Being Bewitched by GDP

August 16, 2011

GDP does a funny thing to the minds of economists. It represents the total value of goods and services produced in an economy over the course of a year, and in doing so says little about the actual content of an economy. The old example is a train crash and the resultant clean-up; the money spent on it would represent an increase in GDP for that year.

GDP is a flow, rather than a constant: GDP could crash to zero, and we’d still retain all of our infrastructure, wealth and property. We’d all be dead because we hadn’t spent any money on food, but nothing would be actually destroyed. It’s in this context that stories about GDP should be understood.

It is entirely possible, therefore, for GDP figures by themselves to ignore a correction that is vital to the future of our economy, and correspondingly put on pressure for action that actually runs counter to this. Let’s look at a very current example of this, as identified in this article by Duncan Weldon.

Consumer demand is down, as a result of a combination of lower wages and ‘consumer deleveraging‘, paying down of consumer debt. Right now, consumers appear to be firefighting existing levels of debt, which are remaining broadly constant; the £1 trillion the Labour years added to personal debt is going to take a while to pay down. Something similar is happening in the corporate world; fewer applications for more debt are being made, and corporations are paying down existing debt.

Just like the Government, everyone is trying to pay down their debt rather than spend their credit. The nervousness amongst economists is that this very sensible activity represents a decrease in the flow of money throughout the economy; real wealth is paying down the pretend-or-future wealth of credit. To an economist, both types of wealth look exactly the same in terms of GDP – what matters is whether that wealth is allocated in such a way as to increase its value. From the perspective of GDP, paying down debt is the same as destroying wealth; it decreases the amount of wealth flowing through the economy.

Of course, if everyone stops spending, then no-one has any income and so everyone immediately defaults as soon as their savings run out. This is the danger in a spending slowdown: people are forced to reduce their spending because they have less income, and everyone spirals down into recession. However, paying down debt has the effect of reducing your future fear of bankruptcy, and of putting your future wealth expansion on a less risky basis. It leads to more sustainable growth, rather than growth that suddenly vanishes as soon as your credit gets too expensive, which caused the last recession.

This is the challenge confronting the West more generally: if we can pay down our debt fast enough without reducing growth too much, we’ll have overcome the heady credit drunkenness of the boom years and put future growth on a sustainable, less risky footing. If it turns out that we can’t do that, then we may yet be trapped in a downward spiral. The danger is that GDP figures, unrepresentative as they are of the relative risk associated with a form of economic growth based on credit, may terrify politicians into trying to encourage people to borrow more to spend. With £1 trillion to pay down, that’s far too big a risk to take.

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