If you want to lose weight, you can starve which will guarantee weight loss or you can go on a well balanced diet. A starvation diet is a bad diet and a well balanced diet is a good one.
Today nutritionists teach us that not all fats are bad. In fact some diets encourage eating a fair bit of fat with a high protein low carb diet. It turns out there are good fats that can actually contribute to weight loss.
When it comes to economic growth, not all growth is good.
The problem starts with the way most economists and governments measure economic growth, i.e. GDP (gross domestic product). There are major shortcomings with this approach, I will probably do a proper critique on this metric in a future letter but for the purposes of my note today we can simply look at the components of the metric as a base to work from.
GDP = P + I + G + (E – Im)
P = Personal Consumption Expenditure
I = Investment
G = Government Expenditure
E = Exports
Im = Imports
It is Sunday so I don’t want to stress you out with algebra, lets park this equation for now and come back to it shortly when we have a few more pieces of the puzzle on the table.
In 1850 French economist Frederic Bastiat wrote in an essay a now famous parable of the broken window to illustrate how destruction and its recovery is not a benefit to society.
In the parable Bastiat describes the scene where a shopkeepers son carelessly breaks the pane of glass in the window. This results in them having to call the glazier to fix the broken window. The shopkeeper pays the glazier some money say $100. The glazier takes the money and deposits $50 in the bank and spends the rest in the local market. The bank lends $500 (with fractional reserve banking banks are only required to hold 10% in reserves). The $500 loaned by the bank gets spent in the economy.
The net result is that from that 1 broken window and a $100 expenditure, the money circulating in the economy increased by $500. Was that a good $100 of expenditure? All it achieved was fixing something that was already working, surely its not a good way to spend money. The shopkeeper surely could have spent his money on more productive resources.
Let us look at another example:
2 people dig a hole and are paid $1000 each. After digging a massive hole for the entire day, the one digger is told to fill his hole with the soil he removed and the other is told to fill his hole with water. Is the $1000 spent on each hole of equal value? The one has no purpose and achieved nothing but blisters and a sore back the other one results in a swimming pool.
Ok its time to bring this back to the GDP formulae. When people spend lots of money on consumption like flatscreen TVs, colourful sneakers and things that bring little productivity to the economy it still contributes “P” to the GDP measure. When government spends money on welfare cheques, military equipment and road infrastructure this contributes to “G” in the GDP calculation. There is a big difference between spending G to give people a cheque to go spend $1000 on a flat screen TV and spending $1000 towards roads, schools, energy power plants etc….. However GDP does not make the distinction.
Repairing broken windows is not a productive way of spending money. Rather the money spent on repairs could either be saved to spend on productive investments in the future or it could be spent on productivity enhancing investments today.
The same could be said for money spent on needless fashion items or consumer goods that provide once off enjoyment at the expense of investing in goods that provide future benefits. For example spending money on a coding course that will teach you how to increase your productivity by getting a machine to do work in seconds that was previously taking you hours.
The same could be said for governments spending huge amounts on wars or military equipment or welfare payments or other items that do not produce the kinds of long term returns that investing in productive resources do.
So in the end you have good economic growth that is productive and you have bad or empty calorie economic growth that gives you a short term buzz as it does the GDP metric but long term it adds very limited lasting value.
My goal is not to act as some killjoy and suggest that there is no place for consumption and welfare in a healthy economy. Rather my goal here is to provide you with the knowledge that GDP is a weak measure of the underlying health of an economy. Do not be the sucker to fall for the headline numbers when the talking heads on TV and the newspaper headlines shine the light on high GDP growth. Rather ask yourself the question have the numbers been focused on digging holes only to refill them or are they digging holes to build swimming pools.