How Is GDP Financed?

It may seem strange to ask how GDP is financed.  GDP simply measures the total market value of final goods and services that an economy produces.  It is a way to measure national income, not a measure of assets on a national balance sheet. 

But the way GDP is paid for does matter.  If large quantities of borrowed money finance GDP, then GDP in future years may be less sustainable than GDP produced by organic growth (i.e., GDP derived from people and companies spending their earnings, rather than borrowings).  The pauper nations of the EU, mostly located on the southern rim, are good examples.  They borrowed heavily (or their banks borrowed heavily) to finance consumption.  For a while, their GDPs grew.  But debt, unfortunately, has to be repaid.  A nation's whose GDP is heavily dependent on borrowed money will eventually have to pay the piper.  If those payments are burdensome enough, the nation's GDP bubble will burst, and recession will follow.  That isn't hypothetical; look at Greece, Ireland, Cyprus and Spain.  Indeed, look at the EU as a whole, which is sinking into recession even as we blog.

In America, the picture ain't pretty.  Even though GDP is nominally growing, in the first quarter of this year at an annual rate of 2.5%, the question of sustainability looms.  The federal government is constraining its borrowing (partly because of sequestration and partly because of Social Security and income tax increases).  Thus, the federal budget wouldn't be a source of GDP growth. 

But the Federal Reserve's quantitative easing program is.  The Fed is pumping $85 billion a month into the economy through purchases of financial assets.  Over a full year, the QE program would pump $1 trillion into the economy.  That's equivalent to about 6% of America's $16 trillion GDP.  It wouldn't be accurate to say that $1 trillion spent on QE results in $1 trillion of GDP.  Much of the money printed by the Fed for QE is recycled back to the Federal Reserve System in the form of member bank deposits at Federal Reserve banks.  This process is a near wash (except that it gives the depositor-banks riskless profits).  But QE is boosting the economy.  Our stock market--bizarrely exuberant in the face of a tepid economy--needs its regular fix of QE to maintain and increase its high.  The real estate markets seem to be getting a boost from the Fed's purchases of mortgage-backed securities.  Increases in asset values such as these appear to be creating a wealth effect that boosts spending (mostly by the top 10%).  That is probably a primary source of GDP growth today. 

But QE is similar to borrowed money.  At some point, the Fed will start selling down its more than $3 trillion balance sheet.  This akin to debt repayment.  It will remove money from the economy.  When there is less money to spend, there may well be less economic growth.  The Fed is hoping that the economy will be organically growing briskly by the time it goes into QT (i.e., quantitative tightening).  But there's no way to know for sure that will be the case.  The Fed may have to shift to QT because of a rise in inflation, whether or not growth has revived.  Whatever the reason for QT, it will constrain growth.  In some circumstances, it could produce a recession. 

Like toothpaste and genies, QE on the loose isn't easily put back into the place where it came from.  There's no riskless way to execute QT.  It's possible that continuation of the Fed's QE program could stimulate the economy to resume vigorous growth.  But that's far from certain.  And every additional month of QE heightens the risks that our economy is becoming overleveraged.

The China GDP Head Fake?

Yesterday, April 12, 2012, rumors in the morning about China's first quarter GDP growth coming in around 9%, higher than the expected 8.4%, fueled a stock market rally. (See http://blogs.wsj.com/marketbeat/2012/04/12/stocks-jump-china-gdp-whisper-number-fuels-rally/). The Dow Jones Industrial Average bounded up 183 points.

Today, China's first quarter GDP growth was reported at 8.1%, lower than expectations by 0.3%. (See http://money.cnn.com/2012/04/12/news/economy/china-gdp/). The Dow closed down 136. The rumor was wrong, seriously wrong.

Maybe it was all an innocent mistake. After all, today's Friday the 13th. Maybe someone just misinterpreted something and spread the misinterpretation. But one thing's for sure. Some people made a bunch of money trading the market up yesterday, and then trading it down today. Volatility makes money for Wall Street pros, including market makers, specialists, high speed traders and so on. But some less cynical market participants, who bought and held overnight, probably lost money and quickly.

Volatility can come from exogenous sources. The idiocy underlying the EU's structural problems and its sovereign debt crisis weren't creations of Wall Street. But they sure as pumpernickel have caused a lot of volatility.

There's also home grown volatility, emanating from Wall Street sources that might have a good day at the office if the market is hopping. Spreading truthful and accurate news is generally okay, unless it happens within the context of insider trading. But spreading false information can make regulatory brows furrow.

It's difficult to investigate rumor mongering, especially if the rumor concerns aggregate economic data (as opposed to company-specific or security-specific information). But trading surges triggered by false information undermine investor confidence. Natural investors (i.e., those that buy with the hope of profiting from investing, as opposed to make a quick buck from trading) are the foundation of the financial markets. But, with the 2000 tech cash, the 2008 financial crisis, and the 2010 flash crash, they are leaning, if not running, toward the exits. It really doesn't help when they are jerked around by false rumors.

Demote GDP and Enhance Economic Well-Being

The most frequently used measure of economic well-being is Gross Domestic Product. Government and private sector leaders, economists, commentators and polemicists fixate over GDP. Its upward movements prompt celebrations and congratulations (usually, self-congratulations). Its downward movements provoke calls for resignation, electoral ouster, and tea parties, and fuel no end of tiresome cable TV commentary. Whether the country is in an economic downturn or upturn is defined by movements in GDP.

Whenever a numerical figure is used as an important benchmark, it can become a tail that wags the dog. A well-known example is corporate earnings per share. Public companies scheme and maneuver to make earnings per share large enough to cast management in a good light and boost the company's stock price. While there are legal ways to "manage" earnings per share, financial regulators' rap sheets are replete with public companies that lied and cheated in order to doll up their financial statements. Earnings per share as a benchmark drives behavior. It is a narrow, incomplete way of measuring a company's value, which diverts management's attention toward the next quarter and away from long term planning and investment.

The use of GDP to measure economic well-being may distort government behavior. GDP, as it's usually calculated, measures the amount of a nation's consumption and investment. It includes private consumption (ham, eggs, shoes, DVDs, cars, kiddie train sets, etc.), gross investment (basically, business investment plus new home sales), government spending (which doesn't include transfer payments like Social Security and unemployment compensation, but these tend to get picked up through private consumption), and net exports (gross exports minus gross imports, which can yield a negative number). Most of GDP consists of consumption (private consumption and most government spending, reduced by net exports (read, net imports)). Business investment, new home sales, and government investment account for a relatively small portion of GDP.

GDP does not differentiate between consumption financed with debt, as opposed to consumption paid for with earnings or savings. Thus, consumers indulging in home equity loans or cash out mortgage refinancings boost GDP by the full extent of the dollars they borrow and spend. The same is true when a government borrows money to pay for its spending. Thus, the government is incentivized to borrow and spend in order to boost GDP, as opposed to raising taxes to cover its budget (which would reduce private spending and perhaps business investment, thereby diminishing GDP). The government is similarly rewarded when it cuts taxes (providing more money for private consumption and business investment), and substitutes borrowed money to cover its budget. Either way, government borrowing can boost GDP and make the government look good.

Government subsidies of private borrowing, such as home mortgage and home equity loans, can also enhance GDP, because GDP is not adjusted for private consumption fueled by debt. If government policy inflates home prices, which in turn encourage more tax code subsidized borrowing to finance consumption, the larger GDP becomes and the better the government looks.

A major shortcoming of GDP is that it doesn't reflect the worst aspects of the current financially driven economic crisis. Instability and volatility in the stock and real estate markets have shaken the middle and upper middle classes. Increased unemployment levels don't show up in GDP. Wage and salary cuts, reductions in working hours, and other earnings losses aren't recorded in GDP. The hundreds of billions of dollars of interest income lost by savers, who can get barely a pittance for their hard earned savings, is not an input for GDP. Even the loss of home equity loans and generous credit card lines of credit, so important to fueling the boom of the early 2000s, doesn't enter into the calculation of GDP. All of these factors may be reflected indirectly in lower consumption and reduced business investment. But those statistical effects don't begin to reflect the insecurity gripping tens of millions of Americans. Government pronouncements and Wall Street boosterism that tout GDP growth clash with the daily experiences of typical Americans. A recovering GDP uplifts the stock market, disproportionately benefiting the wealthy and well-to-do. But this uneven impact fuels Tea Parties and other harbingers of discontent.

A number of readily available statistics can be used to create a more complete picture of economic well-being. Unemployment levels, median household income, per capita income, distribution of income, trends in asset values, volatility in asset values, savings rates, debt growth or reduction, business investment, and changes in worker productivity all help to round out the picture. There is no single measure of economic well-being that really works. We have to look at a basket of statistics to get the full picture. And getting the full picture would lead to more well-rounded government policies. GDP is a valid measure of an economy's size. But using it as the principal benchmark for the government's performance can distort government policy by encouraging borrowing, while reminding numerous Americans that they remain outside the Beltway.

Homeowners didn't become wealthier by embracing home equity loans and cash out mortgage refinancings. They simply frontloaded their consumption. Now, later in life, they are having to pay for their unwillingness to delay gratification. Borrowing to finance government spending is largely the same (with the exception of government investment in highways, bridges and other infrastructure, which may enhance future economic growth). A better balanced approach to measuring economic well-being would reduce the political reward to the government from borrowing to finance deficits.

The Euro zone sovereign debt crisis illustrates the dangers of outsized government borrowing. Greece's economy is about 0.6% of the world economy. But bailing it out has proven to be intractable. Imagine what could happen if a much larger economy overspent.