Friday, March 6, 2009

What is productivity? (or how far could GDP drop?) - Vega

The economist JK Galbraith introduced the idea that in an affluent society such as ours, demand must be invented. While we’re all willing to work to afford food and shelter, we’re not automatically willing to trade our leisure time for a nicer watch or an expensive painting. Once our basic needs are met, companies must convince us to continue working to buy designer clothing, a sleeker phone, or front-row seats to a concert.

The frightening thing about this is just how much of the production in the US is “unnecessary.” GDP is a measure of all the goods and services produced in this country. What if we’re no longer willing to pay much for the “unnecessary” consumables? Could GDP drop by 20%? 40%?

About 71% of GDP is personal consumption, 14% is investment, and the rest is government expenditures (I’m ignoring the minor effect of imports). If consumers make a long term shift in their spending habits, there’s simply no way to make up for it. An increase in investment would just create overcapacity and more empty office buildings and closed factories. If the government tries to take up the slack from consumers and starts buying goods and services itself, it just keeps buying until it runs out of money. Keynes idea of fiscal stimulus is for the government to make up for a temporary lack of consumption. If the drop in consumption represents a permanent shift, Keynes is helpless.

Another way of thinking about it is via Say’s Law. Say’s Law basically argues that supply creates its own demand as laborers are able to buy the products they produce. The classic problem is that while this argues against a general glut, there can be great dislocations between what’s produced and what’s consumed. For example, when the government subsidizes the Detroit auto industry, workers make cars that no one wants to buy. When the government throws money into inefficient infrastructure projects as Japan did, workers make trains that no one needs and bridges that no one wants.

In the short-term a shift in consumption habits creates painful dislocations that result in unemployment and real wealth destruction. In the long-term, while GDP may be lower, utility (the economic measurement of happiness), is unchanged. For example, a chef’s wages contribute directly to GDP; if that chef uses all his wages to hire a nanny to take care of his kids, the nanny’s wages are also included. If that chef decides to be a stay at home dad and cook for his family instead, GDP will measure a loss of productivity, though no one is any poorer or less productive.

One of the pillars of economics is that trade is good. Through specialization we all benefit and become more productive. This holds true until our specialization supports the consumption of things we no longer care about. If I’m a rolex watchmaker and you’re a designer dress maker and we each lose interest in the other’s products, the specialization no longer benefits us.

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