Thursday, 27 January 2011

Double-dip dementia

The world of modern politics is so dominated by form rather than substance that we can hardly be surprised when a piece of total nonsense becomes the benchmark for success or failure of a particular governmental policy. This week we have seen the threat of a return to recession dominating the feeble sparrings of the frontbenches in the House of Commons. The problem with this is that recession is treated as an unmitigated ill when it is anything but because, as always, it depends on what is actually happening.

I know this is old ground but it is worth examining again what a recession is. The conventional definition is that it is two consecutive quarters in which Gross Domestic Product (GDP) declines. So, what is GDP? It is in answering this question that we see why recession cannot always be considered a bad thing. GDP can be measured in various ways but they all amount to pretty much the same thing, GDP is the amount the UK spends on goods and services within the UK plus the amount spent on investment within the UK plus the value of exports minus the value of imports. The amount spent on goods and services comprises both the amount spent by consumers and the amount spent by government. GDP is not a measure of profitability nor of sustainability - it tells us nothing about whether the amount of spending that has occurred was affordable.

To see the limit of GDP as a measure of substance it is possible to isolate one household and see what effect it has on GDP. Mr & Mrs Ordinary have take-home pay of £500 a week. They spend £400 and put £100 in a biscuit tin under the bed. They contribute £400 a week to GDP from their own spending and thereby allow the recipients of their spending to have more to spend and this adds to GDP and the recipients of that spending also spend and so it goes on. After three months they decide the biscuit tin is sufficiently full and not to save any more. The next week they spend £500. GDP has gone up. After three months they change their minds and start saving again, but only £50 a week rather than £100; they still spend £450. GDP has fallen. The next quarter they have further concerns about spending too much and cut their spending back to what it was before so they spend £400 and start stuffing a second biscuit tin. GDP has fallen again. Oh woe, we are in recession. But what is the reality? A family that could afford to spend £400 and needed to save £100 in order to provide for its future started overspending, then they reduced their spending again in instalments to get themselves back on an even track. The reality is that the rise in GDP caused by spending more than they could afford was an illusion, it should never have happened and if it had not happened there would have been no wailing and gnashing of teeth. As it is, panic has set-in simply because spending that could not be afforded has been removed from the system. In fact there should be a sigh of relief rather than panic. At the start and end of the exercise they spend what they can afford, in between they overspend. The problem is not the return to affordability, the problem is the unaffordable splurge between the start and the end.

The position gets even more absurd if Mr & Mrs Ordinary borrow £100 a week while they are spending all their income so that they spend £600 a week on an income of £500 a week. GDP goes up even further and it falls even further when they come to their senses and decide to live within their means. In this situation there has been a GDP bubble - like every bubble it is full of nothing but air, there is no substance to it. Deflating the bubble reduced GDP and we should say "about bloody time too".

Similarly, because GDP includes government spending on goods and services, all unaffordable spending by government boosts GDP. In particular, spending borrowed money on goods and services boosts GDP. Spending money they have gleaned in tax will always be pretty much neutral in terms of GDP because if not taken in tax it is likely to have been spent by the taxpayers (of course some could be saved, but that which would be spent would undoubtedly be spent better than government spends it).

Government could borrow £10billion a year and spend it on two gangs of workers - one gang to dig holes in the morning and another to fill them in again in the afternoon. This pointless activitiy boosts GDP because it leads to more money sloshing around the economy but it is utterly pointless in any other respect. Were the exercise to end GDP would fall; again it should elicit a sigh of relief. As things are we don't yet have gangs digging and filling holes, but we have the modern politically-correct equivalent in an army of public sector naggers, snooper, counsellors, fake charities and form-fillers who are not necessary, provide little if any benefit and yet are retained and paid for from borrowed money. What does that additional GDP mean? It means no more than the additional GDP derived from Mr & Mrs Ordinary spending borrowed money, it is bubble GDP and tells us nothing about the state of the economy as a whole. Remove it over a couple of years and we could find ourselves in the longest and deepest recession in history, a situation that would bode extremely well for the future because the future would not include the wasteful and unnecessary expenditure that boosted GDP artificially.

"Artificially" really is at the heart of the matter. GDP is boosted by government borrowing to fund pointless activities that achieve nothing other than to boost GDP. If you look only at GDP you can be fooled into an illusion of perpetual motion. Borrowed money can increase GDP therefore we must borrow more and more. Nonsense. It omits the other side of the equation which is that borrowed money must be repaid and commands interest in the meantime. If you pay 5% on the borrowed money the benefit of spending the borrowed money must be more than 5% to make the exercise worthwhile. Even a benefit that can be measured as 5% of the borrowed money only allows you to stand still, it does not repay a penny of the capital sum borrowed. That there is an increase of GDP is irrelevant because it only looks at one side of the equation, it does not take into account the cost of borrowing the money. It fails to acknowledge the broken window fallacy.

We shouldn't fuss about whether GDP is up or down this quarter or the next, it really doesn't matter. What matters is that money is used wisely because the unwise use of money eventually results in retrenchment if not bankruptcy. A decade of it being used unwisely can thrust GDP into the stratosphere but that tells us nothing about the health of the economy. GDP was never higher than before the recent recession started yet the economy (to be more accurate the government's finances) was in a complete mess. That recession has not yet ended.

Of course it has ended according to the artificial measure called GDP and we might re-enter recession according to the artificial measure called GDP, but the reality is that we still have government overspending by about £160billion a year and we will be in recession until the resultant debt is eliminated. We will be in recession because ordinary people will continue doing what they are doing now, namely paying-down debt and putting aside some money for fear of unemployment, rising taxes and rising fuel bills. All they are doing is returning their own economies to a sound state. If GDP plunges but people are in charge of their finances rather than their finances being in charge of them the country will be in better shape.


Phillip Downs said...

Dear Mr Bigot

It is my overwhelming experience from a working life dealing largely with business failures that the simplest explanations are more often the truest. Your analogy deserves a much wider audience but I don't hold much faith that a simple explanation such as this can overcome the deceits peddled by the former government. The trouble is that the majority of the country is blinded by some form of misplaced class hatred and does not have sufficient common sense to see through it.

I notice that your blogging has been very light of late. It would be a shame if you were to disappear completely!

Best regards

Phillip Downs

john miller said...

What you say is true and the tragedy is that this was well understood by Brown.

Remember in the 60s and 70s the key economic indicator was the balance of payments?

As a measure of how well GB Limited was doing, it wasn't a bad one, but one that a Labour Government would find impossible to achieve. Hence Brown embarked on his usual brainwashing campaign.

GDP was the sole economic indicator used by Labour and the campaign worked. The balance of payments going down the pan, the unfunded spending, the tax rises, the run on sterling, none of these mattered.

Of course, even GDP wilted after 11 years of Labour. But it is the coalition's problem that they have always fought Labour on Labour's terms.

They should say; "What if your personal balance of payments goes out of kilter?" They would be amazed at the number of voters who understood. But the modern politcian is one of the worst communicators on the planet.

H.R. said...

F.B., that was a very, very, very (did I mention very?) well written explanation of the limited value of GDP as an economic indicator.

Here in the States, we're using GDP as well and it's really just a tool for the pols to fool the proles.

Superb post, sir!

P. S. Glad to see you back and in such fine form.

Tomek said...

Tomek - A Pole in UK