Monday, June 04, 2012

How does this "fake GDP" work?


Actually, it's incredibly easy to create fake GDP. You simply scratch my back and charge me $10, and then I scratch your back and charge you $10. Repeat that 750 billion times, and you'll double the GDP of the United States. I'm dead serious. Expenditure and income will both go up by $15 trillion, all of it in the "back-scratching services" sector.

Just have fun paying the income tax. 

Really, the question is why you'd want to create fake GDP. If you got $10 in additional income, you probably wouldn't spend it on a back scratch you didn't want. Economists typically assume that the dollar transactions that go on in our economy represent exchanges of scarce resources - that people would prefer to spend their money on things they want rather than things they have no need for.

So I just do not understand why so many people keep on insisting that our GDP before the financial crisis was "fake". Here's Steve Pearlstein:
Indeed, there is a suspicion that at least some of the downturn [in the UK] is a statistical mirage caused by the necessary adjustment to wages and prices following the bursting of that financial bubble. If the financial sector never really added as much genuine value to the economy as was indicated from all those inflated salaries and bonuses, then at least some of the decline in GDP since then may merely reflect a healthy repricing of labor, financial assets and goods across the economy rather than a worrisome loss of output. Low inflation, slowly rising employment, little or no growth in measured productivity, household incomes and GDP — these are all consistent with that story of statistical mirage.
This via Tyler Cowen.

OK, I just don't get it. First of all, if all that has changed are prices, not quantities, that should show up in the price level, as measured by the GDP deflator. Maybe Pearlstein thinks the GDP deflator is mismeasured, and that Britain has actually been experiencing a deflationary boom? How would such a thing be possible, unless some sort of secret supply shock had actually given the British economy a big boost? Is the UK secretly doing better than ever?

(Answer: No it's not. Look at unemployment.)

Anyway, if the GDP deflator is not grossly mismeasured, then the contraction in the financial sector entails not just a fall in prices, but a fall in the quantity of financial services performed. Pearlstein seems to be saying that yes, this has happened, but that this is OK, because these vanished financial services had not been adding value equal to their price.

Which makes us ask: If these services were not worth the price, why were people paying for them? People could have taken the money that they spent on financial services and spent it on cars or video games or sandwiches instead, or left it to their kids. 

If you think that people were paying for useless crap before the crisis, then you must believe that people were tricked into throwing away their money on things they didn't need or want. Maybe that's true! Maybe people in a free market can be tricked en masse into flushing their income down a toilet. George Akerlof, for example, has spent a lot of time arguing that this is not just possible, but common.

But if you believe this, you believe that free markets are not always a great way of allocating resources. If people can be tricked to such a degree that the size of the trick makes the difference between a boom and a depression, well...that's one big trick! It would be a waste of resources as big as any war, except perpetrated by the invisible hand of markets instead of the visible hand of government. In other words, it would mean that free markets tend to fail, and fail massively.

So am I getting things wrong? Do Pearlstein and others mean something else when they claim that part of GDP is a "statistical illusion"? What is this "fake GDP" they speak of, and how does it work??

38 comments:

  1. If you think that people were paying for useless crap before the crisis, then you must believe that people were tricked into throwing away their money on things they didn't need or want.

    Is that so strange? Madoff schemes, chain letters, etc. The hope for free money springs eternal and there is a universe of suckers out there. Plus, all those financial players who know what is going on think they are the clever guys who are going to cash out before the crash and leave other people with the losses. But they are alwasy too clever by half.

    Here is what the econ books seem to miss in their models. The world is full of dirty, thieving, lying, conning scoundrels, and hapless marks. Laissez faire is rule by predator. You need a pretty vigorously enforced rule of law just to prevent the normal destabilizing forces of money manager capitalism from melting everything down.

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  2. During the housing bubble you had new houses selling at more than long run replacement cost plus a normal profit margin - that gives rise to fake gdp.

    During the housing bubble you had mortgages on new and old housing being purchased, packaged and sold at a profit when the mortgages themselves were really worth less than the original price (and perhaps a lot less) - that "profit" gave rise to fake gdp. Banks processed transactions and charged fees. The cost of those fees was capitalized into mortgages that will never be paid and were for services which subtracted, rather than added, value - those fees were fake gdp. The bankers who did these transactions had an incentive to do it because the bank would report profits which gave rise to bonuses for individuals. The banks did these transactions because these value destroying transactions nominally paid more than the banks could earn doing useful, value adding stuff -> fake gdp.

    Banks arranged loans for Spain, Greece and Italy which will never be paid. The fees they charged for arranging those loans are fake gdp.

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  3. We actually have a substantial fake GDP (fgdp) gap right now. I have been recommending that the FOMC establish a formal fgdp target of about 4.5% pa. let here it more fdgp!

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  4. Anonymous8:02 PM

    If you want to call "fake" on useless financial transactions then I get to call "fake" GDP on useless high-speed railways to nowhere stimulus projects.

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    1. Like, which ones?

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    2. We just saw how many trillions of alleged Wall St $ turn out to be fraud?

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  5. Anonymous8:04 PM

    To paraphrase Krugman, even if people were paying for useless crap before the crisis, that doesn't explain why perfectly good workers and resources have to go unused now.

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    1. This comment has been removed by the author.

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    2. "To paraphrase Krugman, even if people were paying for useless crap before the crisis, that doesn't explain why perfectly good workers and resources have to go unused now."

      The problem is that the "buyers" were overpaying for the useless crap and those perfectly good workers and resources cannot generate real gdp equal to the fake gdp that was attributed to them in the period before the bubble burst. The Wall Street bankers were never worth what they were being paid.

      I agree that the workers do not have to go unused. But, they cannot create the gdp that was attributed to them in the run up to the collapse.

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    3. "The problem is that the "buyers" were overpaying for the useless crap"

      how do you know they were overpaying, and more importantly, why do you care about a number on a price tag?

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    4. even if people were paying for useless crap before the crisis, that doesn't explain why perfectly good workers and resources have to go unused now.

      Well, Pearlstein is claiming (incorrectly) that Britain's employment has not fallen, based on some people he saw working.

      Really, he's just totally full of crap, I'm just using this one way he's full of crap to make a point.

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    5. "how do you know they were overpaying, and more importantly, why do you care about a number on a price tag?"

      At this point in time, I am prepared to accept without further investigation that most of the people who bought new houses in the US, England and Spain in the period 2003 through 2007 overpaid the builders. I am prepared to accept without further investigation that the investors who paid banks to place and then bundle mortgages on over priced housing overpaid the banks. You may disagree with my view in which case I believe there are several trillions of dollars in real estate and real estate backed loans available for you to purchase at bargain prices.

      I care about those price tags because they represent the revenue of the builders and banks respectively and flowed through to GDP numbers.

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    6. "You may disagree with my view in which case I believe there are several trillions of dollars in real estate and real estate backed loans available for you to purchase at bargain prices."

      yes, there are: the yields on converting property to rentals is very high right now, and there is a lot of demand for housing, rental rates are going up faster than inflation.

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  6. Pearlstein (and, by the looks of it, Cowen) learned Mellonomics, not economics.

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  7. I don't think "fake" would be the correct term, but one could argue that excessive debt (especially private) pushed real GDP above a sustainable level for a time.

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    1. "excessive debt"

      really? what was it spent on?? why was it excessive??

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    2. really? what was it spent on?? why was it excessive??

      The money came from home equity loans which were predicated on rising house prices. It was spent on household consumption including new cars and electronic gadgets. It was excessive because house prices did not rise. Spending of that money by households would have had standard Keynesian effects and circulated in the American economy before leaking back to China or Europe where it had come from.

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    3. @absalon, good example.

      It was excessive because incomes could not support the interest payments, let alone principal repayment, and required rising prices/refinancing in order to maintain the status quo. This is basic Minsky Ponzi finance. Steve Keen has done great work in this area too.

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    4. Anonymous10:07 PM

      "but one could argue that excessive debt (especially private) pushed real GDP above a sustainable level for a time."

      Bingo.

      BTW , you don't need to explain what "excessive" means. Your detractors are the ones with some 'splainin to do.

      They'll agree , if they're like most economists , that rapid credit growth stimulates economic activity , i.e. GDP growth. They'll also agree that debt/gdp can't grow to the sky , that there are limits. Several economists , in separate studies , have arrived at similar thresholds for the debt/gdp level that , if exceeded , tends to slow growth. For households , business , or gov't , that level appears to be ~ 90%. The actual figure probably varies among countries based on the influence of interacting factors , but you can bet that nowhere is that threshold 500% , or 5000%. ( Financial sector debt/gdp may be a special case , requiring special study , or maybe just a special global meltdown , to sort out. )

      Japan is a good example of what happens when debt/gdp runs away in an advanced economy. You may have heard that their stock market is now touching levels last seen in 1983 ( ! ).

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    5. ahh, the Hayekian zeitgeist. So illuminating in black and white medium.

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  8. I don't know about fake GDP, but certainly some GDP creates far more total societal utils than others of equal dollars. I talked about this in a recent post:

    Long ago I came to the realization that not all $10 trillions in GDP are the same. You could have two countries (or separate worlds): One has $10 trillion in GDP, but $7 trillion in yachts, mansions, super-luxury resorts and restaurants, etc., vast income inequality, and $0.5 trillion in high return investments like basic science, education, and smart infrastructure. The other has the same $10 trillion in GDP, but is far less unequal, and has ten times the high return investment, $5 trillion.

    That second country (or planet, to preclude the issue of free riding on technological advance), even though it has the same $10 trillion in GDP, could have much higher total societal utils today, and at the same time, in 50 years will be far wealthier – ridiculously wealthier a century later. After all, $5,000 meals and 50,000 square foot homes don't do much to advance science and productivity. And even the most extreme libertarian economists haven't yet had the gall to claim that marginal utility doesn't diminish greatly with increased consumption. And don't even get me started on positional externalities.

    Remember, economists love to talk about Pareto optimality, but when you draw your Edgeworth Box in micro, with your curvy line containing all of the Pareto Optimal allocations, some of them have vastly more total societal utils than others. And it really shows the right wing bias in economics that the focus is almost exclusively on Pareto efficiency as opposed to maximizing total societal utils efficiency.

    at: http://richardhserlin.blogspot.com/2012/03/solar-panels-new-safety-net.html

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    Replies
    1. One example might be paying doctors. If France pays its doctors $100,000 per year and the United States pays its typical doctor $250,000 per year for the same work effort and outcomes is the US really generating an extra $150,000 in gdp per doctor per year?

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    2. Absalon, international GDP's are sometimes expressed in terms of purchasing power parity to try to correct for that.

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  9. This "fake GDP" argument reminds me of a similar argument one runs into on a recurring basis--that GDP does not measure what we think it measures (we ignore, for the sake of this discussion, what GDP is *intended* to measure).

    The argument goes something like this: GDP is *supposed to measure* economic well-being. Much of what we produce--like environmental protection, or emergency room services, or protective (police & fire department) services--don't really *add* to economic well-being, they just help us *recover* from outcomes (pollution, accidents, crime, fires) that damage us. So the "value of output" attributed to those activities is not "real," because it does not "really" increase welfare (relative to a world in which no harm is being done--that's my qualifier, not one you'll find being made by the people propounding this position).

    Now, the response to this is really easy...(a) GDP is designed to measure the value of output, not economig well-being and (b) given the world as it is, would we actually be better off without environmental protection laws, or ERs, or police/fire departments? I think the answer to that is easy.

    A similar issue arises in the discussion here. The primary argument is that some trades are taking place at "false prices," prices that are higher than the "real value" of the goods and services being produced in those sectors, so the value attributed to output in those sectors is artificially inflated.

    The response to that is that, in a disequilibrium system--which is what's being described here--if there are some prices that are "too high," there must be others that are "too low." So the measured GDP in the sectors in which prices are "too low" is artificially *deflated* by the "inappropriately "too low" prices.

    And, just as an added attraction, the assumption of trading at false prices is one that may be hard to validate...

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  10. It’s certainly not a “statistical mirage”.

    The financial sector GDP compression shows up in the effect of the balance sheet recession on financial sector revenues, and the corresponding effect on related factor payments (employee compensation and net interest margin compression, primarily).

    It’s a financial sector revenue and expense recession/compression, along with the balance sheet recession.

    That’s a true nominal effect, not a “mirage”.

    As to the reasons for the recession/compression, that’s been discussed enough already.

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  11. Anonymous5:51 AM

    Fake GDP comes from goosed prior spending - fiscal and monetary stimulus. Not for much longer. The long run is here. Keynes is dead. http://www.insofisma.com/wp2/the-long-run-is-here-keynes-is-dead/

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    Replies
    1. ...written at a time when Keynes is right, and the others are wrong.

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  12. Anonymous6:46 AM

    $10 x 300 billion transactions = $3 trillion, no?

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  13. I think this deserves a bit of push back. First what do most commentators and policy makers think GDP is telling them? In general, aside from literally measuring the total value of goods produced in a year, the assumption by most commentators and policy makers is that this flow is at a sustainable level.

    I'd argue that problems can and do arrive in both parts of that, the measure of value and the implied sustainability. Any significant market failure will lead to a systematic mismeasurement of GDP, or for that matter any significantly distorted government incentives. I have no problem thinking that environmental externalities or a financial bubble might push the exchange value of transactions away from their long term social value.

    Here's Michael Pettis on China's GDP in a similar vein:

    http://www.mpettis.com/2011/01/29/how-big-is-chinese-gdp/

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  14. That is precisely what gdp is. I suppose what people have in mind is the composition of that gdp (how much from consumption, investments, government etc.)and making value judgements. Something like "earnings quality" for corporations.

    Som Dasgupta

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  15. From (http://highclearing.com/index.php/archives/2009/01/11/9057):

    "Past Performance Does Not Guarantee Past Performance"

    The blogger points out that the crash was big enough that we might have to revise past statistics.

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  16. GDP is a lousy economic measure, as Stiglitz and others point out. Wall Street causes outright fabrication, as you seem to imply. Here it is in a little more detail.

    The way it really works is that I sell you my dog for $100 million, with favorable 30 year financing. You then sell me a hamster for $100 million with the equally favorable financing. I am now rich, so I then take your billion and buy a bundle of dog loans, sold to me by Goldman Sachs, who collect fees and promises there is virtually no risk and there are sufficient revenue to service the loans, plus a profit. Bear Sterns creates hamster derivatives and trades in dog derivatives, keeping the finest hamster tranches on their books. Wall Street arbitrages between dog and hamster markets while the hedge fund managers do their thing. ( Why invest in the real economy, where you have to hire people, consume resources, make something the public wants (or needs) when you can make more money dealing with a few spreadsheet jockeys on Wall Street? Talk abour crowding out!)

    Everybody is creating instruments, collecting fees, trading for their own accounts and the markets for dogs and hamsters goes through the roof, created by the demand for dog and hamster derivatives to be sold and traded. The derivatives are breeding even faster than the dogs and hamsters themselves. Soon there are trillions of dollars of world-wide notional value in dog and hamster derivatives.

    Suddenly the market realizes that hamsters die long before the original loans on which much of everything is based will be repaid...

    (See Michael Lewis 'The Big Short' for the ending and a more detailed explanation)

    JRHulls
    somewhatlogically.com

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  17. Anonymous11:31 AM

    Maybe that's true! Maybe people in a free market can be tricked en masse into flushing their income down a toilet.

    Well, duh!

    But if you believe this, you believe that free markets are not always a great way of allocating resources. If people can be tricked to such a degree that the size of the trick makes the difference between a boom and a depression, well...that's one big trick! It would be a waste of resources as big as any war, except perpetrated by the invisible hand of markets instead of the visible hand of government. In other words, it would mean that free markets tend to fail, and fail massively.

    Well, duh!

    How is this not stating the obvious? I think the fact that this is not obvious to any economist is what drives me and many of us absolutely crazy about economics.

    The idea that markets are perfect strikes me as so ludicrous in the face of the overwhelming mountain of data that it is hard to fathom.

    The idea that markets are perfect is a bit like thinking that evolution is perfect. It's nice, it makes it easier to think about, but it will give you the wrong answer almost always.

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  18. Anonymous4:37 AM

    nice posting.. thanks for sharing..

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  19. Anonymous7:13 AM

    The discussion is similar to the problem of distinguishing investment vs consumption. If anything, many economists seem happy to dispute that there is a difference.

    This problem carries over in the "debate" over the size of government. Small vs large is a meaningless debate (Probably everyone agrees that 0% is too small and 100% too large). Value for money (infrastructure investment) vs waste (bridge to nowhere) is more relevant and less commonly heard. The cultural difference between these two positions has to do with the relative expectation that "good" policies can be selected democratically more than corrupt/rentier policies.

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  20. Anonymous7:20 PM

    hiya all

    just reading some of the posts on here and found it very interesting.

    one thing i want to know, i dont fully understand economics. i have been having a problem trying to work out what is gdp. i mean where is this figure plucked from and more importantly how is the money put into the economy to create this gdp.

    you see as i see it, and yes i know its a simplistic view, but here goes. imports exports are pretty straight forward but services, how the hell do we create such huge gdp, is the money just created and added to the economy based on a system of debt.

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  21. Anonymous2:39 PM

    US government GDP figures:
    2000: $9.89 Trillion
    2009: $13.86 Trillion
    2010: $14.45 Trillion
    2011: $15.09 Trillion

    Obama: “OMG GM failed, the financial sector collapsed, housing market plummeted, and all these people out of jobs. People are going to realize our GDP/Debt ratio is worse than Greece. What are we going to do Ben?”

    Ben Bernanke solution: print money, transfer to banks, banks transfer it back. There you go, GDP just went up by a trillion.

    Prediction: $20-22 Trillion dollar debt by end of Obama’s 2nd term. GDP will magically grow to a figure close to that. On the road to prosperity!

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