In this issue:
1) The Credit Card Analogy
2) What is GDP?
3) Why isn't Fiscal Stimulus Real Growth?
4) What is the US' True GDP?
5) Where is the Stimulus Going?
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Over the last two quarters, US real GDP grew at an annualized rate of 5.6% and 3.2% respectively. Wow! Over the last 3 and half years, US real GDP grew a total of about 1.5%. Not bad for the worst economy since the Great Depression. Unfortunately, the US government had to spend an incredible $4.1 trillion to produce this $200 billion in growth. Without this new government spending, real GDP would have shrunk 30% (if nothing else had changed). How should we think about this fiscal stimulus? Is it more accurate to say that GDP has grown 1.5% or shrunk 30%? I believe the latter is more accurate and will demonstrate why.
The Credit Card Analogy
If I lose my job, I can sustain my lifestyle for a while, first with my savings and then with credit cards. Despite having no income, I can continue going to the movies and eating at fine restaurants. I can use one credit card to pay off another, but over time the interest I’m paying on the credit cards will rise until eventually I can’t make the payments. The US is currently in the situation of using our credit to maintain the lifestyle to which we’ve become accustomed. Optimists hope the economy will recover before we’re overwhelmed with our interest payments, and that over time we can pay back the newly accumulated debt. Regardless of whether we’re eventually able to pay the debt back, we should recognize that the “GDP growth” spurred by debt is a mirage; it’s the equivalent of getting a $1000 cash advance from a credit card and thinking you’re a $1000 wealthier. I started with this analogy to explain how “true GDP” could have shrunk by 30% without us feeling that much poorer; our new borrowings are being spent to maintain unsustainable consumption levels.
What is GDP
“Real GDP growth” is defined as GDP growth minus inflation. GDP = consumption + investment + governments spending + exports - imports. The important thing to notice is that if the government increases spending by $1, GDP automatically goes up by $1. So why doesn't the government just increase spending by 10% every year and give us permanent 10%+ GDP growth? I'll explore that question in the next section.
First I want to distinguish between “real gdp growth” and “true gdp growth.” I’ll define the latter as real GDP growth minus fiscal stimulus. I’ll show why GDP growth generated by stimulus isn’t real growth so much as a temporary loan that the economy will eventually pay back with interest. Then I’ll look at growth in the US and roughly estimate the “true GDP growth” number.
Why isn't Fiscal Stimulus Real Growth?
Unfortunately there’s no free lunch and stimulus produces all sorts of nasty effects. The most obvious problem is that it increases government debt and eventually investors will stop lending to an over indebted government. Every major long-term economic study I could find suggests that $1 of government spending in mature economies produces less than $1 of growth, probably much less. Businesses thrive by borrowing $1, growing it to $1.20, paying the bank a nickel in interest, and pocketing the extra 15 cents. If the government is borrowing $1, turning it into 70 cents, and then owes investors $1 in principal with 5 cents in interest, it will eventually go broke. This problem can take decades to manifest, so let’s look at some of the more immediate ramifications.
The economist Hayek noted that most economic collapses are the result of a misallocation of resources. The problem is that when a ton of people are employed making buggy whips that no one wants, sooner or later they’ll be unemployed and the economy will have little to show for the labor but warehouses of dusty whips. Japan’s excess infrastructure spending in the 90s is a real-world example. Capitalism works when bad businesses go broke and incompetent employees change jobs or even careers. When we provide massive stimulus to pay for projects that the market doesn’t value, not only are we misallocating resources, we are also creating perverse incentives. For example, the government guaranteed the debt of the country’s largest banks. That gave investors an incentive to give those banks as much money as the banks wanted. The banks knew they couldn’t fail with government backing, so they have tremendous incentive to take excessive risk with the unlimited money investors are giving them. In other words, $1 of government stimulus can actually reduce future GDP by producing perverse incentives.
What is the US' True GDP Growth?
From January 2007 until today, US government debt increased by $4.1 trillion dollars.
During that time, real GDP increased by about $200 billion. This means that “true GDP growth” over the period was about -30%. This sounds very extreme which is why I started with the analogy. It doesn’t feel like GDP shrunk by 30%, because we’re maintaining our consumption levels with new debt.
How is the Money Being Spent?
My argument is entirely dependent on the assumption that $1 of government spending produces less than $1 of real productivity. It’s worth looking at the actual spending to see if this is true. In developing countries, there is frequently an opportunity to invest productively in the infrastructure of the country. For example, China has spent a lot of money on roads, railways, and energy infrastructure that will support future growth. Of the roughly $600 billion in stimulus, about 65% was spent on infrastructure, and 20% was spent specifically on long-term development projects like new education and energy technology; a meager 10% was spent on transfer payments (e.g. unemployment benefits). Alternatively, very little spending in the US has gone to productive projects. The bulk of stimulus went to tax cuts, Medicaid, state fiscal relief, and unemployment benefits. We can view the tax cuts as just more spending on our core budget. Currently about 56% of the US budget goes to entitlements like social security and Medicare and 23% to defense. Obviously, none of this produces great future growth. A quick look at the remaining budget suggests that only about 6% of the total is in any way devoted to growing productivity.
A final note – I’m not arguing against Keynes’ style fiscal stimulus; it may prevent far worse economic outcomes. Heck, if I was out of a job and starving, I’d probably use my credit card to buy food. We just need to recognize as investors that growth in government spending is fundamentally different from growth that comes from consumption and investment.