of total final production minus imports. Both the final products as well as the input materials are adjusted for inflation to give real GDP. With such large markets, it is extremely tricky to calculate GDP and the figures need to be revised often.

Apart from the difficulties in calculating GDP, however, there are many other problems with this measure.

Problems with GDP

1. GDP does not take innovation into account. While a light bulb costs much more than a candlestick, it will also provide more light. The increase in quality of production, however, is not accounted for in GDP.
2. Free products are not accounted for. Most of the Internet, including Google, Facebook and YouTube, is accessible to everyone at no cost, but is not counted as the GDP calculation requires the final market value.
3. GDP does not take into account negative externalities such as pollution or congestion. For example, building an incinerator adds to GDP, but the pollution it produces is of no consequence.

World War II and GDP

The modern definition of GDP includes government spending. During World War II, the American government requested Russian-born economist Simon Kuznets to calculate national income. While he wanted to make government spending a cost for the private sector, economist John Maynard Keynes noted that during wartime, if government spending was a cost to the private sector, GDP would shrink even as the economy grew. (More about this is explained in ‘Context’.)

It is important to note the modern definition of GDP was established during wartime, when the main function of GDP was to manage supply. Today’s problems with GDP, such as its dismissal of pollution as a cost, was pedantic compared to the daunting task of survival of an economy during a war and after the Great Depression.

GDP was therefore devised to calculate manufacturing, which, during the fifties, took up a third of Britain’s GDP. Now, manufacturing takes only a tenth of the economy. Nowadays, there is increasing backlash against GDP. Former French president Nicolas Sarkozy and economist Joseph Stiglitz called for an end to “GDP fetishism”.

GDP and free goods

The problem with measuring manufacturing for GDP is that the measurement results in a bias. GDP, by definition, only measures output that is bought and sold, because the value of the output can be easily determined by looking at its market value. The problem with this is that “home production”, such as stay-at-home mothers and caring for the elderly, are not considered when calculating GDP, even when these services have a large intrinsic value.

Still, government services, most of which are free, are included in GDP, proving that there is no steadfast rule when it comes to measuring free goods in an economy.

To try and place a value on free services, the Bureau of Economic Analysis in the United States equates the market value of cooking in a restaurant to the value of cooking at home. Erik Brynjolfsson and Joo Hee Oh of MIT follow this approach when it comes to free online services to calculate the welfare gain.

Other sections of GDP measurement are done very indirectly. For example, houses which are rented have a clear market value and can therefore be included in GDP calculation, but the value of self-occupied houses has to be imputed.

As well, there is little consensus on how to treat products that used to be paid for but are now free, such as listening to music online, or reading newspapers. Just because newspapers are not printed anymore, but are read online, does that mean that GDP has decreased as the actual act of printing a newspaper is dwindling?

Adjusting for inflation

Perhaps the biggest problem with GDP as a measure of welfare is that adjusting for inflation has its own complications. In terms of simply calculating it, it is very hard to calculate changes in quality. While a newer computer might cost more than an older one, it can do more. Simply looking at the price therefore overstates inflation by about 0.6%, suggests Michael Boskin of Stanford University. People correct this error by using hedonic estimation (explained in ‘Key Terms’). However, as hedonic estimation takes a long time, it is not used all that frequently. And when a product develops so much that it can practically be considered a completely different product, such as when mobile phones developed from large, bulky ones to Smartphones, hedonic estimation does little to help.

Measuring quality for inflation becomes even harder when considering services instead of goods. A restaurant’s value depends on more than just the cost of producing the meal: it depends on the ambiance, crowd and many other factors that do not have a market value.

Completely new products are especially hard to incorporate into the consumer price index (CPI). In microeconomic theory, the value of the product to a consumer is the consumer surplus (explained in ‘Context’). But calculating consumer surplus requires knowledge of the reservation price (explained in ‘Key Terms’). As this is extremely hard to calculate, new products usually go into the CPI without the adjustment for consumer surplus.

Is there something better than GDP?

Using GDP as a measure of national economic performance can thus be questionable. If GDP calculation methods vary from month to month with, for example, the inclusion of new goods, then comparing GDP from year to year is even less reliable.

The Economist does not suggest alternatives for GDP. If a new GDP measure would be created, it must account for the change in quality of goods as well as the incorporation of new goods. Some economies use alternative measures. For example, Bhutan uses Gross National Happiness (GNH) as a measure of economic performance in order to preserve its Buddhist values. The Genuine Progress Indicator (GPI) is often suggested as it tries to measure quality of life. GPI accounts for pollution, unpaid work and family work. Unfortunately, it does not measure human capital, nor does it correct the problem that the CPI struggles to incorporate new products.

Right now, there is no feasible alternative to GDP. For the moment, economies have to stick with GDP as a measure of economic growth, problems and all.

Key Terms:

1. Inflation: the sustained increase in the average price level of an economy.
2. Hedonic estimation: a method of estimating the intrinsic value of a certain product, using questions to estimate developments of its characteristics. For example, “how much would you pay for a different-colored shoe than last year’s shoe?”
3. Consumer price index (CPI): a basket of consumer goods and services that represents usual purchases by households. Change in the CPI represents change in the average price level of an economy, i.e. inflation.
4. Reservation price: the maximum price a consumer will pay for a product, or the minimum price a producer will sell the product for.

Context:

1. What is GDP and how is it calculated?GDP measures the market value of all the final goods and services in an economy, i.e. the price at which they are sold. GDP is comprised of four parts:

GDP = C + I + G + (X-M)

‘C’ stands for private consumption.

‘I’ stands for investment.

‘G’ stands for government spending minus government transfers (e.g. financial aid). Government transfers do not count, as nothing new is being created in the economy; money is just shifting hands.

(X-M) stands for net exports, where X is exports and M is imports.

2. What is real GDP and how is it calculated?

Real GDP is GDP adjusted for inflation. It is calculated by:

Real GDP = Nominal GDP – Inflation

3. Why did Kuznets consider government spending to be a cost to the private sector? Why would wartime imply higher government spending?

The theory that government spending is a cost to the private sector is called the “crowding-out effect”. The crowding-out effect is two things:
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a. When the government significantly increases its borrowing in order to spend in the economy, demand for money increases, as does the price of money, i.e. the interest rate. This is illustrated in the diagram below. When this happens, it costs more for the private sector to invest in capital, as borrowing money costs more. Thus, the private sector cannot invest and produce as much, and they are crowded out by the government.

In the diagram above, Ms stands for money supplied and Md stands for money demanded. Ms is a straight line because the central bank can only produce a fixed amount of money at any point in time. Before the government borrowed money from the central bank, Md was at Md1, resulting in the interest rate being at i1. Once the government borrows more money from the central bank, Md increases to Md2, resulting in the interest rate shifting to i2.

Why doesn’t the central bank increase money supplied in order to decrease interest rates? A central bank can increase money supplied a limited number of times before inflation becomes uncontrollable.

b. When the government spends on roads and other such projects, it takes away the opportunity to build those projects from the private sector, thus crowding them out.

4. Consumer surplus

​Consumer surplus is the difference between the reservation price and the price paid for the good, i.e. the amount of benefit consumers get from buying the good. In the diagram below, consumer surplus for someone willing to spend $k is the difference between the reservation price, $k, and the market price, P*, illustrated by the red rectangle. Therefore, total consumer surplus is the area below the demand curve but above the market price, i.e. the green triangle.

Synopsis: A look at Japan’s economy and a discussion about how best to improve it

​Click here to read the original article.

Discussion:

This article discusses the ways in which Japan could improve its economic situation, chiefly through fiscal and monetary policy.

Krugman highlights aspects of the Japanese economy that are encouraging: “Output per working-age adult has grown faster than in the United States since around 2000, and at this point the 25-year growth rates look similar”, and “… Japan is closer to potential output than we are”. Nevertheless, Japan is struggling to escape from deflation. Why has Abenomics not worked as well as people hoped?
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The main ideas in his article are best portrayed through a flow chart:

1. According to Krugman, the two biggest issues are Japan’s over-reliance on fiscal expansion (which leads to a high debt-to-GDP ratio) and its chronic deflation. Fiscal consolidation may be called for to balance the debt-to-GDP ratio and to reduce Japan’s reliance on fiscal expansion, but Japan has no way of offsetting the effects of fiscal consolidation through QE; after all, the interest rates are already as low as can be.

2. It follows that one of the only solutions is to raise inflation such that real interest rates fall. This way, QE can happen alongside fiscal retrenchment. Krugman adds as a side note that raising inflation would also reduce the value of debt.

Krugman describes how Japan may be facing a negative Wicksellian rate (explained under ‘key terms’) as a permanent condition. He points out that even if the Bank of Japan were to promise greater QE, it is ultimately consumer expectations of future inflation that will determine inflation (more about this will be explained under ‘context’).

Krugman’s solution is to combine monetary policy with a burst in fiscal stimulus. The fiscal stimulus will raise the inflation, and the increase in inflation leaves room for more QE. Only when more QE is enacted can fiscal consolidation occur, which would cut down the debt-to-GDP ratio.
The question, then, is how high should inflation be? While the answer does not have a certain numerical value currently (i.e. it has to be high enough to allow QE to occur), it is clear that Japan’s 2% inflation is not enough.

Krugman emphasizes the problem of fiscal consolidation alone: it may cause an economy slump, in which case Abenomics may be beyond redemption. He says that the only measure left is for Abe to engage in aggressive austerity and QE together to increase inflation.
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Key terms:

1. Wicksellian rate (a.k.a. natural rate of interest): Kurt Wicksell was a leading Swedish economist who was best known for his idea of the natural rate of interest. The theory suggests that there is a long-run natural rate of interest, and if the current rate of interest is higher than said natural rate, there will be deflation, and if the current rate is lower than the natural rate, there will be inflation. When the current interest rate equals the natural rate of interest, there is equilibrium in the commodity market and price levels are stable. To read more about this (and how it pertains to modern-day economics), click here.

Context:

1. To understand this article, it is important to understand what Abenomics is. Abenomics is a portmanteau of the words economics and Abe – Shinzo Abe being the Prime Minister of Japan. His plan is to fire three ‘arrows’ to stimulate economic recovery. The first arrow is expansionary monetary policy in the form of QE, the second is fiscal stimulus, and the third is structural reforms, mainly through strengthening the Japanese army.

While these three arrows seem like feasible ways to revive the economy, Japan is still faced with lacklustre inflation, and many attribute this to the fact that Abe is not aggressive and hawkish in any of his three tactics, or arrows. Paul Krugman discusses what Abenomics’ next steps are.

2. How does future inflation determine inflation today? Consider this situation: a consumer in an economy wants to buy a new phone. She believes that inflation will increase in the future, i.e. the price of the phone will be higher in the future than it is currently. For this reason, she buys the phone today. Many consumers in the economy also believe that future prices will be greater than current prices, and buy the goods and services today instead of waiting for the price to increase. The aggregate demand in an economy suddenly increases, and producers increase the price of the goods and services in an economy as a response. This increase in prices of goods and services is, in fact, inflation. Deflation works in a similar way. In this way, inflation (or the lack thereof) is a self-fulfilling prophecy.
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3. In my opinion, there are a few problems with Krugman’s proposed solution. The first is that despite years of fiscal expansion by the Bank of Japan (BoJ), deflation still persists. Even aggressive fiscal expansion, which is what Krugman suggests, has its problems. Firstly, there is no telling when the aggressive expansion will result in a sufficient level of inflation; it could take much longer than the BoJ can afford, and it will exacerbate the debt-to-GDP ratio greatly. Secondly, even when the BoJ deems the inflation level in Japan as healthy enough to allow fiscal retrenchment to happen, they have to be wary of consumer expectations. Either the BoJ will have to execute fiscal consolidation so slowly that it now faces high inflation and a high debt-to-GDP ratio, or it will have to carry out fiscal consolidation quickly enough to avoid inflation from becoming a worry. The problem with the latter is that consumer, investor and producer confidence in the market is shaky enough as it is; fiscal consolidation may scare them enough to revert the economy back into the original state of deflation where people are hesitant about consumption, production and investment.

Synopsis: An article on how demography (age) affects inflation.

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Discussion:

This article discusses the link between inflation and demography. Ageing populations leads to “slower growth, because a country’s potential output tends to fall as its labour force shrinks.” They also have to face heavier fiscal burdens because governments must provide for more pensioners from fewer taxes. Given its ageing population, this is a big problem for Japan.

Many economists take persistent deflation in Japan as evidence to show that prices fall when counties age, and consequently, growth slows. The Prime Minister of Japan, Shinzo Abe, has tried disproving that link by increasing inflation through aggressive quantitative easing. However, as inflation has yet to reach the targeted 2%, the tempting conclusion is that ageing populations cause deflation.

Recent research has sought to disprove that link.

It is important to not just see the links between ageing and prices, but the way they cut. In terms of the factors of production, when growth slows, businesses reduce investment so that the cost of capital can decline. However, wages should rise when the supply of workers falls. And in terms of government action, some governments reduce their spending on other projects to support pensioners, causing slow growth and sluggish inflation. Other governments, however, may decide to monetize their debt, pushing inflation up.

The article disentangles all these possibilities to descry a clearer link between an ageing population and inflation.

This article states a few main points:

1) In a recent paper by Mr. Katagiri of the Bank of Japan and Mr. Konishi of Waseda University distinguished between an ageing population caused by lower birth rates and an ageing population caused by increased longevity.

a. Fewer births would lead to a smaller tax base, encouraging governments to “embrace inflation to erode its debts and thus stay solvent”. This will be further explained under ‘context’.

b. Longer lives would cause the ranks of pensioners to swell, along with their political influence. Their influence would augur for “tighter monetary policy to prevent inflation eating into savings”. This will also be explained under ‘context’.

Messrs Katagiri and Konishi believe that the latter (increased longevity in Japan) has caused deflation of about 0.6ppt over the past 40 years. Therefore, it is not just ageing that has caused deflation, it is more longevity.

2) This article then looks at the impact of ageing on financial assets. The “life-cycle theory” suggests that people average out their consumption over lifetimes: “going into debt when young, buying assets when their earnings peak and selling them to pay for retirement”. In theory, it should lead to lower asset values, but in practice, while house prices often fall, stocks rise.

One important aspect is whether the assets sold are domestic or foreign. Messrs Anderson, Botman and Hunt of the IMF found observed the decrease in Japan’s net saving rates from 15% to 0% of disposable net income from the 1990s to 2011. Many of these savings are invested in foreign assets, and when retirees repatriated their funds after selling stocks and bonds abroad, the yen appreciated. This, in turn, causes deflationary pressure by lowering the cost of imports. This can be negated by “strong monetary easing combined with a credible commitment to an inflation target”. In other words, Abenomics.

3) A recent paper by Messrs Juselius, and Takats from the Bank for International Settlements offers a vastly different explanation for how ageing affects inflation, pointing out that Japan may be quite atypical. They observed 22 advanced economies from 1955 to 2010, and found a steady correlation between deflation and demography, even though just the opposite is assumed. They found that a larger share of dependents is linked with higher inflation, while lower inflation is linked with a higher labour force. Their explanation for this is that countries that consume goods more than they produce them (i.e. with a smaller labour force) causes excess demand, and thus, inflation. However, countries that consume less than they produce causes excess supply, and thus, deflation.

This then begs the question of why Japan has such low inflation. Some possible explanations are damaged balance-sheets caused by the asset bubble pop in the 1980s, or the tentative and hesitant Abenomics.

Context:

1) Why does the government need to make “painful cuts as pensioners multiply”? And what does it mean “monetise their debt”? Number 1 is for the former, and number 2 is for the latter.

2) Why would embracing inflation erode a country’s debts? As inflation goes up, the value of the debt goes down in real terms. Therefore, the amount of debt a country owes decreases.

3) In the section, ‘Greyflation’, the article discusses a finding that explains how a larger share of dependents is linked to higher inflation, and how fewer dependents mean lower inflation. I am sceptical about this argument because, if this were the case, what should we expect in the US when baby boomers retire en masse? A spike of inflation? This is contrary to what a lot of people believe.

Synopsis: A debate between Larry Summers and Ben Bernanke about why US interest rates are so low.

Click here to read the original article.

Discussion:

This article by Greg Ip details a debate between former Federal Reserve Chairman Ben Bernanke and former Treasury Secretary Larry Summers about why interest rates in America are so low. While Summers argues that it is due to secular stagnation, Bernanke disagrees, citing “cyclical and special factors” as the reason for low interest rates.

Secular stagnation includes low growth, low inflation and low interest rates and lasts a substantial amount of time. As Ip points out, it is the real interest rate (nominal interest rate – inflation) that is important. It is the real interest rate that balances savings and investments. More about this will be explained under ‘Context’.

Summers states that the “real rate needed to balance desired saving and investment may actually be negative”, a key factor of secular stagnation.

Bernanke disagrees that the real rate may be negative and details a scenario to illustrate his point. The rough idea is that if the real interest rate was always negative, then all investments would be profitable. Due to an increase in demand for investments, the real interest rates would increase.

Greg Ip further illustrates this point by outlining a scenario with stock dividends, where, if the real interest rate were 0%, the value of the stock would theoretically be infinity, and if the real interest were negative, the equation becomes nonsensical. This will also be explained under ‘Context’.

Summers retaliates by showing that, according to Summers, “rates in America have been negative at least 30% of the time”. His reasoning behind this is that “negative real interest rates are a phenomenon that we observe in practice if not always in theory”.

How is that possible? There are a few reasons for this.

1) While government bonds, or risk-free bonds, are negative, private borrowers would often pay a positive due to the higher risk involved in giving private borrowers loans. Further, investors may demand an “even higher hurdle, especially if they expect the project’s profits to grow quite slowly in a stagnant economy”.

2) Bernanke agrees that real rates can be negative temporarily, not permanently. (Here, Ip points out that Summers never argued that the interest rate was permanently low, it could just be for a 10-15 year time period).

Even if the real rate was not negative, secular stagnation could still be a culprit in low interest rates as secular stagnation does not need rates to be negative, just low.

Next, Bernanke faults Summers for downplaying the international element of the argument. If it were true that there was a lack of profitable investments in the US, the savings would go abroad, increasing interest rates in the US. Bernanke believes that the weak recovery of 2002-06 was due to a global savings glut, as opposed to Summers’s belief that the weak recovery was due to secular stagnation. China and other countries with large trade surpluses “saved more than they invested and exported the rest to the US”. Therefore, the lack of US growth, according to Bernanke, was because imports were displacing domestic production. Since then, China’s trade surplus has decreased while Europe’s has grown, but Bernanke thinks this is a “cyclical, temporary problem”.

Paul Krugman questions Bernanke’s theory that open capital markets would not depress real interest rates by citing Japan as an example. Bernanke however argues that while interest rates were extremely low, inflation was lower, causing real interest rates to be slightly higher than that of the US.

Greg Ip then cites a few reasons why he believes interest rates are so low:

1) Worldwide monetary policy. When QE ended in the US, which had brought real rates worldwide down, ECB’s QE began, keeping the real rates down.

2) Supply side factors – slower growing labour and productivity.
a. Slowing labor can be classified as slower population growth, which depresses the supply of workers and investment, as a smaller workforce need less machinery and other equipment. It also depresses demand, as retirees consume less and aging workers save more for retirement.
b. Productivity has also slowed down worldwide, partly due to the residue of the financial crisis on capital spending, which will eventually fade. However, it also reflects a lack of innovation. And firms may invest less because they see “fewer payoffs to new technology”.  Robert Gordon, a famous economist in the productivity field, also cites education attainment no longer increasing as why growth is slowing down.

Key terms:

1. Financial bubbles: where there is an unsustainable increase in asset prices such as stocks, houses, property and even land.

2. Risk-free interest rate: The interest rate acceptable to a lender when he believes that the borrower will not default on the loan. In practice, this refers to the interest rate on US treasuries, which are considered the safest investment.

3. Hurdle: The minimum expected rate of return from a project, below which the investors will not go ahead with it.

Context:

1. Economists care about real interest rates rather than nominal interest rates. As inflation erodes the purchasing power of the interest earned by the lender, he will make lending decisions based on interest rate after deducting the inflation; in other words, the real interest rate.

2. An important idea to understand from this article is the relationship between real interest rates, savings and investments. As stated in the article, investments can be considered demand for savings, while savings can be considered supply of savings. The diagram below illustrates the relationship.

At real interest rate R2, investment is at I2 and savings is at S2, i.e. they are equal at an equilibrium point. If the real interest rate decreases from R2 to R1, investment would increase to I1 and savings would drop to S1. Similarly, if the real interest rate increases from R2 to R3­, investment would decrease to I3 and savings would increase to S3. This relationship shows that as real interest rates increase, investment decreases and savings increase.

3. Nominal interest rates cannot be negative. Given the equation that real = nominal – inflation, real can still be negative, if inflation > normal.

4. Gary Ip’s discussion of stock dividends:  A stock is worth the sum of its future dividends, discounted at an appropriate interest rate to bring them to today's present value. In other words:

Stock value = D/(1+i) + D/(1+i)^2  + D/(1+i)^3 + D/(1+i)^4 + D/(1+i)^5 ... 
(assuming that the stock pays a fixed divided of D every year and i is the interest rate).

As you can see, as the value of i falls,  the stock value increases; if the value of i reaches zero, the stock value is infinity; if the value of i goes below -1, then the equation turns nonsensical.

5.  Larry Summers states that “negative real rates are a phenomenon that we observe in practice if not always in theory”. This is an allusion to Bernanke’s earlier statement that quantitative easing works in practice if not always in theory. More about that can be read here.

6. There is a discussion about the 2002-2006 weak recovery. The context of this is that, during that time, China exported high volumes of goods to the US, and used the resulting surplus to invest back in America, which led to low real interest rates, and displaced domestic production in America.

7. One important thing to consider is why there is persistent low growth in America, as that is reason for QE and low interest rates in the first place. Some reasons for low growth to persist are:
a. The benefits of technology adoption are finished. Tyler Cowen, a professor at George-Mason university, is famous for discussing this concept in his book “The Great Stagnation”, the gist of which is that the low hanging fruits have already been plucked.
b. Retirement of baby boomers.
c. Long left over effects of the Great Financial Crisis (GFC).
d. Ageing population.