Wednesday, February 17, 2010

Growing Debt Paradigm (GDP)

The study of modern economics gets broken up into the macro and the micro. Of all the complex equations that one solves while studying macro and micro, one of the few that probably gets remembered is that of GDP, or gross domestic product. GDP is composed of consumption, investment, government expenditures, and net exports. Now that my studies in this field have long been completed, I can't help but wonder about the logic behind the premise that we measure growth in an economy through the four components listed above. If economic growth is desirable, doesn't it take no more than every consumer to take out as big a loan as possible and spend it in the economy to make GDP go up? And doesn't it also take no more than the government to decide on a few trillion dollar expenditures (or more) to make GDP go up? And doesn't it also take no more than the central bank to print the currency ad infinitum to weaken its exchange rate versus foreign currencies, and therefore make our exports and subsequently, GDP go up? There is something fundamentally wrong with each of these actions moving the supposed growth parameter upwards. In fact, based on the above descriptions and how consumers, government, and the central bank actually behave in reality, GDP is more of a measure of growth in debt than it is of legitimate economic growth. The next question then is: so what is an accurate measure of economic growth? I would argue that this is largely irrelevant given that what we are trying to do is measure the health of the economy. Let me elaborate.

The most important function of an economy is that it satisfies consumer wants; it is not important, necessarily, to produce and then consume as much as possible. Here is an example: imagine a small economy on an island whose inhabitants don't like to work very much. They produce very little and consume very little and this makes them perfectly happy. A modern economist would look at this situation and gasp that the economy might not even be growing year after year. But is this a problem? The inhabitants, by their actions, don't want the economy to grow. They are happy because the economy is satisfying their wants. The more accurate measure of the health of this economy is if there are no institutions that in some way hamper consumer demands from being satisfied, or even add a minor cost to the satisfaction of consumer demands. Would it be an improvement if we had a government-like entity on this island that took resources from the inhabitants and made them work longer hours so that it could "produce" and then "consume" more? Or what if this government-like entity borrowed in the inhabitants' names and then required that they work off these debts for years to come. These actions would make the island's GDP go up.

The GDP metric fails even for its stated purpose of calculating economic growth because it actually calculates growth in debt. But irrespective of this wish to determine the level of growth, we should be determining how free an economy is from artificial impediments so that we know whether or not consumer demands are being met to the fullest extent. We should not necessarily be concerned about how quickly or slowly an economy is growing, ignoring entirely these more vital questions.