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.