DRI-296 for week of 4-27-14: Is Gross Output the Rightful Successor to GDP?

An Access Advertising EconBrief:

Is Gross Output the Rightful Successor to GDP?

Last week, we lamented the failure of Gross Domestic Product (GDP) to do its job; namely, to accurately depict the welfare of U.S. citizens. That failure has been chronic since its inception in the late 1930s, but became acute with the rise of the digital age. GDP measures the monetary value of final goods by calculating value added at each stage of the production process. The digital economy puts the emphasis on free goods and substitutes for many goods and services that formerly added to GDP’s monetary total. Thus, GDP and consumer welfare can often move in opposite directions in today’s economy.

Last week, Austrian economist Mark Skousen’s op-ed in The Wall Street Journal previewed the release of a new measure of economic output by the Bureau of Economic Analysis. That measure is called “Gross Output.” It measures total sales through the production chain from raw materials through to the wholesale level. At the wholesale and retail levels, the measure includes value added.

This addition to the national income accounts is the first major innovation since the modification of gross national product called gross domestic product, made over fifty years ago. It is a personal triumph for Skousen, who pioneered the concept of Gross Output with his 1990 book, The Structure of Production. In it, Skousen introduced what he called “Gross Domestic Expenditures (GDE).” It is a more consistent measure of Gross Output than the BEA’s new measure because GDE also includes total sales at the wholesale and retail stages of production. (The somewhat vague rationale given by a BEA researcher for this seeming inconsistency is that there is “no further transformation” of goods at the wholesale and retail stages.)

Despite the difference between his measure and Gross Output, Skousen is convinced that the latter will improve markedly on GDP. He believes that Gross Output is much the better descriptor of the economy. And, with the help of a second change that has received virtually no publicity, Gross Output may also prove to be a vastly superior analytical tool for understanding changes in economic activity.

Gross Output vs. GDP

Skousen quotes the director of the Bureau of Economic Analysis, Steven Landefeld, who calls Gross Output a measure of the “make economy.” That is, Skousen elaborates, a “supply-side statistic, a measure of the production side of the economy.” This contrasts diametrically with GDP, a measure of the “use economy,” or the consumption (demand) side of the economy.

Oddly, Gross Output is not a new measure; it dates back to the beginning of the national income accounts in the 1930s. As Skousen notes, it is the statistical counterpart to the input-output analysis developed by Nobel laureate Wassily Leontief. (Indeed, its data were even listed in the accounts under “benchmark input-output tables”.) What is new is the attention paid to it; henceforth, it will be released quarterly. Previously, intervals between releases were as long as five years and the date lagged two or three years in arrears of the release year. Now we can directly compare Gross Output with GDP.

What will a comparison of the two achieve? Heretofore, the single-minded concentration on GDP has nurtured a certain mindset among economic and financial commentators, particularly those in the broadcast media. That mindset pictures an economy that is demand-driven, with the leading component of demand being consumer demand and government spending following close behind. For decades, commentators have robotically insisted that “consumer spending drives the economy.” The corollary to this maxim is that consumer saving is bad and counterproductive because what is saved is not spent, a “leakage” from the flow of income and expenditure. In fact, this is exactly what generations of undergraduate students learned in their macroeconomics course, so we shouldn’t be surprised that this toxic thinking seeped into the popular discourse.

In 2012, GDP was $16.42 trillion. But Gross Output was $28.69 trillion. Consumer spending was 68% of GDP; that explains it preeminence in popular thinking. But consumer spending was less than 40% of Gross Output. Business spending, encompassing fixed investment and production of intermediate goods, comprises over 50% of Gross Output. That is, the totality of business investment actually exceeds consumption spending. Only 20% of the labor force is employed in the consumer (e.g., retail and leisure) sector. 15% work for government, but a whopping 65% work in the mining, manufacturing and service industries. If we substitute Skousen’s personal measure, Gross Domestic Expenditures, for Gross Output, the contrast with GDP is even more marked.

The components of the Conference Board’s fabled Index of Leading Economic Indicators are almost all connected to the “early” stages of production – that is, those farthest from consumption. These include new orders by manufacturers, non-defense capital goods purchases, and new building permits. The stock market reflects a secondary market in assets, not consumption goods. Claims for unemployment insurance relate to intermediate (labor) markets, not consumption-good markets. Retail sales are not among the leading indicators. Skousen notes the intriguing datum that, in 2012, the so-called “consumer confidence index” was conceptually altered to reflect “average consumer expectations for business conditions.”

Why do forecasters look to measures of Gross Output, production and intermediate inputs rather than GDP and consumption? Because they are looking at where the action really is. The “make” economy is 3-4 times more volatile than the “use” economy. In the Great Recession of 2008-2009, for example, nominal GDP declined by only 2%, but Gross Output fell by over 7% and its intermediate inputs components dropped by over 10%. Since the recovery began in 2009, Gross Output has increased by over 5% annually, compared to much smaller increases for GDP.

Gross Output from an Accounting Standpoint

To devotees of accounting, the combination of “gross domestic product” and “gross output” must seem strange, even outré. If GDP is the “gross” measure of domestic output, how can Gross Output also be “gross?” If both of these terms purport to measure output, shouldn’t at least one of them be “net?” As a matter of fact, the standard national income accounts include a secondary measure of national product called “net national product;” it subtracts depreciation from GDP, thus converting the investment component to net investment. Ugh – what a semantic mess.

It is clear, though, that Gross Output is the real “gross” magnitude. Putting it differently, GDP is already a “net” figure even before depreciation is subtracted, because its value-added construction nets out a substantial portion of input cost from the total sales figure. This subtraction is sensible when consumption is the only datum of interest. But the whole point of this notable change in statistical direction is that it isn’t – we desperately need to focus intensely on saving, investment and asset accumulation as well.

The distinction between a “make” economy and a “use” economy has a traditional rationale in business accounting – the “sources and uses of cash” statement is a valuable tool for gauging a company’s processes and productivity. In this case, it is the nation’s sources and uses of national income and product that are contrasted by Gross Output and GDP.

Macroeconomic Theory and the National Income Accounts

Mark Skousen criticizes GDP because it “creates much mischief in our understanding of how the economy works.” Right. He goes on to say that “in particular, it has led to the misguided notion that consumer and government spending drive the economy rather than saving, business investment, technology and entrepreneurship.” Right again. The public has been taught not merely to worship consumer spending but spending in general. Instead of accepting the fact that production is necessary to create the real income that we consume, they have swallowed the fairy tale that the spending itself creates the income that pays workers and business owners. Repeated doses of that viral contagion have gradually built up immunity in the body politic to massive federal-government spending and budget deficits.

But what the public doesn’t know is that economists themselves are schizophrenic on this issue. The macroeconomic theory of aggregate demand and Keynesian economics, deploying government spending to reduce unemployment and eliminate recessions via the multiplier, applies strictly to the short run. In the long run, economists switch to a theory using diametrically opposed logic. Nobel laureate Robert Solow’s theory of long-run economic growth treats saving as both beneficial and necessary to increase investment and economic growth. Skousen notes that subsequent research by Robert Barro of HarvardUniversity has confirmed the value of Solow’s theory, linking economic growth to “increased technology, entrepreneurship, capital formation and productive savings and investment.”

How is it possible for economists to simultaneously believe both theories, considering that the long run is defined as a succession of short runs? Well, natural scientists have never developed the “unified field theory” that would reconcile contradictions in their different fields. Of course, changing the subject by pointing to other people’s mistakes isn’t even an excuse for living with contradiction, let alone a justification.

At least the profession is finally doing something about this yawning lacuna. But rather than reforming economic theory, the economics profession has chosen instead to begin by reforming the data collection process. Skousen diplomatically chooses to accept the party line that “Gross output is the natural measure of the production sector, while net output [GDP] is appropriate as a measure of welfare. Both are required in a complete system of accounts.” This is the view of mainstream economists Landefeld, Dale Jorgenson and William Nordhaus in “A New Architecture for the U.S. National Accounts.”

No, these economists have simply brought the national accounts into line with the theoretical contradiction between short-run Keynesian economics and Solow’s long-run growth theory. A next step would be to straightforwardly face the failures of GDP itself. But incorporating Gross Output into the accounts is certainly a step in the right direction.

Disaggregating the National Income Accounts

That step is only part of the recent reversal in policy by the Bureau of Economic Analysis, which is clearly designed to decouple the national income accounts from their longtime rigid linkage with Keynesian macroeconomic theory. This month, for the first time, the components of national output are available in disaggregated form by industry. On April 25, 2014, GDP became available at the industry level for 22 industry groups.

When Keynes published his General Theory in 1936, national aggregates of income and output – that is, consumption/saving and consumption/investment, respectively – were not collected because economists had not previously couched theory in these specific aggregative terms. The closest they had come to aggregative analysis was the Quantity Theory of Money, developed centuries earlier by men like John Locke and David Hume. It had developed a linkage between the total quantity of money in circulation, the speed with which it circulated, the general level of prices and the volume of goods or (alternatively) transactions.

Keynes criticized classical economics for not being aggregative enough, for failing to capture effects that could be good on a small scale but bad when they occurred economy-wide. He demanded that theory suppress detail at the individual, firm and industry level and concentrate only on the national level. The national income accounts followed in his wake and were modeled in accordance with his macroeconomic theory. Keynesian theory broke with precedent by arguing in monetary terms; economists have always known that it is the real quantity of goods and services that constitute economic wealth, not money per se. But the only way to aggregate the incredibly diverse volume of goods and services in a huge, modern economy is by expressing all values in monetary terms. Because the national income accounts followed Keynesian theory in structure, they preserved this strict monetary nexus. And this left them vulnerable to the innovative practices of the digital age that provided consumers with goods at zero prices, thereby severing the monetary nexus and posing the puzzle of accounting for these transactions.

Now, for the first time ever, the tight linkage between Keynesian economic theory and the national income accounts have been broken. This reflects the Bureau’s recognition of the need for disaggregation.

It is ironic that this has occurred just as GDP has become well-nigh irrelevant in the digital age, as last week’s EconBrief demonstrated. But the BEA’s behavior is thoroughly typical of and consistent with a bureaucracy threatened with obsolescence. To drop GDP, their signature statistical product, would be unthinkable, no matter how superfluous or inaccurate it has become. After all, a bureaucrat’s primary objective is preservation of his or her bureaucratic mandate, upon which the bureaucrat’s income and prestige depend. By redesigning the product, the agency can make a show of responding to public demand and of improving its procedures – meanwhile delicately ignoring the ever-growing irrelevance of GDP.

All these changes – the introduction of Gross Output, the disaggregation down to industry-level data, the divorce from Keynesian theory – respond to another gnawing problem that dates back to the 1930s. The competing theory that Keynes defeated was formulated by his rival, F.A. Hayek. Hayek’s theory was couched in terms of relative prices; changes in the general level of prices were mentioned only in passing. The national level of investment was only incidental; the important issue was the relative amount of investment in long-lived production processes compared to investment in shorter processes. But in order to study his theory using data from the national income accounts, those accounts would have to collect data at the industry level. Their refusal to do this for over 70 years greatly hindered the empirical debate on the Austrian business-cycle theory.

The Austrian Theory of the Business Cycle and the Need for Statistical Disaggregation

Mark Skousen, a well-known practitioner of Austrian economics, celebrated one important change in the national income accounts but completely neglected another one. That change bears on another theoretical controversy from the 1930s: the Austrian theory of the business cycle.

That theory is very well-known to a small number of people and completely unknown to most people. It played a key role in the history of economic theory. When John Maynard Keynes published his General Theory of Employment, Interest, and Money in 1936, he was coming off a five-year fight for intellectual predominance in economics with F.A. Hayek, the Austrian economist whose business-cycle theory had taken the economics profession by storm in 1931.

Hayek developed his theory by synthesizing the monetary theory of his mentor, Ludwig von Mises, with the interest-rate theory of the Swedish theorist, Knut Wicksell. (Mises, in turn, had relied on Austrian capital theorist Eugen von Bohm-Bawerk.) Although Hayek’s theory has been popularized and simplified by American followers of the Austrian school like Roger Garrison, Gerald O’Driscoll and Mario Rizzo, the guts of Hayek’s theory comprise what today is known as the Austrian theory of the business cycle.

Bohm-Bawerk maintained that time is a key component of economic production because human beings exhibit positive time preference. That is, they prefer consumption sooner rather than later, all other things equal. Thus, production processes that are more roundabout must be more productive in order to be favored over less time-consuming ones. The productive side of the economy therefore should be thought of as a capital structure consisting of different processes of varying lengths. When you pick fruit off a tree or drink from a stream you are engaging in the shortest kind of production process. At the other extreme, some processes have a dozen or more stages stretching from raw material to ultimate consumption.

The value of the capital goods in the process is dependent on the estimated value of the consumption good(s) at the end of the process. The consumption value is estimated by discounting the estimated future value of the consumption good(s) using an interest rate that reflects the opportunity cost of the resources used to produce them.

Changes in market interest rates affect the discounting process by changing the estimated values derived from it. The longer the process and the farther into the future it stretches, the larger the effect. A decline in interest rates will make participation in longer-lived production processes more valuable and attractive to businessmen, while having little or no effect on the value of output from the shortest production processes.

Wicksell originated the concept of the natural rate of interest. This was a conceptual tool he used to refer to the market rate of interest at which the amount of loanable funds supplied to the market by savers exactly equaled the amount of investment funds demanded by businessmen at a given term to maturity. This was Wicksell’s way of describing a condition of perfect time coordination between people who plan to consume in the future (savers) and people who plan to produce goods to be consumed in the future (businessmen who invest in capital goods). Free-market interest rates act to equate the desires of these two independent groups across time in the same way that prices of goods equilibrate the quantities of goods that consumers and producers wish to buy and sell, respectively, at the same time.

But when central banks create money that is pumped into loan markets by banks, this created money is indistinguishable from funds supplied by savers. In other words, it lowers the market interest rate just as if savers were voluntarily supplying more funds to enable increased future consumption. The lowered interest rate causes a (temporary) investment boom. It causes businessmen to invest more in longer-lived production processes and less in shorter ones. But this change in capital structure does not match the actual desires of savers, whose future consumption plans will determine the success or failure of the longer-lived investments.

Sooner or later, this mismatch will emerge and the malinvestments caused by the government money creation and artificially lowered interest rates will come to grief. The working out of this process, the precise content of “sooner or later” and the nature and extent of the grief were the subject of furious theoretical contention in the 1930s and early 40s. They remain so today, at least among those knowledgeable in the subject.

It is worth noting, however, that the general pattern of government money creation, lowered interest rates, investment boom or “bubble” and subsequent bust has been observed in the U.S. and around the world throughout the 19th, 20th and 21st centuries. The most recent case was the worldwide housing bubble that burst with such force beginning in 2006.

The Business Cycle in Theory and Practice: GDP vs. Gross Output

If we grant the importance of business cycles in general and the Austrian theory in particular, how does the comparison between GDP and Gross Output affect these issues?

It would be useful to know when we have entered a cyclical downturn. It would also be useful to be able to validate the worth of a business-cycle theory using information collected in the national income accounts.

GDP has proved to be of little value on both counts. Time and again, we have found ourselves mired in recession, only to eventually find that the recession started much earlier. Again, the Great Recession is the most recent example; we didn’t learn until late 2008 that the recession had begun in December, 2007.

GDP has been even more worthless in deciding between rival business-cycle theories. Theorists agree on little else but the fact that investment must be the pivotal factor in a cycle. It is the volatile factor, whereas consumption tends to be stable by comparison. (Theories of under-consumption have abounded throughout history, but they have been so naïve that economists have shunned them.) Yet, as we have seen, consumption is the focus of GDP, not investment.

Consider Austrian business-cycle theory as it is conveyed by each measure. In the standard accounts, Gross Output has been calculated but only released irregularly and in arrears by two or three years. So it is useless for diagnostic purposes. The standard investment categories didn’t disaggregate and dealt only with value added, not total sales. Thus, they did not convey the fact that Gross Output is “far more volatile” (Skousen’s words) than GDP. We want a measure of output that will reflect an increase in investment when the lower interest rate triggers an investment boom. Ideally, it should happen quickly enough to allow the central bank to “pop” an incipient bubble by raising interest rates. (Admittedly, that notion seems quaint in the current “zero-interest-rate” environment ushered in by the Fed’s “quantitative easing” policies.)

Gross Output attacks the volatility problem, and Skousen’s full-on measure, GDE, is even more effective on that score. Indeed, Gross Output was developed specifically to stress the importance of investment and saving in production. But the remaining problem, the high level of aggregation, is a traditional weakness of macroeconomics. Artificially low interest rates do not increase all investment uniformly – they increase long-lived investment relative to short-term investment. In order for this distinction to be clear in the accounts, those accounts must disaggregate down to the industry level to delineate different investment stages. We must be able to actually tell that long-lived investments are increasing markedly while short-lived ones are not. The national income accounts have never offered that kind of clarity because they have never been disaggregated to the industry level – until now.

It is odd that Skousen, a modern Austrian economist, devoted an entire op-ed to the introduction of Gross Output without mentioning the introduction of industry level disaggregation. The combination of these two changes promises to be revolutionary. There has never been a one-two punch like this in the history of U.S. government statistics gathering.

DRI-420: It’s Official: The Recovery is Receding

Coping with change is famously difficult. The first stage of the adjustment is recognition. It’s hard to adjust to something when you don’t realize – or won’t acknowledge – its reality. That is the problem most people have adjusting to the current state of the economy. They can’t or won’t acknowledge that we are undergoing an unprecedented transformation rather than merely another business cycle.

We periodically review the performance of Access Advertising’s Driver Recruiting Index (DRI) as a tool to gauge the ex ante demand for commercial drivers. We juxtapose it alongside other indices of trucking and transportation to review their performance and assess the state of the economy. Two salient points emerge from our latest review.

First, the economy in general and the transportation (and trucking) sector in particular are caught in a limbo that is neither recession nor expansion. Second, experts who have been slow to recognize this fact are now belatedly doing so.

The DRI’s Spring Plateau

In 2011, the DRI began its annual climb up the ladder in mid-January, then took off sharply in February. It plateaued in April and May, only to accelerate again in June and July. Total upward movement from January to July was dramatic.

This year, after one of the warmest winters on record, the DRI began with its usual vigor in February. But in early March, it reached a plateau from which it seldom deviated through mid-June – a most unusual seasonal performance under any circumstances and even more so now. The index never came within hailing distance of last year’s spring highs and remains mired at least 10% below the values on comparable dates last year.

It is not unusual for the DRI to increase at certain times of the year or in appropriate circumstances, or for it to decrease at other times. But plodding consistency during a season and circumstances in which rapid increase would be expected is unusual. Moreover, this mimics the DRI’s trance-like behavior early last fall, when the increases in trucking activity normally associated with preparation for the end-of-year retail rush did not materialize.

Our recognition of this uncharacteristic lassitude by the DRI and the economy in general is on record. Now, however, we are part of a chorus of mainstream commentators on transportation and the economy.

The ATA Gets on Board

A longtime trucking bellwether is the American Trucking Associations’ (ATA) Monthly Truck Tonnage Index. This seasonally adjusted index of trucking volume backed up its 1.1% decline in April with a 0.7% fall in May.

ATA’s Chief Economist Bob Costello is a reliable go-to guy for a quote on the economy in general and trucking in particular. He is reliably mainstream in his views – which are favorable to big business and big government. He is consistently cautious in his projections – which is to say, not given to dramatics or overstatement.

So when Costello calls the Truck Tonnage Index’s recent dips “reflective of the broader economy, which has slowed,” you need look no further to discern the consensus of the forecasting fraternity. Costello’s lineup of suspected culprits for the slowdown is predictable – Eurozone turmoil and U.S. electoral uncertainty. This double whammy clouds crystal balls and turns corporate planners into chickens who sit clucking atop cash instead of hatching new investments.


The Transportation Services Index (TSI) of the Bureau of Labor Statistics is another familiar index of transportation activity. The Truck Tonnage Index is a component of this broader survey of the overall transportation picture, compiled under the auspices of the Department of Transportation.

Not surprisingly, the federal government moves slower than the world it governs. Consequently, the most recent month available for the TSI is April, during which the freight index rose at the snail’s pace of 0.2%. The DOT summarized recent movements of the index thusly: “Plateauing of the freight TSI since January appears to reflect slowing growth in the general economy.”

The Cass Index

The Cass Index is yet another transportation index of long standing. It compiles separate indices for volume and expenditures. The volume index has increased throughout 2012, but the increases have been steadily decreasing in magnitude – 2.5% in February, 2.3% in March, 1.9% in April and 1.8% in May.

Commenting on this record in the June 5, 2012 posting of Logistics Management, industry analyst Jeff Berman observed “…a dearth of people that truly have real confidence in the economy,” noting that “volumes are still not close to 2007 [e.g., pre-recession] levels.” The economy, he concludes, “remains in teeter-totter mode.”

The Ceridian PCI

The Ceridian Pulse of Commerce Index (PCI) is the brainchild of UCLA econometrician and forecaster Edward Leamer. It captures real-time data on the diesel-fuel consumption of over-the-road trucks at some 7000 locations across the U.S. from the transactions cleared through stored-value card provider Ceridian.

Like most transportation indices, the PCI has registered slowing growth in early 2012 – 0.7% in February, 0.3% in March and 0.1% in April. At first glance, May seemed to reverse this trend with 0.8% growth. But there are reasons to take even this modest piece of good news with a grain of salt.

For one thing, as pointed out by Jeff Berman in Logistics Management on June 7, the May figure still represented a year-over-year decline of 0.6%. Even more telling is the fact that the volume of diesel-fuel purchases reacts strongly to diesel-fuel prices. These, in turn, depend on oil prices and the health of diesel-dependent economies like China and India. Recent downturns in both the above indicators are good news for diesel-fuel consumption specifically, but they are something of a mixed blessing for overall U.S. economic activity.

A decline in oil prices caused by an increased supply of oil is an unambiguous benefit for us. This increases the amount of resources available for production purposes, and the reduction in oil prices translates into lower costs for countless production processes in which oil is an input. But if the decline results from a reduced demand for oil at home and abroad, it is a harbinger of recession. The lower demand will result in less oil being purchased and used in production, leading to less output of derivative goods and services. Moreover, less demand for oil abroad means lower incomes and less demand for U.S. exports, which will ultimately lower our incomes and imports as well.

We are experiencing both effects – the former due to improved recovery methods like fracking and horizontal drilling and sources like shale oil, the latter due to a myriad of influences including Eurozone woes, Chinese recession and our own slogging-through-molasses economic climate. At the moment, the bad tends to outweigh the good. In turn, this tends to mitigate the significance of upturns in the PCI.

Leamer himself is just as lukewarm about our prospects as other transportation forecasters. In Berman’s piece, he characterizes trucking as “soft generally” because “growth in the components of the economy that depend on trucking is not strong.”

Light Dawneth at Last

The current consensus has been slow in forming. In the three years since the official end to the Great Recession in June 2009, mainstream commentators like Bob Costello and Edward Leamer have continually insisted that prosperity was just around the corner. In effect, they have assumed that the United States was living through a typical business cycle, characterized by a downturn that eventually hit bottom, followed by an upturn that picked up steam until it became a full-fledged expansion. Cycles might differ in detail, with respect to trajectory of contraction or expansion and duration of recovery, but not in terms of their general character.

When the rate of GDP growth began to increase somewhat in 2010, Costello confidently asserted that growth would soon accelerate and unemployment would start to fall. After all, he reminded us, unemployment is a lagging indicator and usually is the last symptom of recession to abate once expansion sets in. Late last year, Leamer reacted to a favorable monthly PCI by reading into it the long-awaited resurgence of trucking that would lift the economy off the mud flats and into the whitewater of fast-track growth.

Few economic indicators are as volatile as housing starts, but the slightest upward blip in housing over the last three years has invariably been touted as a neon arrow pointing unerringly at the promised land of full employment. Despite all economic logic to the contrary, the presumption has been that because housing was the most severely affected sector during the Great Recession, it must of necessity lift the general economy up to recovery on its shoulders.

In view of this record, the question isn’t so much how or why we all abruptly find ourselves on the same page. Instead, we should wonder why it took so long.

Revolution and Crisis

The science of macroeconomics (an oxymoronic term that is nonetheless useful) has reached a watershed moment. In his landmark study, The Structure of Scientific Revolutions, Thomas Kuhn decried the conventional view of science. A scientific theory or paradigm is not formulated, tested experimentally and formally accepted or rejected. Instead, it is adopted on the basis of practical usefulness and retained until supplanted by a more useful theory. Replacement is not effected by testing but rather in response to a crisis – the failure of the reigning theory to perform the tasks that made it useful originally.

We are now in the midst of such a crisis.

The reigning theory of macroeconomics was developed by John Maynard Keynes over 75 years ago using a combination of old and new ideas. The principal old idea was that capitalist economies suffered recurrent insufficiencies of spending that gave rise to depressions and unemployment. The principal new idea was that government could and should remedy these shortfalls by spending money and/or inducing citizens to increase spending. Eventually, economists borrowed the term stimulus from behavioral science to characterize these policies. The government spending should be funded by either borrowing or money creation. Induced private spending should be funded by either tax reductions or money creation. Increases in private investment should be induced by artificially lowering interest rates via money creation. Increases in employment should be induced by exploiting “money illusion” of workers – that is, by lowering the purchasing power of wages by money creation, fooling workers into thinking their real incomes had risen while persuading illusion-free businesses to hire more workers at lower real wages.

For over forty years, this theory was subjected to rigorous theoretical and empirical scrutiny and extensive practical application. By roughly 1980, the results were in. The theoretical scrutiny was unfavorable to the theory: no tendency toward underconsumption and unemployment was inherent in the system, government action would be unavailing, unnecessary or even counterproductive; and “money illusion” did not exist. Empirical studies were either unfavorable or equivocal. Practical application of the theory was widespread and remarkably consistent; it failed whenever and wherever tried.

In retrospect, this should not have been surprising. By 1980, the American economy had endured over 30 recessions. It had recovered from all of them without the application of the theory.

Still, the theory was not abandoned.

Macroeconomists claimed that the theory was still useful because government policy would work faster than allowing markets to recover from recession and depression unaided. Why suffer for two or three or four years when we can cure the problem in a few months or a year with the aid of government stimulus?

A Kuhnian explanation would instead find other ways in which a demonstrably wrong theory might nevertheless be useful. Government gradually took on the role of problem solver of first resort, not just in economic policy but in every nook and cranny of society. It actually solved few, if any, problems, but it was required to look as if it were trying to solve them. Trying hard.

Democrats, who had been the first party to advocate tax reductions as economic stimulus, eventually had to repudiate this policy because it supposedly enriched the rich. Republicans could not endorse a policy of government spending for economic- policy purposes because it would enlarge federal-government budget deficits. Both parties desperately needed a way to look busy. By default, they turned to monetary policy; e.g., money creation.

Ironically, Keynesian theory had originally rejected money creation as ineffective, but its practitioners had to abandon that stance for tactical reasons. Now they were backed into the corner of having to rely on it almost exclusively.

The economic theory that had proven utterly bankrupt as economics now became the sole policy tool of both political parties, virtually by default. It had never worked. Nobody in Washington, D.C. really expected it to work. Nobody cared all that much whether it worked or not.

Keynesian economics was in the same position as medicine prior to the eighteenth century. Doctors had few remedies that worked, but they continued to use the ones they had even though they seldom, if ever, cured anybody. If the doctors had admitted the truth, they would have had to stop being doctors. Macroeconomics had established a secure beachhead in the economics profession, with course offerings at every level of instruction, dedicated scholarly journals, major research grants, government positions and a public mission to make the world safe for markets. Admitting the truth about the theory that had midwived all that would have forfeited their gains.

What Time’s the Next Revolution?

So much for politicians, bureaucrats and academic economists. Where does that leave the rest of us? Essentially, it leaves us pacing the streets, looking around nervously, waiting for the next revolution. What we need is the next scientific revolution, and a theory to take the place of the failure being propped up by the Washington, D.C. policy Establishment – a composite version of Frank Morgan in The Wizard of Oz.

Heretofore we have been in denial. We have been telling ourselves that we went through a bad time in 2008, but the worse is over and we’re gradually getting over it now. Only it is now beginning to dawn on mainstream pundits that we’re not really getting over it – that, in fact, we may be getting ready to repeat some of the worst all over again.

We’re starting to realize that hardly a man is now alive who remembers the famous days and years when unemployment wobbled between eight and ten percent for over three years with no sign of relief. Interest rates have never been this low for this long – and what has it accomplished? Amend that slightly – what good has that accomplished? When in peacetime has government debt ever loomed so large? When has regulation bound so tightly? When has freedom seemed so tenuous?

When at last we have mustered the courage to admit the truth, the next stage will be to face the fact that Keynesian economics had no theory of the business cycle as such. Keynesian theory never asked why aggregate demand declined. The question didn’t seem to matter because the answer didn’t affect our course of action, which was to spend ourselves silly until things got better.

Well, we’re silly and they’re not better. Now it’s time to ask what really causes the business cycle. Wisdom begins when we acknowledge that the only time we faced a climate of recurrent limbo such as this one was in the 1930s – after both the Hoover and Roosevelt administration tried every interventionist nostrum under the sun to artificially cure the recession that began in 1929. As Roosevelt’s Treasury Secretary, Henry Morganthau, admitted to his diary, they ended up in 1939 worse off than when they started. Only when FDR himself forsook “Dr. New Deal” for “Dr. Win-the-War” were the chains hobbling American business broken. After World War II, with Roosevelt dead and no sponsor for the New Deal, a Republican Congress and tax cuts ushered in the greatest one-year boom in U.S. economic history.

If we went to the doctor to be treated for a serious illness and he offered us a new drug, how would we react? Would we not ask if it had been tried out? Would we not expect to find a history of successful use? If we found just the reverse – a history of failure – would we not reject the drug? If the only rebuttal argument the doctor could muster was, “Well, we can’t just stand here and do nothing,” wouldn’t we at the very least have the gumption to fire back, “Oh, yeah? Why not?”

This much can be done by any intelligent layman. No Ph.D. in economics is required. Afterward will be the time to grapple with the complexities of intertemporal capital theory and dynamic adjustment, to penetrate the mysteries of the structure of production. You have to learn to crawl before you can walk.

DRI-444: And the Beat of the Economic Greek Chorus Goes On

Early in 2012, broad indices of income and employment turned upward. Although not dramatic, the upturn raised hopes that at long last the economic recovery was about to shift out of low gear and into overdrive.

Of course, there were nagging problems with this optimistic scenario. For one thing, the transportation sector did not participate in the upturn. Trucking in particular languished. This seemed odd in view of the fact that roughly two-thirds of all freight travels by truck. While puzzled by this seeming anomaly, commentators like Edward Leamer of UCLA voiced optimism that trucking would soon get with the program. And it seemed unlikely that the pace of trucking activity could long lag that of the general economy.

Well, one quarter later, trucking’s rate of growth has lined up with that of the overall economy. But convergence has not been effected by a growth spurt in trucking. Instead, it is the overall economy that has dropped back into line with the dismal growth rate of the trucking sector.

What might account for the seemingly inexplicable pattern of economic fluctuations that have plagued the Great Recession and its stunted offspring, the Little Recovery? Can we identify the keynotes that distinguish this Great Recession from past business cycles?

The Greek Chorus on the Economy

In ancient, classical drama, the Greek chorus served the function of narrator and commentator on the events depicted. Over the last few years, economic commentators have formed their own Greek chorus. This suits the dramatic quality of world economic history ever since the financial crisis of 2008 – crisis following crisis, the major industrial nations bleakly eyeing a wall of worry. No sooner has one fraught moment passed than another pops up.

The Greek Chorus may be theatrically effective, but they are analytically deficient. They lack the experience and assurance needed to ad lib an explanation for this, the least conventional business cycle of them all.

The traditional model of the business cycle posits wave-like movements of economic activity joined by high (peak) and low (trough) points. The falling portion of the wave is the contraction phase. The rising part is the expansion. This roughly corresponds to the experience of living Americans. But the current Great Recession is new and different.

At the outset, the recession began in December 2007, but few would have made book on its existence until the meltdown came in the fall of 2008 – at which point the economy nosedived like a crooked prizefighter. The official end of the recession in June 2009 came and went without notice; unemployment remained sky-high for months afterward.

Eventually, it became apparent that a recovery was underway. Make that an apparent recovery – two or three months of modest growth was succeeded by a backslide in income and employment. This is hardly a classic business cycle scenario and it’s no way to run a railway to economic growth. You can travel between two points by dancing a box step but it’s not an efficient way to traverse the distance.

But the Greek Chorus could only sing its part from a script. It could moralize about the Greeks and their woes, and how those woes would wound the West if we weren’t careful. It could sing about morality – greed and inequality and protest and such. It could narrate a familiar tale about the business cycle. But it couldn’t analyze. It lacked a theoretical framework in which to look beyond history and tradition to ask why this episode differed from all that had gone before.

The Greek Chorus Sings the Same Song, Different Verse

In the fourth quarter of 2011, the U.S. economy achieved annualized growth of 3.0% and unemployment fell to 8.3%. The Greek Chorus raised its voices in hosannas of praise and thanksgiving. In January, employment jumped further. This was an “unmistakable” sign that we had turned the corner.

Alas, first quarter of 2012 simply repeated the same song heard ever since 2009. This verse featured reduced annualized growth of 2.2% and slightly lower unemployment, culminating in an 8.1% rate in April, 2012.

Unfortunately, even a lower unemployment rate became a mixed message. While the number of unemployed persons fell by 175,000 between March and April, 2012, the number of employed persons also fell, by 165,000. The job gain of 115,000 was well below the 200,000 job gain usually considered necessary to absorb increases in population and labor-force growth in a typical month. Of course, this month was anything but typical – the civilian labor force fell by 342,000. Since the unemployment rate is calculated by dividing the number of unemployed (12,500,000) by the total number of people in the labor force (154,365,000), the resulting 8.1% was only a razor-thin improvement over the previous month (12,675,000 divided by 154,707,000 equals 8.2%). The total number of employed people was 141,865,000 – up from 137,968,000 in December 2009 but well behind the 146,595,000 in 2007, before the recession started.

Once again, the “unmistakable” signs of recovery had become mistakable.

Why the Greek Chorus Sings Off-Key

In its narrative role, the Greek Chorus is not performing but instead “phoning in” its performance by relying on pre-digested Keynesian platitudes and bromides, as if it had substituted a pre-recorded instrumental for live performance. And that instrumental is like an old phonograph needle stuck in a crack, playing the same notes over and over again.

The Greek Chorus excoriated Wall Street for the failures of its “rocket scientists,” who developed complex derivative securities and relied on statistical databases to develop safety ratings for mortgage-backed securities. Rightly so, for radically changed credit standards had made the databases worthless for evaluating creditworthiness in today’s environment. But now the Chorus fails to recognize that the textbook business-cycle model cannot describe today’s reality, in which policymakers manipulate markets in vain efforts to make miracles or buy time in which to maneuver.

The simple business-cycle model only worked when markets were allowed to work. Today, the economy functions like an automobile whose fuel supply is impaired by some flaw such as a clogged filter. The vehicle lurches forward, stutters, stops, and lunges forward again. Something is obviously wrong, even if the source is not quite clear.

Insofar as they have any economic training at all, most people are trained to look to aggregate demand, or total spending, as the key to all mysteries. But that is not the problem.

In a functioning economy, markets tend to reconcile diverse perspectives of different people by providing objective knowledge about reality. People rely on that. Each of us knows that we don’t know everything, so we rely on what markets tell us and we rely on our ability to get information on the future and in the future. We can’t do that today because we all know that today’s economy is not “real.”

The best example is the “zero interest rate” policy (ZIRP) followed by the Federal Reserve. Everybody knows that interest rates do not reflect the actual saving and investing desires of consumers and businesses. We all know that ZIRP cannot go on forever, and when it ends the interest-rate environment will change drastically. We know that all those drastic changes will have tremendous effects on most of the economic choices we make now and in the immediate future.

In effect, most of the country is living with one ear attuned to daily life and the other one keenly listening for the other shoe to drop – that is, for any sign of the change that we know is coming. Obviously, we can’t live in a state of suspended animation. But just as obviously, it’s in our interest to do the minimum necessary to get by until this state of massive uncertainty clarifies.

And guess what? Everybody “doing the minimum necessary” translates into an economy with minimal growth and confused direction. Long-term investment is attractive only when the circumstances are absolutely ideal – or when political corruption or cronyism tips the scales in favor of action. Hiring is analogous to long-term investment because it entails assumption of so many costs and because firing has become correspondingly difficult. It’s no wonder, then, that we’re in the fix we’re in.

Waiting – But Not for Godot

Some other paralysis-inducing factors are related to ZIRP. Current and future projected spending at the federal level is producing unprecedented peacetime accounting deficits. These require federal borrowing. Interest payments on the necessary bonds threaten to eat up the entire federal-government budget before the decade ends. Everybody knows that this process cannot continue. Everybody knows that its termination will require massive dislocations. Some of these might be large spending cuts, huge tax increases, elimination of federal-government agencies and departments, privatization of government functions, and large-scale reductions in federal employment. Nobody can dispute the stunning impact of these measures. Everybody is waiting to see what will happen.

Many state and local governments are in bad financial shape as well. Included among them are some of our largest and most populous states, such as California, Illinois and New York. Most people realize that the promises made to many public-employee unions regarding retirement pension and health-care benefits have placed government finance in an untenable position. Once again, the necessary remedial actions will have dramatic effects on all the affected parties. Everybody is waiting to see what will happen.

In Europe, Americans can watch a preview of coming distractions. The European welfare state is imploding. Whether the implosion becomes an explosion will depend on where the charges are set and on their strength. Greece is facing default on its public debt and withdrawal from the European Monetary Union. In an unprecedented action, Spain is about to bail out its largest bank. Everybody suspects that the stronger European countries are rapidly running out of time to deal with the depredations of the weaker ones. Deep in our hearts and heads, we know that Germans will not work until age 67 so as to pay higher taxes whose revenues will allow Greeks to retire at age 50.

We are waiting to see what happens.

The Federal Reserve has created astounding amounts of money by purchasing both new and existing federal debt. Instead of entering the flow of income and expenditure via the loan process, most of this created money has sat on bank balance sheets in the form of excess reserves, drawing interest paid by the Treasury. This policy was deliberately contrived by the Fed and Chairman Bernanke, presumably because of fears that many banks required bolstering to forestall insolvency and couldn’t be expected to bear the risks of normal operations. Everybody knows that this situation cannot continue indefinitely. Everybody knows that if this flood of money is injected via the usual loan process, hyperinflation will result. Everybody knows that hyperinflation would throw the U.S. economy into chaos. We are waiting to see what happens.

Tune Out the Greek Chorus

All this “waiting to see what happens” is frighteningly real. It cannot be quantified into a simple model like the Keynesian multiplier of income and expenditure, so it is beyond the ken of the Greek Chorus. It requires economic analysis of a kind that went out of fashion at the point when economics became “scientific” by relying exclusively on mathematics and statistics. We are beset by radical uncertainty, a term that is qualitative rather than quantitative. We cannot meaningfully assign probability values to possible outcomes, so the so-called economic theory of uncertainty is mostly useless here.

The solution, counterintuitive though it may be to so many of us, is to step back and allow markets to work. Every single source of radical uncertainty listed above is caused by policymakers either trying to overwhelm the market or trying to buy time to decide what to do next. Only time and markets can lift the fog of uncertainty, because only markets can generate and collate the objective information necessary to dispel the uncertainty that currently paralyzes us. In the meantime, we should ignore the Greek Chorus. If necessary, use earplugs.