You Cannot Manage New Economies With Obsolete Measuring Tools
First-year students of statistics are routinely warned that, “On average, every person has one ovary and one testicle.” More seriously, they may be told the story of the six-foot man who drowned in a river with an average depth of four feet.
These quips are supposed to prevent students from mindlessly using irrelevant or misleading statistical averages or aggregates. Yet economists often do just that when they measure a country’s or a region’s activity and growth rate by using statistics that bundle together sectors or jobs that, in reality, are behave quite differently from each other.
Often, a single macroeconomic statistic aggregates or averages components that could signal either economic weakness or an acceleration with the potential to rekindle inflation. The resulting uncertainty probably is why, today, the major central banks still hesitate between more monetary easing and its opposite, a return of higher interest rates.
Math, Myths, and Misunderstandings about China
We see one of the most obvious current examples of how misleading averages and aggregates can be in the ongoing, so-called “rebalancing” of the Chinese economy.
[drizzle]Several years ago Andy Rothman, one of the most astute and least “bipolar” analysts of the Chinese economy, acknowledged an emerging consensus that the country’s GDP would soon slow down from its breakneck pace of more than 10-percent growth per annum. He warned, however, that this slowdown would not happen evenly across the board.
Once the huge pent-up demand for infrastructure, plant construction, and housing was satisfied, these sectors would settle into the lower growth rates typical of more-developed economies. However, household spending was still in its infancy, and would probably continue to grow at double-digit rates. It thus would remain “the world’s best consumption story”; but since it could not physically be expected to accelerate beyond the annual 11 percent of recent years, China’s GDP would naturally settle into a much slower growth trend. That, however, would not necessarily be cause for alarm.
Rothman recently updated his views, from which I paraphrase some snippets with my own emphasis added 1:
- Exports haven’t contributed to GDP growth for the past seven years. Only about 10 percent of the goods rolling out of Chinese factories are exported. China largely consumes what it produces.
- Manufacturing is sluggish, especially in heavy industries such as steel and cement, as China has passed its peak in the growth rate of construction of infrastructure and new homes. But factory wages are up 5 to 6 percent this year, reflecting a fairly tight labor market, and more than 10 million new homes will be sold in 2015. Manufacturing has not collapsed.
- China has rebalanced away from a dependence on exports, heavy industry, and investment: Consumption accounted for 58 percent of GDP growth during the first three quarters of this year. Shrugging off the mid-June fall in the stock market, real (inflation-adjusted) retail sales actually accelerated to 11 percent in October and November, the fastest pace since March. China has remained the world’s best consumption story.
- Unprecedented income growth is the most important factor supporting consumption. In the first three quarters of this year, real per-capita disposable income rose more than 7 percent, while over the past decade, real urban income rose 137 percent and real rural income rose 139 percent.
- The strong consumer story can mitigate the impact of the slowdown in manufacturing and investment, but it can’t drive growth back to an overall 8-percent pace.
So we are far from the gloomy forecasts of analysts who blindly trust GDP statistics aggregating very disparate sectors or, worse, who mistake stock-market fluctuations for evidence of economic strength or weakness.
Measurement Lags Reality
I am not a fervent disciple of the “This Time Is Different” School of Economics. In fact, I have often argued the opposite – that, over its cycles, history tends to “rhyme”2. Still, economies do change over time, and one of the problems of economic analysis is that the way in which we measure activity or growth often lags well behind changes in the real world.
In the late-1980s, for example, Tocqueville Asset Management argued that America’s manufacturing was not dying, as the consensus then proclaimed, but was in fact being reborn, as became apparent in the 1990s. One of our main arguments, articulated with the help of Harvard Professor Robert S. Kaplan, was that corporations were still using accounting methods invented in the 19th century, when basic, heavy industries dominated economic activity3.
In these “ancient” times, raw materials and direct (or “touch”) labor constituted up to 80 percent of total manufacturing costs. It was thus acceptable, when analyzing companies’ sources of profits, to allocate “indirect” costs (those difficult to impute to specific activities or products) in proportion to the easier-to-measure costs of materials or direct labor. But by the 1980s, electronics and other newer and lighter industries used fewer raw materials; their direct labor rarely exceeded 5 to10 percent of total costs. As a result, a situation had developed where a majority of total costs was allocated arbitrarily based on the small portion that was easily measurable.
This obsolete accounting method grossly misestimated which corporate segments were profitable or not, so that corporate strategies often continued to fund less-profitable, traditional activities instead of investing in potentially more-profitable opportunities. This had been detrimental, not only to the competitiveness of individual companies, but also to the overall U.S. economy. Fortunately, by the late 1980s, a more accurate approach to cost accounting was being adopted, which augured well for a US economic revival.
Could History Be About To Rhyme?
Venture capitalist and author Bill Davidow argues that today our techniques for measuring economic performance are obsolete, and thus lead us to reach improper conclusions about the state of the economy. Many economists, policy-makers, and politicians, he says, are still using 20th-century methods to analyze our 21st-century economy, in which two worlds co-exist:
“The physical economy is anemic, struggling, biased toward inflation, and shrinking in many developed countries…. We use dollars to measure most of the activity. If more dollars are spent or earned, we conclude that the economy is growing.
“The virtual economy is robust, biased toward deflation, and growing at staggering rates, everywhere. A lot of the services provided to us in the virtual economy are free. If we paid dollars for those services, they would be counted as part of the GDP and would add to economic growth. But we don’t, so they are not counted.”4
In his analysis, all the “free” services we get on the Internet are actually paid for, not with money that can be counted, but with our privacy and attention. Services like searches on Google, the listing of residential rentals on Airbnb, free email, information storage on Dropbox, phone calls on Skype, hotel and restaurant reviews on TripAdvisor or Yelp, free text messages on WhatsApp, or free music cost zero in money terms, so they are not counted in the GDP. But in fact, they are worth billions.
If advertisers paid us directly to invade our privacy and capture our attention, and we then turned around and spent the money to purchase the services mentioned above, the government would count what they pay us as part of our income and the sale of their services as part of the GDP. There are no accurate numbers, but a partial idea of