Don't panic. This is a "high concept" idea that would be less impressive if it were complicated by details. Just appreciate the grandeur of analyzing the entire production of 300 million people, simply by giving it a name.
Don't be afraid of the few formulas you will see. They are only a fancy way to add things up, and they look great on a cocktail napkin. Any formula will amaze your friends and show your deep insights into finance. This is exactly the same effect enjoyed by graduates of Harvard Business School.
The GDP Formula For the Economy
The detailed interactions that describe the U.S. economy are many, complicated, and mostly not understood.
In the meantime, many macro-economists use a short formula which is easy to remember. They use it to promote deficits, spend $789 billion on stimulus, impress the non-PHD's, and win arguments on blogs. You can use this formula as an amateur. It is merely addition, but it does require memorizing the letters (the variables or quantity names) to show that you are unusually intelligent.
Y (same as GDP) = C + I + G + (X - M)
You can casually say at a party "Stimulus increases G, which increases Y and creates more jobs throughout the economy". The effect is electric. Politicians will applaud.
The quantity "Y" or "GDP" is Gross Domestic Product. That is all of the goods and services produced in the country.
Just like "DIY - Garden Shed", we will build from the bottom, giving you hints along the way. Here is the foundation:
GDP = Total U.S. production. All goods and
services produced during the year
That is merely a definition. We can make it less boring by slicing GDP into philosophical pieces. Really, schools award degrees in this stuff. Here is our first slice:
GDP = Consumption C + Investment I
This says that everything we produce can be assigned to two categories. "Consumption" is what we use personally, like food, clothing, and automobiles. "Investment" supports businesses to produce those goods and services, like supermarkets and automobile factories. There are some gray areas, but why worry? The macro-economists don't.
How does government fit in? We slice again:
GDP = Consumption C + Investment I + Govt Spending G
Consumption is spending for individual use, also called consumer spending. Investment is spending to support businesses, like buying machinery. Government Spending is everything purchased by government.
Notice that there is no "Government Investment". We know that government builds a few useful things like bridges, but government doesn't try to make a profit (more is the pity) so it is all called Government Spending.
We have left out "Exports X - Imports M" for now. You can look below for that explanation, so that people don't accuse you of reading "only that stupid DIY post". "X - M" is "Exports minus Imports". It is there mostly to show that you understand the complexities of the economy, after completely ignoring all of those complexities by relying on this stupid formula.
That is the GDP Formula. I know you were looking forward to more complexity and hours of study. You may even be angry, thinking now that this whole post is a big joke. You think it can't be this simple. Our leading government economists and Keynesian pundits just can't be using this simple formula as justification for their economic policy. I share your anger. Don't blame me. That is just how it is.
About GDP
Here is the GDP Formula again. You will find out how our government uses this formula. Sadly, this is not a joke.
GDP = Consumption + Investment + Government Spending
This formula is simple and absolutely true. People are dazzled by its truth, but are not aware of how useless it is. It is only a broad mental exercise for thinking about the money spent in our economy.
GDP is everything produced in our country. An economist notices that your income results from selling what you produce. You sell your effort each day to earn your salary in money. You spend your salary to buy the food, clothing, and services which support your life. Your income in cash comes from your share of the goods and services you help to produce. So, production and income are two sides of the same coin. All production represents someone's income.
In general, more GDP is good because more production means more income to the people of the country. Government economists look for ways to increase GDP, especially during recessions. They most often find their answer in the GDP Formula above. They see that GDP would be larger if one or more of its parts were larger.
Consumer Spending
Economists note that consumer spending is 70% of the economy. This means that about 70% of all purchases are by people for their personal benefit. Looked at another way, 70% of what is produced (GDP) is made for people to use personally.
During recessions, people spend less on consumption because some are out of work and others want to save more, in fear of losing their jobs. GDP is produced by people, so higher GDP is associated with more people working. Government economists look at the GDP Formula and conclude that if people would spend more on consumption, there would be higher GDP and more jobs, ending the recession. This extra consumption would be economic "stimulus".
It is difficult to encourage people to consume more. A few tries have been made with Cash for Clunkers for buying autos, and cash subsidies for buying homes. But, people can't consume much more if they are out of work.
Both presidents Bush and Obama gave one-time tax refunds or payments to people. These didn't do much for the economy. Government economists complained that people saved most of it instead of spending it all, reducing the "stimulating" effect.
I don't understand why saving (investment) is supposed to be worse than spending. According to the GDP Formula, they add equally to GDP. I suppose that is just inconvenient to what politicians want to do. They want to spend.
Investment
Nope. The government doesn't know how to invest, and it hates making a profit. Investment is done by the prosperous business people that the government takes taxes from. Government isn't about to give back that money for investment, followed by "trickle down" prosperity.
Government Spending
Now we are on to something. Government economists interpret the GDP Formula as showing that government spending increases GDP. That is something that government can do with a few votes, and spending is something that all politicians like to do. Any recession creates calls for much more government spending, and they do it.
The Personal Spending Formula
I said above that the GDP Formula is true but useless. Let's get a feel for that by looking at a smaller, friendlier, more understandable relative The Personal Spending Formula:
My Spending
= Restaurant Meals + Savings + Other Spending
In general, more of My Spending is good because I enjoy most of the things I buy. I often daydream about buying more things to be happier. The Personal Formula seems to give me guidance: I should buy more restaurant meals to increase My Spending. In fact, I might think it tells me that I should eat out all the time, and take friends and family with me. More spending on restaurant meals is good, and the more the better.
I hear some shouting in the audience, that I can't just increase what I spend on restaurants. I would have to decrease what I save or decrease what I spend on other things. I might enjoy more restaurant meals, but I would have to cut elsewhere. In fact, I can't really change My Spending at all (!) because I have properly included Savings in the formula.
By definition, my entire income is equal to My Spending, and I can only allocate my income to different purposes. I can't raise or lower My Spending by spending more or less in one category, because I must adjust the other categories. The formula is correct, but it can mislead me about how the quantities affect each other.
To increase My Spending, I would have to work more hours, or find a better-paying job, or save/invest in a growing company. None of that is represented in the Personal Spending Formula.
I could buy more restaurant meals if I cut Other Spending. I might spend less on maintaining my car and use the difference for more restaurant meals. But, my car might break down, and that strategy could work out as a bad choice. Whatever happens, the Personal Spending Formula will reliably add up the results, but it does not say what I should do or what will happen.
An increase in my income would allow me to spend more in one or more categories. The Personal Spending Formula doesn't tell me that I can increase my income by purchasing more restaurant meals or anything else. That would be a crazy interpretation of a formula that merely adds up my spending choices.
The Personal Spending Formula is absolutely true, which impresses people at first glance. But, it is worthless for guiding me to earn more income. It only says that I must spend less in one category if I spend more in another category.
Borrowing Savings For a Price
If I want to buy a new television for $1,000, and I don't have enough in savings, possibly I can borrow the money. This works if I can reliably save enough to pay for the TV plus interest, and I don't want to delay the purchase until I have saved the money.
I could buy the TV for $1,000, and pay $80 per month for the next 15 months to pay off a $1,000 loan. My total cost to buy the TV this way would be $1,200. So, I could pay an extra $200 to the lender to buy the TV now, rather than save $80/month for 12.5 months to buy the TV later.
It seems that I have increased My Spending by $1,000 by getting that loan. Actually, I increase Other Spending by $1,000 when I buy the TV, and I decrease Savings $1,000 by getting the loan. Savings has become negative.
Negative savings means that I owe money. I put less into savings over time than I have now taken out. I will pay about $67/month into savings as I pay off the loan, and I will pay the loan company about $13/month interest for the use of the money. Savings will become $0 after 15 months (assuming it was $0 to start), the loan will be paid off, I will own the TV, and I will have paid about $200 to borrow enough savings to buy the TV sooner rather than later.
This is interesting. "My Spending" did not change because of the loan. Other Spending went up by $1,000, and Savings went down by $1,000, offsetting each other. This contrasts with the usual assumption that taking out a loan increases "spending". In fact, loans are a transfer of savings for a price.
This personal accounting agrees with what the society sees. I bought $1,000 more of something, but the lender bought $1,000 less of something. These cancel out for the society, and they cancel out in a proper personal accounting.
Confusion
I confess that I introduced some confusion, but only the same confusion that government economists use. The Personal Spending Formula should have looked like this:
My Production or Income
= Restaurant Meals + Savings + Other Spending
It is entirely true that Production = Income = Spending. We can account for Production by either valuing everything that is produced as GDP, or adding up all Income, or adding up all Spending (when Savings are properly accounted as a category of spending).
Here is the confusion. When I say "My Spending = . . .", that choice of word gives the impression that I can change what I spend in total. "Spending" seems to be something that I can do more or less of. In fact, when we properly account for transfering money into Savings/Investment, I can't change the total of My Spending, I can only allocate it between Restaurants, Savings/Investment, and Other Spending.
If I had said "My Income = . . .", then it would have suggested the correct conclusion from the start. "My Income" depends on what I earn, and I can only allocate it between different types of purchases, including Savings/Investment. It becomes much clearer that what I earn doesn't change because I spend more or less on consumer goods rather than on Savings/Investment.
Stimulus
Here is the GDP Formula again:
GDP = Consumption + Investment + Government Spending
It should look different to you now, after reading the section above.
There, we saw that the Personal Spending Formula is a true representation of how I might allocate my income among different categories of goods. It is useless for deciding what I should do to increase my income. It doesn't express or relate any of the complexity in my life that determines what my income is or what it could be.
The GDP Formula has the same qualities. It is definitely true. But, it is merely a true statement about how all GDP (production) can be allocated to various categories, in principle, philosophically.
It is crazy to use the GDP Formula to claim that increasing Government Spending will increase GDP. The GDP Formula only says Government Spending buys some part of what is produced. It says nothing about how we could produce more or increase employment. The GDP Formula says nothing about the immense complexity within our society. If anything, the GDP Formula tells us that there is a tradeoff, that more government spending requires less personal consumption and/or less investment.
Government economists say that the government is in a special position to create "stimulus", to borrow money and increase spending now to create jobs now. Although spending will go down in the future when the loans are repaid, they say the economy will have time to recover.
There is a problem in this reasoning. Borrowing does not increase "spending" overall. The government spends more, but the lender spends (invests) less to support business. It is mostly a wash. If anything, resources lent to the government are applied with a lower productivity than they would be by individual investors in our society, reducing employment.
Your car has a speedometer that reports how fast you are going. You would be crazy to think that you could increase your speed by grabbing the needle and pulling it toward 50 mph.
The GDP Formula reports (only in principle) how production is allocated among uses. You would be crazy to think that you could increase production merely by allocating more of it to the use of government. That is what increased government spending does.
The GDP Formula is a magic trick. Observers see that the formula is true by definition. Then the magician economist interprets the formula in a crazy way to support the taxing and spending desires of the politicians who employ him. Assuming that government economists are smart and college educated, I think that they are lying, not merely mistaken about this crazy interpretation of the GDP Formula.
The Complete Keynes Formula
Total Production Y =
Consumption C + Investment I + Govt Spending G
+ Exports X - Imports M
The Keynes Formula divides all production within a country into categories. Consumption + Investment + Government Spending seems to include everything, so what is (Exports - Imports) doing there?
The Keynes Formula accounts in principle for every spending transaction within a country and assigns each transaction to Consumption, Investment, or Government Spending. But, usually that is not quite equal to the goods and services produced within the country.
If a French company buys from the U.S., the spending is done in France for goods manaufactured in the U.S. This foreign spending on U.S. exports should be added to U.S. GDP.
If a U.S. company buys from France, the spending is done in the U.S. for goods manufactured in France. This local spending on French imports does not represent U.S. GDP, so it should be subtracted from the spending figures.
So, if we start with "All spending transactions within the U.S.", we can add exports and subtract imports to get the true dollar value of U.S. GDP (Total Production Y above).
Showy Complexity
The Keynes Formula is contrived.
First. The division of GDP into Consumption, Investment, and Government Spending is arbitrary. It seems to me that Government Spending is in the formula merely to refer to it as a component of political strategy.
I could as easily write this formula:
GDP = Consumption + Investment
+ Video Games + Cat Food
Then I could argue for increasing GDP by subsidizing the purchase of video games and cat food.
The categories of spending seem analytical, but they aren't used for any further analysis. There is no discussion about which is better, and there couldn't be; these terms are too vague to provide an analytical insight.
Keynes did not make a distinction. He famously recommended distributing cash to the public, or paying them to dig holes and fill them up. Any means of increasing consumption, investment, or government spending was supposed to increase overall production. Of course, politicians have always preferred government spending.
Second. The inclusion of "Exports - Imports" adds unneeded complexity. Our government certainly buys some foreign goods, and sells government services to foreign countries. So, part of "Exports - Imports" is Government Spending. Who cares? The Keynes Formula is only used to incorrectly claim that increased Government Spending must increase GDP. That fallacy is the central point of this post.
The value of including "Exports - Imports" is to present another absolutely true and complex fact about GDP accounting which is irrelevent to the discussion. It puts another gloss of legitimacy on the incorrect interpretation of the Keynes Formula.
Third. Keynesian economists have analyzed the failure of one-time tax rebates or subsidies to "stimulate". They conclude that the public didn't spend enough of their new money. They saved much of it or paid down debt, which is another way of saving.
But, the interpretation of the Keynes Formula by Keynesian economists would make consumer spending, saving, and investment equally "stimulative" and equally powerful in raising GDP. This bias toward spending and against saving is not part of the Keynes Formula, but they illogically use the Keynes Formula as a quick justification for their political preferences.
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Keynes, Digger of Holes
12/2008 - EasyOpinions
No one should trust a theory that predicts greater prosperity from digging holes. Yet, this is the theory by Keynes that Obama is following, and that many past presidents have followed to forcibly change our society. We will supposedly create even more wealth in the future by wasting our current wealth today.
I know. I must be wrong. No one could believe such a thing. Certainly no president of a great country would listen to a dead crank who spouted such nonsense. But, there it is.
There is a story at the link about Keynes dirtying some towels in a washroom and claiming that he had just helped the economy by creating work.
How many obviously false statements must a person make before the quality of his entire thought is in question? The limit has not yet been set for Keynesian economists and politicians.
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The Keynesian Accounting Trap
06/17/10 - 12/21/09 - Mises.org by Robert P. Murphy
[edited] I think Krugman [a Keynesian economist and pundit] is committing a very basic error. He is confusing the Keynesian accounting identity [the GDP Formula above] with a causal theory of how changes in one of the variables lead to changes in the other variables.
This formula very often misleads people that the way to increase output [GDP] is to try to increase one of the variables on the right side. But this is a fallacy. The accounting identity must always be true, but it can remain in balance if other variables on the right side fall.
Krugman is wrong even within the Keynesian framework. For example, Keynesians often use this formula to argue that increases in government spending are necessary to "fill the gap" when private consumption and investment are below "potential GDP." They naively assume that boosting Government Spending on the right side of the formula will lead to an increase in GDP on the left side. But, that relies on the Keynesian theory of how the macroeconomy works; it doesn't follow from the formula itself.
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Bigger Government Is Not Stimulus
12/15/08 - Cato Institute by Dan Mitchel (YouTube video 7:29)
A video by the Center for Freedom and Prosperity Foundation.
Both theory and evidence show that allowing politicians to spend more money does not produce better economic performance. Keynesian theory doesn't make sense. Government can only put money into the economy by first taking it out as borrowing. Transferring the economy’s money from its left pocket to its right pocket is not a recipe for growth.
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Macroeconomics is Astrology, Not Science
01/30/09 - EO -> RealClearMarkets
Frank J. Tipler is Professor of Mathematical Physics at Tulane University:
[edited] The inability of macroeconomic theories to make accurate predictions about an entire economy means that those economists do not know what they are talking about. Our leaders are being advised by macroeconomists who haven’t got a clue where they are leading us. Their actions may lead us out of the current recession, or they may lead us into a depression as bad as the Great Depression.
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