BusinessWeek on the GDP Mirage

Michael Mandel at BusinessWeek claims that By overlooking cuts in research and development, product design, and worker training, GDP is greatly overstating the economy's strength.

Please consider The GDP Mirage.

Here's a riddle: If a scientist or engineer is laid off, does it affect gross domestic product?

The third-quarter GDP figures, released on Oct. 29, showed the economy growing at a 3.5% annual pace, breaking a string of four consecutive negative quarters.

The trouble is that those GDP and productivity growth figures could be significantly overestimated�perhaps by one percentage point or even more.

That's because the official statistics are not designed to pick up cutbacks in "intangible investments" such as business spending on research and development, product design, and worker training. There's ample evidence to suggest that companies, to reduce costs and boost short-term profits, are slashing this kind of spending, which is essential for innovation. Without investment in intangibles, the U.S. can't compete in a knowledge-based global economy. Yet you won't see that plunge reflected in the GDP and productivity statistics, which are still too focused on more traditional sectors, such as motor vehicles and construction.

Here's a sobering sign that companies are robbing the future to pay for short-term profits: Over the past year, U.S. employment of scientists and engineers�the people who create the next generation of products and make the U.S. more competitive over the long term�has fallen by 6.3%, according to a BusinessWeek tabulation of unpublished data. Yet overall employment has fallen only 4.1%. "There are really bright people who are struggling to find a job," says Josh Albert, managing director at Klein Hersh International, an executive search firm for life scientists.

The Bureau of Economic Analysis, the government agency that compiles the GDP figures, is taking steps to deal with the new realities. Software has been treated as investment since 1999, and the BEA plans to include R&D in the official GDP statistics in 2013, four years from now. But the agency acknowledges that other areas of intangible investment still need to be worked into the numbers. "We think it's important not to ignore the fact that R&D is only part of broader innovative activity," says BEA Director J. Steven Landefeld. For now, though, the U.S. is navigating through the downturn with fragmentary information.

While the statistics don't account for it, there's good reason to suspect intangible investments are falling. Companies are under pressure to cut costs by reducing R&D expenditures and deferring other crucial intangibles, notes Hulten. "Because these are expensed, it looks like a pure win," he says. "You are not seeing the benefits of the intangibles in the financial statements�only the costs."

One clear-cut sign that GDP growth is being overestimated: the sharp drop in venture capital investment, which goes directly to new businesses. VCs invested about $12 billion in the first three quarters of 2009, barely half the $22 billion plunked down during the first three quarters of 2008. Some of this shortfall would have been spent on computers and other physical equipment, which would have been picked up in GDP. But most of the drop in VC money would have gone to pay for scientists, engineers, and new product development�all valuable intangible investments that show up nowhere in the published stats.

Adding to the uncertainty, companies report their R&D only on a global basis, not broken out by country. As a result, even though some companies are adding to such spending, there's no way to know how much of those increases are taking place in the U.S.

Counting Production Before There Is Any

There is much more in the article. Please take a look.

I have met Mandel. He is a smart guy. However he is counting chickens before they are hatched, better phrased as counting production before there is any. Research may pay off, or it may not. When it does pay off it may be 5 years from now or 20 years from now. It may pay off a little or it may pay off a lot.

Attempting to count what does not exist, and may never exist is simply wrong. Compounding the problem is the last paragraph in the blockquote above. Are we supposed to give the US GDP a boost because the thinking takes place here rather than the UK or Japan?

The reality is that it does not matter where the thinking or the research occurs. All that matters is that a product is created that people want to buy. That is what GDP is and should be.

Mandel is correct in one aspect: That cutbacks in R&D are highly likely to affect future GDP. However, one just does not know when or by how much or even what country will benefit.

GDP is hugely overstated, but not for the reasons Mandel suggests. GDP is distorted by hedonics, imputations, and government spending.

Imputations

Imputations are a part of GDP that the government decides to estimate value, where no cash actually changed hands. In other words, if I scratch your back and you scratch mine but no one gets paid, then back scratching is undercounted in the GDP.

One such imputation is the value of "free" checking accounts. The reality is bank checking accounts are not free. Banks are sweeping out nearly every penny every night and lending the money out. What's "free" is the fact that banks have free access to your money.

Nonetheless the BEA assigns a value to those free checking accounts and adds it to the GDP.

Imputations go far beyond that into other absurdities. For example: If you own your own house, the government recalculates your income as if you were renting your house from yourself and thus paying yourself rent.

Imputed rent just happens to be one of the most frequently asked questions of the BEA. Please consider Why does GDP include imputations?

In the GDP, the purchase of a new house is treated as an investment; the ownership of the home is treated as a productive activity; and a service is assumed to flow from the house to the occupant over the economic life of the house. For the homeowner, the value of that service is measured as the income the homeowner could have received if the house had been rented to a tenant.

Another important imputation measures financial services provided by banks and other financial institutions either without charge or for a small fee that does not reflect the entire value of the service. Examples are checking-account maintenance and services provided to borrowers. For the depositor, this �imputed interest� is measured as the difference between the interest paid by the bank and the interest that the depositor could have earned by investing in �safe� government securities. For the borrower, it is measured as the difference between the interest charged by the bank and the interest the bank could have earned by investing in those government securities.

Since the mid-1990s, the shares of GDP accounted for by some imputations have increased as the activities measured have grown faster than other activities.

• From 1996 to 2006, the share of GDP accounted for by the imputation for owner-occupied housing increased from 6.0 percent to 6.2 percent.
• From 1996 to 2006, the share of employer contributions for private health and life insurance grew from 3.2 percent of GDP to 4.2 percent of GDP.
• From 1996 to 2006, the share of all imputations in GDP grew from 13.8 percent to 14.8 percent.
• In 2006, imputed financial services represented 1.7 percent of GDP, the same as in 1996.

Imputed rent makes about as much sense as the idea we rent cars or lawnmowers from ourselves.

Hedonics

Hedonics is a way of accounting for the changing quality of products when calculating price movements. For example, today's computers are many times faster and have more memory than models produced just a few years ago.

The BEA adjusts prices for the improved quality as noted in The Role of Hedonic Methods in Measuring Real GDP in the United States.

I believe prices are prices. The way to measure productive output is simple: goods times real prices paid, not goods times what the government thinks the value of the product is.

Definition of GDP

Wikipedia gives several Formulas for GDP.

GDP can be defined in three ways, all of which are conceptually identical. First, it is equal to the total expenditures for all final goods and services produced within the country in a stipulated period of time (usually a 365-day year).

Second, it is equal to the sum of the value added at every stage of production (the intermediate stages) by all the industries within a country, plus taxes less subsidies on products, in the period.

Third, it is equal to the sum of the income generated by production in the country in the period�that is, compensation of employees, taxes on production and imports less subsidies, and gross operating surplus (or profits).

The most common approach to measuring and quantifying GDP is the expenditure method:

GDP = private consumption + gross investment + government spending + (exports - imports).

The problem is that government spending, no matter how useless, unproductive, or overpriced it may be, adds to GDP. That is likely the biggest problem, not hedonics or imputations.

GDP Stall Rate

If it seems like the economy is at the stall rate when it is growing at 2.00 or even 2.5% it is because it is.

Inquiring minds are taking another look at the Incredible Shrinking Boomer Economy.

In his Town Hall Meetings Bernanke said:

"It takes GDP growth of about 2.5 percent to keep the jobless rate constant. But the Fed expects growth of only about 1 percent in the last six months of the year. So that's not enough to bring down the unemployment rate."

Inquiring minds might be asking: Why does it take 2.5% growth to keep the jobless rate constant? The answer is the first 2.5%+- of GDP is fictional. When the economy is growing at 2%, it feels like a recession because it probably is, even though no one will admit it.

GDP has grown 3.2% a year since 1965. In a recent study, McKinsey forecast GDP growth of 2.4% over the next three decades as boomers ratchet back.

If Bernanke is correct that it takes 2.5% GDP growth just to keep the unemployment rate constant, and McKinsey is also correct in its 2.4% forecast, we will be stuck with 10% unemployment for decades.

One can believe the reported GDP numbers or not. I don't. And if GDP slips back to 1.5% to 2% don't expect any jobs to come out of it because they won't.

Yes, GDP is a mirage, but not for the reasons Mandel suggested.

Let's now answer Mandel's riddle "If a scientist or engineer is laid off, does it affect gross domestic product?"

The answer by now should be clear: Is does not affect current GDP but it may affect future GDP in an unknown, impossible to predict way, in terms of the time it will take to see any products, as well as the present and future value of those products.

I have two questions for Mandel:

1) Do we really want some bureaucrat at the BEA figuring out the present value of research and training (especially government research and training) and adding that to current GDP?

2) Isn't GDP distorted enough already?

Addendum:

Chris Martenson has an article on GDP and other Fuzzy Numbers that inquiring minds may wish to read.

The reality is GDP ought to stand for Grossly Distorted Procedures, not Gross Domestic Product.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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