Polly want a cracker?

One of the most basic ways of learning something new is to copy or imitate someone else. What if the action being imitated is not just any behavior, but the parroting of something said by other people? If the words being uttered are supposed to convey a sense that the speaker is wise and knowledgeable on the subject then there may be no motivation to really work at understanding the phrase being spoken. Even when what is being said is correct in a strict sense, other ideas flowing from a statement may be misleading. An economic platitude oft repeated is that consumption represent two thirds of GDP (perhaps a lesser portion in the past).

The implication is that consumption is all important, with another set of implications flowing from that observation. The whole point of producing is to consume either in the present or in the future. As economist Alfred Marshall stated, supply and demand work together like the blades of a scissor. Consumption and production are both important but I think that production is the more important driver of the economy under most circumstances. Furthermore, this perspective is more useful in any attempt to understand economic activity.

This article from a few years ago by Mark Skousen provides a good example.

Good news! The U.S. Department of Commerce, which compiles Gross Domestic Product (GDP), has just added a new national income statistic, Gross Output (GO), as a measure of total spending in the economy. I have been making the case for this new statistic for over ten years. Now it is a reality.

Most students of economics are unaware of the fact that GDP was created by Simon Kuznets during World War II to quantify final aggregate demand according to the new economics of Keynes. As such, GDP ignores all intermediate spending in the economy, based on the tenuous argument that earlier stages of production constitute double counting.

First, GDP is a Keynesian concept that measures only the output of final goods and services and excludes intermediate production. Second, government spending is included in GDP data, an autonomous addition to national output.

Both peculiarities of GDP have led to much mischief. In the first case, by focusing solely on final output, many economists and commentators in the media have concluded that consumer spending is more important than capital investment in an economy, based on the fact that consumption expenditures usually represent about two-thirds of GDP. In the second case, including government spending in GDP has led many pundits to believe that an increase in that spending—even if accomplished through deficit spending—will automatically increase economic growth (or conversely, a cut in government spending will inevitably lead to a recession). Both conclusions are false.

Intermediate Input (II) represents the sale of all products in the natural resource, manufacturing, and wholesale markets. GDP represents the final retail market.

I am currently working on a professional paper analyzing GO and II statistics and how they increase our understanding of the economy. Since this paper will not be published for some time, let me give you a few of my preliminary conclusions. Overall, much of the data appears to confirm several Austrian themes.

First, the data support the Austrian theory that the structure of production lengthens as an economy grows. Indeed, from 1987 until 1998 real GDP rose from $6.1 trillion to $8.8 trillion, or 39 percent (using 1996 as a base year). But real Intermediate Input (II) increased from $4.3 trillion to $6.5 trillion, or 53 percent, much faster than GDP. In other words, the producer/capital goods market grew more rapidly than the consumer/retail good market. This suggests that the number of stages of production increased.

Second, the data seem to confirm the Austrian view that production in the intermediate processes tends to be more volatile than final output and thus more sensitive to the business cycle. For example, during the 1990-91 recession, real GDP fell $31.5 billion, while real II fell $74.6 billion—more than twice retail sales. Since then, intermediate production has grown substantially faster (41 percent) than consumer spending (27 percent) from 1991 to 1998. I would like to test these statistics during previous boom-bust cycles (such as 1973-75 and 1980-82), but unfortunately, the data for II and GO are incomplete prior to 1987.

Third, GO data support the Austrian argument that business investment—not consumer spending—is the driving force behind economic growth. The Keynesian argument that consumer spending is the largest sector of the economy is specious and is based on a misunderstanding of GDP statistics. It is true that personal consumption expenditures typically represent 67 percent of GDP, but GDP is not total spending in the economy. On measuring total spending (GO), one sees that the capital/producer goods industry is substantially larger than the final consumer/retail goods industry. Using 1998 data, we find that personal consumption expenditures amount to $5.8 trillion, only 38 percent of GO, and gross business investment (which includes all intermediate production, plus gross fixed investment) amounts to $7.9 trillion, 52 percent of total spending.

In sum, intermediate production does matter, and GO is a better indicator of what is happening in the entire economy, not just the retail sector.

Some of the usual platitudes about consumption may be technically correct, but are ultimately misleading when striving for deeper economic understanding. As an aside, can you imagine a group of central planners orchestrating the deepening of the capital structure as implied above? Yeah, me neither!