GDP Surprise Follows Major Calculation Change

The WealthCycles Staff

Americans got a Merry Christmas gift from the U.S. Bureau of Economic Analysis: the rosy 3.6% Gross Domestic Product (GDP) reading for 3rd quarter 2013 was adjusted even higher on Dec. 20, to an astonishing 4.1%. Not surprisingly, holiday retail sales stayed sluggish through Dec. 24, perhaps a sign that U.S. consumers have reached a point where they no longer buy the government’s book-cooking statistical reports.

As a matter of fact, way back in the spring the BEA announced significant changes to the way in which GDP is calculated: additional types of expenditures were added in to the Economics 101 formula, GDP = C + I + G + (E – I), and, wouldn’t you know it, the revisions were projected to bump GDP up by some 3% in one fell swoop.

In reporting the announced changes to GDP in April, Seekingalpha.com writes:

The conclusion is that investors need to take the third quarter 2013 GDP number with a grain of salt. They also need to keep this GDP adjustment in their mind when they value stocks based on GDP numbers (Chart 3). The 3% increase in GDP will be imaginary, but I predict that the mainstream media will probably tout that the economy is improving and stocks (DIA) will react positively on this coming news. The decay in the underlying U.S. economy however, has not subsided.

The antecedents to Gross Domestic Product, Gross National Product (GNP) and, originally, National Income and Product Accounts (NIPA), were developed in the 1930s and 1940s as a means of measuring and reporting the “national product,” writes Roger Higgs, senior fellow in political economy for the Independent Institute and editor of The Independent Review, in a 2012 article for Mises.org. From the beginning, the question of whether government spending should be included in Gross National Product, which along with Gross National Income and other indicators made up NIPA, was highly controversial. Most government services could not be given a market-determined price or value, and some services, such as those motivated by politics, might have no real value at all. The outbreak of World War II sidelined the debate, Higgs writes, “and the accounts were put into a form that best accommodated the government’s attempt to plan and control the economy for the primary purpose of winning the war.”

This situation of course dictated that the government’s spending, which grew to constitute almost half of the official GDP during the peak years of the war, be included in GDP, and the War Production Board, the Commerce Department, and other government agencies involved in calculating the NIPA recruited a large corps of clerks, accountants, economists, and others to carry out the work.

After the war, the Commerce Department continued its practice of including government spending in its calculations of Gross National Product, which became the primary measure of U.S. production until it was supplanted by GDP in 1991. GNP reflected the annual total value of goods and services produced by U.S. nationals, including income earned abroad, and excluding goods and services produced in the U.S. by non-citizens. In 1991, the U.S. began reporting GDP, which reflected “the market value of goods and services produced by labor and property in the United States,” regardless of the nationality of the producers, according to The New York Times.

The formula for calculating GDP is C + I + G + (X – M), or:

GDP = private Consumption + gross Investment + Government spending + (Exports – Imports)

Although it has become the standard practice, the inclusion of government spending in GDP is problematic for many reasons, and Austrian thinkers such as Higgs object. Its inclusion in GDP opened the way for Keynesian policies that manipulate government spending as a way of attempting to stimulate economic growth. Its inclusion also inflates GDP, reflecting a more robust economy and providing political cover for even more government spending and higher levels of debt. Higgs looks instead at the level of private production, what he calls Gross Domestic Private Product (GDPP) from 2000 to 2011, a period during which private production rose at only about half its historic rate.

[P]rivate product has lost ground relative to total official GDP. Moreover, many of the measures taken to deal with the contraction—the government’s huge run-up in its spending and debt; the Fed’s great expansion of bank reserves, its allocation of credit directly to failing companies and struggling sectors, and its accommodation of the federal government’s gigantic deficits; and the government’s enactment of extremely unsettling regulatory statutes, especially Obamacare and the Dodd-Frank Act—have served to discourage the private investment needed to hasten the recovery and lay the foundation for more rapid economic growth in the long run.

Then in spring 2013, the Bureau of Economic Analysis announced its intention to change “84 years of economic history,” as Zerohedge and The Wall Street Journal reported, in a change that promises to skew GDP to government’s purposes even more deceptively:

US economic history will be rewritten this week, as the most far-reaching methodological changes in years will add the equivalent of a country the size of Belgium to output in the world’s largest economy.
The most important change by the Bureau of Economic Analysis, to be announced on Wednesday, will be to start counting spending on research, development and copyrights as investment, and reflect pension deficits for the first time. 
Combined they are expected to add 3 percent to gross domestic product.

Euro Pacific Capital CEO Peter Schiff, as quoted by DailyCaller.com, lists a litany of problems with the new GDP methodology.

Research and development spending, which adds some 2% to GDP, is arguably an intermediate expense in producing a final product, whereas GDP historically, arguably with the exception of most government spending, has reflected only the price of final products. Moreover, Schiff points out, “most R&D expenses are salaries, and many expenditures never result in a new project or gadget and are effectively wasted money.

“Nevertheless, that money will come under the umbrella of economic output defined by the GDP.”
Schiff also criticized the R&D coming from defense contractors. “Why should that research [to build better bombs] be considered investment?…what if the result is that the bombs aren’t even any better?” Schiff demands.
“These are expenses, not investment,” he says.

As reported by SeekingAlpha.com, the GDP is already “massaged,” in that it is based on the Consumer Price Index, or CPI, the government’s official measure of price inflation. The basket of goods contained in CPI is periodically changed so that today’s market basket includes prices chicken rather than steak (see the WealthCycles.com article, Statistics Are A Central Banker’s Best Friend, for more on this). More significantly the “core CPI” figure used for most government reporting omits such day-to-day necessities as energy and food entirely, based on price volatility.

There are obvious public relations and political reasons for making CPI, or inflation, appear as low as possible.  One is that a low CPI makes GDP appear larger, i.e. if the CPI, or inflation rate is high, a portion of GDP can be attributed to the fact that everything costs a lot more, rather than actual growth in production.

In other significant changes, GDP now includes the cost of intellectual property, such as royalty payments and copyright fees, projected to add another 0.5%; costs associated with real estate transactions, such as sales commissions and legal fees, which do not reflect production of a good or service; and a change in how pension payments are counted. From now on, rather than including pensions in GDP when the benefits are paid to the recipients, the future obligation to pay will be included—even as many companies and state and municipal governments face the prospect of bankruptcy or insolvency due to unsustainable pension deficits.

But why, after 83 years of a relatively stable measure of how much the U.S. economy is producing, would the government opt now to make a change. SeekingAlpha.com, along with Schiff, see government and financial sector desperation at work. From SeekingAlpha:

[Wh]ile the GDP number gets inflated upwards, all macroeconomic indicators that are based on the GDP number will be adjusted with it. For example, the debt to GDP, which is at 105% now (Chart 1), will drop 3% just because of this adjustment to the GDP number. This fictitious drop in debt to GDP will highlight that the U.S. improved its debt load, while it did not. Another example is government spending as a percentage of GDP. By increasing the GDP number, we will get a lower government spending number, which allows the government to increase spending.

Schiff views the change as “propaganda”:

[Schiff] asserts that the underlying reason behind making the GDP looking bigger is so that the debt looks smaller. Economists agree that if public debt continues to exceed GDP past sustainable levels, economic growth will suffer because more and more of the economy is dedicated to paying interest on loans rather than spending on investment or consumption or things that create growth within an economy.
“[I]f you have a BS GDP, that’s artificially inflated based on creative accounting, than it means the economy isn’t generating enough income to service all of that debt,” Schiff says.

In seemingly unrelated news, the government also has announced an increased focus on another relatively obscure measure of economic output that, while not new, has previously only been officially reported every five years. Announcing it has more available resources, the BEA will begin reporting Gross Output, which is derived from Input-Output data at all stages of production. In other words, rather than measuring only the price of final products, as GDP purports to do, GO counts all the expenditures that go into creating the products from start to finish. Writing for Forbes.com, Mark Skousen, whose 1990 book, The Structure of Production (New York University Press, 1990, 2007), introduced the concept of Gross Output as an essential macroeconomic tool, is celebrating the government’s expanded use of the measure. But GO will be more than twice the size of GDP. As it becomes a more commonly used measure, and particularly if academicians and politicians highlight it, will the public notice and pick up on the distinction? Or will GO be yet another available avenue for use in painting a rosy outlook when real production and real economic growth continues to stagnate.

As Schiff remarked on the changes to the GDP and other government-sponsored subterfuge, “It’s going to look like the economy is getting bigger, even though it isn’t. Our GDP is one big lie.”

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