# Monthly Archives: September 2013

This past summer the Bureau of Economic Analysis announced several changes to its approach for calculating GDP.  (See Results of the 2013 Comprehensive Revision of the National Income and Product Accounts, published by the Bureau of Economic Analysis, July 31, 2013). The effect of the changes was to increase GDP by roughly 3 percent compared to what it would have been under the previous GDP accounting rules.

The observer of our government’s recent shenanigans will not be surprised that the accounting change has the impact of increasing reported GDP.  The purpose here is to explain as clearly as possible the change using a simple numerical example.  By understanding the modification one is able form a judgment as to whether the government’s objective is to truthfully and accurately report economic data, or whether the goal is to simply get a higher number that makes the economy appear healthier.   (On a related note, see my March 15th blog titled “Numbers don’t lie, but liars use numbers.”)

To be as clear as possible, I’d like to begin with a review of what GDP is intended to measure.  GDP is defined in textbooks as the “total value of all final goods and services produced in the economy during a year.” So, let’s begin there.

Consider an economy that consists of a single farm that produces only corn, and the farmer generates the following revenue stream by selling the corn (the final output) over a three-year period:

Year 1:  \$400

Year 2:  \$430

Year 3:   \$370

There are two ways to calculate GDP, referred to as the “expenditure” approach and the “income” approach.  Properly calculated the two should result in the same GDP.

The expenditure approach involves tabulating the spending on final goods and services.  As it used to be done, using the expenditure approach the GDP for our example is quite simply \$400 for Year 1, \$430 in Year 2, and \$370 in Year 3.  Easy enough.

The income approach to calculate GDP involves summing up wages, rent, interest and profits.  It should give the same answer.

To illustrate the income approach, suppose our farmer paid an employee \$100 wages in Year 1. The employee’s job was “research and development.”  That is, the employee was paid \$100 in Year 1 to sit around and “think” about how he might increase total output on the farm.  And to keep the example simple, assume the farmer fired the researcher at the end of Year 1 so that no wages were paid in Year 2 or Year 3.

Let’s now calculate GDP for each year using the “income” approach as it used to be done prior to the BEA’s recent high jinx.

Using the income approach, for Year 1 the GDP is the sum of wages and profits, as calculated below:

Profit to the farmer in Year 1 = \$300

Wages paid to the researcher in Year 1 (an expense to the farmer) = \$100

Total GDP  in Year 1 = \$300 (profit) + \$100 (wages)  = \$400.

Summing the farmer’s profit and wages to the worker gives the same \$400 GDP figure as was obtained using the expenditure approach.

In Year 2 and Year 3 the farmer’s profits were \$430 and \$370 respectively, as there was no wage expense (recall, the “researcher” was fired at the end of Year 1).  So GDP was \$430 in Year 2 and \$370 in Year 3.

So far so good.  GDP is the same using either approach.

Now let’s talk about the recent accounting change and again calculate the GDP and using the expenditure and income approach.

First, consider the expenditure approach under the new rules.  Now the \$100 paid to the researcher is considered a “final output” and is added to the year’s GDP.  That is, under the new rules GDP in Year 1 consists of the \$400 of corn produced AND the \$100 paid to the researcher.  Using the expenditure approach, GDP for each year is now as follows:

Year 1:  \$400 (corn) + \$100 (wages paid to the “researcher,” now dubbed to be output) = \$500

Year 2:  \$430 (corn)

Year 3:  \$370 (corn)

Too bad the farmer didn’t pay the “thinker” to do more research in Year 2 and Year 3 so GDP would have been higher then as well!  By “capitalizing” R&D spending it looks like GDP went up in Year 1, but no more output was really produced.

Lastly, let’s see how the GDP will be calculated using the “income” approach going forward.  The researcher’s “thinking” has now been capitalized similar to the purchase of an asset such as tractor.  Thus, like a tractor, it will be depreciated over time.  When calculating GDP using the income approach the BEA adds back in depreciation on capital—that is the only way the expenditure and income approach will yield the same answer.

So, back to the example, suppose Year 1’s R&D spending is expensed using straight-line deprecation in Years 2 and 3.

Under the new GDP accounting gimmick, in Year 1 the farmer’s profit is \$400, not \$300.  The reason is simple:  The \$100 wages paid to the “researcher” are not recognized as an expense in that year—it is now treated as the purchase of an asset!  So in Year 1 the farmer’s profit is \$400.  Added to this are the wages earned by the researcher in the amount of \$100, resulting in GDP of \$500. Presto!

In Year 2 the farmer’s profit is only \$380, as a result of the \$50 expense incurred depreciating the capitalized R&D expenditures.  But depreciation is added back on to wages, rent, interest and profit in order to calculate GDP using the income approach.  So, here is Year 2’s GDP:

Year 2 GDP  =  \$380 (profits) + \$50 (deprecation) = \$430.

And, for Year 3,

Year 3 GDP  = \$320 (profits) + \$50 (depreciation) = \$370.

Again, each year we obtain the same GDP whether we use the expenditure approach or the income approach.  By either approach the accounting change makes the GDP higher in Year 1 by precisely the amount of the R&D spending.

My ultimate purpose here was not to provide a review of the expenditure and income approach to GDP accounting.  But it was necessary to do so in order to provide clarity to the recent change that the government made to the GDP accounts.  And the above example cuts to the heart of the matter.

By treating R&D expenditures as the purchase of capital—treating it like it was a tractor—allows for a higher reported GDP.  In our numerical example, GDP went up in Year 1 by the amount of the R&D expense, with no change in Year 2 and Year 3.  Of course, had our example also had R&D spending in those years, GDP would have been magically higher then as well.

Worse still, under the new GDP accounting, government spending on R&D will count as final output too!

We have preferred capital as money (the benchmark of value and the exchange good) because it seems to us the most natural choice.  After all, the central decision of a free market economy faced by every consumer is what to consume and what to invest (or, put differently, whether to consume now or enjoy a greater amount of consumption later).  It is, at the margin, a production or consumption decision that needs to be made efficiently, on average, in order to result in an optimal economy.  Optimality, in our view, is measured by an economy achieving the maximum future growth path of per capita consumption.  It is stark choice that would and should face each individual consumer every time a unit of capital is given up for a pizza.  The opportunity cost of consumption is especially clear to us, if there is no intermediate good involved in this decision.  That is why we believe that units of broad productive capital are the ultimate money—not commodities, not restricted supply-constrained fiat monies (or virtual commodities) such as Bitcoins, and certainly not government-controlled fiat monies.  A unit of productive capital is intrinsically valuable because it will produce a stream of output over the future.  It incurs an opportunity cost to create because current consumption must be given up to create it.

Although the capital invested has real value, the shares that represent its ownership can be diluted by the inflationary issue of company managers.  Examples of companies that have done this are, unfortunately, not hard to find.  Other companies have retired shares to increase their value.  On balance, the historic return performance of the U.S. broad capital market as represented, for example, by the S&P 500 is impressive compared both to the real and nominal growth of the U.S. economy.  This is testimony to the fact that dilution on average has either not been overdone or to the fact of historic underinvestment in productive capital relative to its optimal level, or both.  Creating a greater incentive to correct underinvestment in productive capital so that a greater per capita consumption path can be attained is our major motive for preferring capital as money—the benchmark of value and the medium of exchange.  At the “golden-rule” capital-intensity, the real return to capital will converge to the growth rate of labor plus the growth rate of labor productivity (read Capital as Money for a more detailed explanation).

Finally, there is another beautiful reason for capital to be money.  In an economy that uses capital as its money, let’s suppose you are a lazy or distracted actor.  You choose not to consume all of your income, for example, but you simply cannot be bothered to think much more than that about the allocation decision or you postpone it.  Probably a more common behavior than we care to admit.  In a capital-as-money economy, your decision not to invest, but rather to simply accumulate money balances, results in you becoming, possibly unintentionally, an owner and holder of more capital by default.  In so doing, you raise the price of capital and stimulate the actual investment in new productive capital.  What a wonderful default characteristic that would be in an under-invested real world economy such as ours.  To see why, consider a lazy consumer in our current fiat-money economy.  When they passively accumulate excess income now, it typically will end up as added balances in a bank savings or checking account.  From there, through the magic of fractional-reserve banking, it is likely to be lent out to some new “credit bubble” activity or other dubious if not fraudulent consumption.  It is probably unlikely to actually find its way to actual new investment in productive capital.

As a theoretically stable, strong private money, Bitcoins, in our view is the next best monetary alternative.  With no intrinsic value, its universality, its simplicity, its growing acceptance, and the faith of the market in its fixed supply are powerful attributes.  If the supply is ultimately fixed, then the real value of Bitcoins will steadily increase at the average real growth rate of the economy.  That Bitcoins are actually gaining traction and acceptance in exchange and value is of huge significance.  The fact that their scarcity and hence value is artificially created is ironically, at the same time one of their greatest strengths and a potential weakness.  Costless to produce, its acceptance and value are irrevocably tied to a faith that its supply is inviolate.  Were Bitcoins to be successfully gamed, duplicated or counterfeited, all bets would be off.  At this point, all the proponents of Bitcoins would hasten to assure us that this is a logical impossibility given the technical sophistication of Bitcoin creation and exchange control.  Yet to raise the concern, however unlikely, is necessary to any who have witnessed the history of unlimited cleverness and greed of humans.  Bitcoins can become a superb private money, but there is no magic.  Avoiding abuse of any private money still requires its users to be astute and vigilant.  We are too familiar with the manipulation and abuse of central bank/government supplied currencies.

Some may be surprised that we would rank an artificial, fixed-supply commodity money superior to an actual commodity money such as gold or silver.  After all, these commodities have the attribute that their ultimate supply is limited by nature.  Further, precious metals have historical record of use that compares favorably with that of the Federal Reserve.  The problem of commodity monies lies in the natural supply.  It is determined not just by nature but also by demand and technology.   Playing either no critical role or a lesser role in production, their highest value is often as money and is ultimately dependent upon their relative scarcity to other goods.

In this light, the U.S. economic history of the 19th century is instructive.  Each major gold discovery—California, Rocky Mountain, Alaska, etc.—was coupled with, not surprisingly, a period of gold inflation (see, for example, The Monetary History of the United States, by Friedman and Schwartz).  The brief period during which we flirted with a bi-metallic standard (gold and silver) was even more volatile.  During the recent run-up in the price of gold and silver, much of the addition to the supply of these commodities has been obtained not only by finding new sources, but rather by us now enjoying the technological capability that makes it possible to more intensively re-process previously uneconomic ores or waste.   Thereby, we essentially “re-mine” previously uneconomic finds.  This should come as no surprise.  When the percentage of the Earth made up by gold, silver, or any other natural commodity is considered—its stable supply and therefore its stable value relative to other goods and services is not at all assured.  Remember, technological innovation, itself, is an economic good (it improves human or physical capital)—it is induced by investors seeking a return, it is not accidental.  Speculative cycles in the value of gold relative to other goods and gold “booms” or “busts” real or imaginary is what led many to conclude that a gold-standard economy would be inferior to one that boasted an “intelligently-managed” government/central bank fiat money.  Sadly, we know where that led.

This is why we prefer the alternative of a fixed-supply cyber commodity to a money based upon a real one.  After all, were it to be corrupted, mismanaged or violated in any way, it could simply be rejected and replaced by a superior alternative.  Of course, any of the three private monies—capital, Bitcoins, or commodity—would lie outside the direct control of the government.  With the demise of the regulated, fractional-reserve banking system and a system of direct lending instead (which seems to be already happening) a money based upon any of them would be vastly preferable to the hopeless money and credit morass we find ourselves in.

For those interested in a more detailed exploration of money, banking, capital and some of the topics discussed in this blog, we recommend checking out the link on this webpage to Capital as Money.   At your preference, we are pleased to announce that the book can now be purchased for either dollars or Bitcoins.  It’s the least we can do to enthusiastically encourage the adoption of an exciting, alternative private money.

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