Time to Put a New Economic Tool in the Box by John Mauldin, Mauldin Economics

Say’s Law Makes a Comeback
The BEA Introduces Gross Output
Time to Put a New Economic Tool in the Box
First, Let’s Kill All the Regulations
Where Did the Jobs Come From?
More Videos from the Conference
Whistler, Maine, Montana, and San Antonio

[E]conomists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.

It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences – an attempt which in our field may lead to outright error. It is an approach which has come to be described as the “scientistic” attitude – an attitude which, as I defined it some thirty years ago, “is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.

– Friedrich Hayek, from the introduction to his Nobel Prize acceptance speech in 1974

Last week we took a deep dive into how the concept of GDP (gross domestic product) came about. We looked at some of the controversies surrounding GDP statistics that we use to measure the growth of the economy, and we noted that the GDP tool seems designed to reflect and serve an economic theory (Keynesianism) that prefers to focus on the demand side of economic activity. If your measurement of the growth of the economy is entirely defined by final consumption (that is, consumer spending) and government spending, then if you want to try to improve growth you are left with just two policy dials to adjust:

  1. How do we increase consumption?
  2. How much government spending should there be to stimulate growth when the economy is in a recession?

But what if there are other ways to measure the economy? Might those other measurement tools suggest a different set of policies and methods to help the economy grow? Indeed, I noted last week that the one thing – besides science fiction – that Paul Krugman and I agree on is that we need more growth. (There are actually some economists out there who don’t agree with that assessment. Go figure.)

As it happens, Mr. Krugman stumbled upon my post and wrote the following under the heading “The Horror, the Horror”:

I happened to click on this John Mauldin post, in which he informs us that GDP is a Keynesian plot, and that without it Hayek would of course have won the macroeconomic debate. Oh, kay – but that’s not the horror. It’s this:

“We have now made the Newt Gingrich and Niall Ferguson Strategic Investment Conference videos available. … This week, we are happy to provide even more material from this incredibly informative event. Newt Gingrich and Niall Ferguson were the two highest rated presenters at a conference packed with some of the finest economic and investment minds in the world.”

Oh, boy.

Well, we did feature two of Paul K’s least favorite people at the conference. (His debates with Niall are classic.) I don’t know why, but I started reading the comments to Paul’s piece from readers, some of which were quite thoughtful and showed that commenters had actually read my letter. To those who found me from that link, let me point out that we also had at the conference my good friend, über-Keynesian Paul McCulley, who, along with two or three of the other speakers, was more than capable of defending the Keynesian position. Paul has been a featured speaker at our conference for over 10 years, but I am quite sure there are many people who wonder why we would include him. As I have always maintained in this letter and in my Outside the Box letter, I think it is important to consider and try to appreciate all positions. In fact, I even featured Mr. Krugman himself in Outside the Box, back in 2009.

(At the end of this letter I offer a link to let you see our conference speeches and judge the various positions for yourself.)

All that being said, Mr. Krugman, I don’t think GDP as it is measured today is a Keynesian plot. GDP is a valuable measurement tool, if you understand what is being measured and all those asterisks with caveats that attend any such measure. But as we will see in this week’s letter, there are other ways to measure GDP that would suggest additional policy dials for spurring economic growth.

Say’s Law Makes a Comeback

Actually, the debate on what constitutes an economy goes back much further than Keynes and Hayek. The debate was well recounted in an essay by economist Steve Hanke, a professor of applied economics at Johns Hopkins University. Let’s quote a few paragraphs:

The Classical School of economics prevailed roughly from Adam Smith’s Wealth of Nations time (1776) to the mid-19th century. It focused on the supply side of the economy. Production was the wellspring of prosperity.

The French economist J.-B. Say (1767-1832) was a highly regarded member of the Classical School. To this day, he is best known for Say’s Law of markets. In the popular lexicon – courtesy of John Maynard Keynes – this law simply states that “supply creates its own demand.” But, according to Steven Kates, one of the world’s leading experts on Say, Keynes’ rendition of Say’s Law distorts its true meaning and leaves its main message on the cutting room floor.

Say’s message was clear: a demand failure could not cause an economic slump. This message was accepted by virtually every major economist, prior to the publication of Keynes’ General Theory in 1936. So, before the General Theory, even though most economists thought business cycles were in the cards, demand failure was not listed as one of the causes of an economic downturn.

All this was overturned by Keynes. Kates argues convincingly that Keynes had to set Say up as a sort of straw man so that he could remove Say’s ideas from the economists’ discourse and the public’s thinking. Keynes had to do this because his entire theory was based on the analysis of demand failure, and his prescription for putting life back into aggregate demand – namely, a fiscal stimulus [read: lower taxes and/or higher government spending].”

The BEA Introduces Gross Output

So what other tool than GDP might we use? Conveniently, on this very day, July 25, 2014, the Bureau of Economic Analysis begins to publish a quarterly statistic called “gross output.” A good part of the reasoning behind this new statistic and the impetus to produce it comes from a book published in 1990 by my friend of 30 years Dr. Mark Skousen. The book was titled The Structure of Production, and in it Skousen forcefully argued that production rather than demand should be the basis for analyzing the strength of an economy. No less an authority on productivity than Peter F. Drucker commented in a review at the time, “The next economics will have to be centered on supply and the factors of production rather than being functions of demand. I’ve read Mark Skousen’s book twice, and it comes the closest to achieving this goal.&rdq uo;

Gross output (GO) measures the total output of an economy, including investments made by businesses in order to produce their goods, such as capital outlays on new equipment, raw materials, or other business-to-business transactions. In Structure, Skousen makes the case that modern economists downplay the importance of the business sector in the economy and overstate the importance of consumer spending. He believes that the GDP should not be used as the sole measure of economic activity.

Let’s go to the lead editorial by Mark that was published in the Wall Street Journal just a few months ago:

Why pay attention to gross output? For starters, research I published in 1990 shows it does a better job of measuring total economic activity. GDP is a useful measure of a country’s standard of living and economic growth. But its focus on final output omits intermediate production and as a result creates much mischief in our understanding of how the economy works.

In particular, it has led to the misguided Keynesian notion that consumer and government spending drive the economy rather than saving, business investment, technology and entrepreneurship. GDP data at the end of 2013 put consumer spending first in importance (68% of GDP), followed by government expenditures (18%), and business investment third (16%). Net exports (-2%) makes up the difference.

Thus journalists and many economic analysts report that “consumer spending drives the economy.” And they focus on retail spending or consumer confidence as the critical factors in driving the economy and stock market. There is an underlying anti-saving mentality in this analysis, as evidenced by statements frequently made during debates on tax cuts or tax rebates that if consumers save their tax refund instead of spending it, it will do no good for the economy. Presidents including George W. Bush and Barack Obama have echoed this sentiment when they encouraged consumers to spend rather than save and invest their tax refunds.

Although consumer spending accounts for about 70% of GDP, if you use gross output as a broader measure of total sales or spending, it represents less than 40% of the economy. The reality is that business outlays – adding capital investment and all business spending in intermediate stages of the supply chain – are substantially larger than consumer spending in the economy. They make up more than 50% of economic activity.

Going back to my more visual “dials” metaphor, when you look at gross output you see that it gives us an additional and much larger dial for stimulating growth than simply trying to increase consumer spending. The real driver of the economy, as measured by gross output, is not consumer spending but private production and business spending. And indeed, we find that that is where the jobs are, and they are far higher-paying jobs than in the retail sector, which is where final consumption resides.

Let’s look at a few graphs my associate Worth Wray created for me today using the new data provided by the Bureau of Economic Analysis. You can see the actual data

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