Tag Archives: Economics

What sense do we make of bad news?

It seems to be the season of bad news. Here, here, here, here and here with some honourable exceptions here and here, various sectors of industry led by the automobile sector seem to be facing slow or negative growth in the last financial year. What sense do we make of these disparate bits of data coming from different corners of the market?

Why are auto sales falling?

Before answering this question, it is important to understand that what we are witnessing is a broadbased fall in sales across the automobile industry, not just in one or two firms. This means that people have, in general, chosen not to buy new automobiles, which in turn means that they have chosen to retain their existing mode of transportation, which could be private or public transportation.

Second, a significant proportion of automobile purchases (2 and 4 wheelers) in India happens with a bank financing the purchase, usually paying a large chunk (70-80%) of the price. The buyer of the automobile pays for it on a 3-5 year EMI schedule. That people are not ready to borrow in order to finance automobile purchases indicates that either funding is not available as easily as before or has become too costly, or the borrowers perceive greater uncertainty regarding their future income and are therefore reluctant to take up the responsibility of paying for a new vehicle under a scheme of EMIs.

So, if automobile sales are indeed falling, it must be a combination of these factors
1. People choosing to retain existing modes of transportation
2. Funding not as easily available as before
3. People not ready to borrow now and pay EMI later due to fundamental uncertainty over their own income
that underlies the problem. But then that raises the further question of why such an outcome should occur, that too across the entire automobile industry after so many years of spectacular, non-stop growth? The answer lies not in an analysis of the automobile industry and its markets but in understanding the broader economic climate in which the auto industry currently operates.

The economic climate

Since 2007, the global economy and the Indian economy along with it have been muddling through what is today called The Great Recession and is being recognised as one of the longest periods of economic growth challenges since the Great Depression. On paper, the recession started in December of 2007 and while there are debates about the official end date, the problems that started in 2007 are far from over. Every now and then, a new crisis pops up and there is a mad scramble to contain it. It was Greece a few months ago and it is Cyprus now. Heaven knows what it will be in the near and distant future.

Like any depression, The Great Recession is just a period of correction that consists of identification of a cluster of entrepreneurial error. In simple terms, a large number of businesses suddenly and surprisingly find that they are and have been producing things that people do not need and are therefore staring at deep losses and capital erosion. As Austrian Business Cycle Theory explains, this cluster of errors is created during the preceding inflationary boom (in this case by the boom of 2001-2007) and is caused by a combination of misleading interest rate signals given to producers, credit injection into the production system and monetary inflation, causing intertemporal discoordination, i.e., a mismatch between consumers’ consumption decisions and producers’ corresponding production decisions.

That producers en masse suddenly find far fewer takers for their goods, as automobile manufacturers currently do, is a result of this intertemporal discoordination. When this happens, what a sensible producer should do is to understand the economic climate, try to develop a better forecast of what the future, medium and long-term, is likely to look like and adjust production decisions accordingly. This could mean, in some cases, producing less of the good. It could even mean completely ending certain lines of production, i.e., shutting down certain businesses.

Such decisions are usually accompanied by a lot of pain as many people are put out of employment and, in many cases, will need to reskill themselves to the requirements of the new production structure. This puts further strain on many already struggling businesses leading to more business failures and more people being out of unemployment. While this sounds painful, it is just the market’s way of clearing past production decisions that are not in line with consumer preferences.

This process goes on till the market clears out all such poor decisions and leaves the production system in sync with consumer preferences. Capital is taken out of the hands of those who made poor forecasts of the future into the hands of better forecasters, i.e., from failed entrepreneurs to successful entrepreneurs. This is the proper point of economic recovery. Further economic expansion would, under a free market, be triggered by fresh decisions to save and add to the capital available to be advanced for production for a more distant future.

An alternative, equally or more likely in today’s FRB system, is that the banking system interrupts the market’s cleaning up process and initiates a fresh round of interest rate depression through credit expansion and monetary inflation, thus flooding the market with cheap money and cheap loans. This time, however, one would also have to contend with the possibility that such measures are not guaranteed to work like they have in the past. Experiments in the Western world indicate that such attempts have not really led to an economic recovery this time round.

Summary

What the auto industry is going through today could very well be one of the manifestations of the bursting of the bubble created from 2001 to 2007. If people are not buying as many cars as they are producing, it is probably because they do not wish to see producers produce as many cars as they are producing. It is possible that the market is crying for a correction and that producers need to cut-back production to the level customers are ready to support. This is clearly one of the possibilities for any producer. Alternately, producers could place their bets on the RBI, through the banking system, inflating a new bubble through a fresh round of credit expansion and monetary inflation. In this case, they need to hold their horses for the recovery to happen while being prepared to profit the most by being at the vanguard of the recovery.

Clearly, therefore, each entrepreneur will have to decide which scenario is likely to play out and what is the most appropriate course of action for him. It’s not easy, but no one ever said that operating a business in an environment of uncertainty created by endless meddling in the market would be easy. The times sure are challenging and let’s hope many entrepreneurs do make their way heroically through this economic fog to do what they do best – meet customer needs in the best possible way.

What we need to take home, and what this article seeks to emphasise, is the point that in many circumstances, having sound economic understanding can help us understand business situations far better than those economically uninformed or ill-informed can. We can also see that cutting through the fog and making sense of complex situations is made possible by a good grasp of sound economic principles. The situation created by falling sales of the automobile industry in India only highlights the point that learning sound economics is a critical prerequisite for any aspiring business manager seeking to create a career out of making effective business decisions in a complex economic environment.

Economic science is in dire straits

This article brings out quite well and rather unintentionally a lot of what’s wrong with Economic science in India (and frankly, the entire world) today. Particular points in the article are especially revealing. Take this segment, for instance, where the author gives you a mental image of the typical macroeconomist.

…. he’ll tell you that he actually studies the impact of soft coal prices in the Ruhr on the velocity of the money supply in West Germany in the 1970s and something else you will never learn because you suddenly hear your phone ring.

So what IS the macroeconomist doing? He is building a model. A model is a mathematical framework that gives us the values of certain output variables for different combinations of input variables. The model does this by assuming certain mathematical relationships between the input and output quantities.

Why is the macroeconomist trying to build a model? The primary purpose of modelling is to be able to predict outcomes of actions and choices. To do this, a model first tries to explain observed correlations between the same input and output variables in one or more historical circumstances. The more the number of such instances in which the model makes accurate predictions and the lower the error, the more robust the model is said to be.

Where would such models be used? One key use of such models is in policy formulation and evaluation. The term policy in particular refers to the particular approach that government would take to the broader economy or a specific segment thereof, which in turn translates to the manner in which government chooses to intervene in the economy or a particular segment of it. Thus, we see that models are primarily used in shaping and evaluating government interventions in the economy.

Another key use is to help businesses in making better economic forecasts and therefore in making better business decisions.

What is the problem with this approach?

The problem is very fundamental. Model building is based on assumptions that are absolutely unsuited to the study of Economics. Every model assumes certain constant quantitative causal relationships between the input and output variables. As a social science that may be defined as the study of exchange, sound economic theory cannot assume any such constant quantitative causal relationships between variables.

Unlike in the natural sciences where twice the volume of water flowing into a leak-free pipe will mean twice the water flowing out as well, in Economics, the subject of the study is man. The singular trait of man is his unpredictability. No two human beings may be assumed to behave the same way in the same circumstances. The same human being may not behave the same way in the same circumstances at different points in time.

What this translates to is this – In the natural sciences, if a stone thrown up today falls back to the ground, a stone thrown up in identical fashion tomorrow will fall back to the ground as well. In economics, however, such automatic repetitive and repeatable behaviour cannot be expected because we are talking of people, not stones.

What models end up doing, therefore, is that they make unreal assumptions about human behaviour in order to make their predictions fit observations at some point in time. The problem in doing so is that past robustness of a model in explaining is no indication of its correctness or its future accuracy. People change, and with that change economic outcomes. Models cannot predict the manner in which people can change.

Modelling in economics is little different from voodoo. Personally, I like to call it the virgins in the volcano method of economics. In simple terms,

The model says that there is a strong correlation between the number of virgins that fell down the volcano and the amount of rain that fell every year. So in order to improve rainfall this year, let’s throw a couple more virgins down that volcano right away.

What we learn is that the very attempt at creating economic models is fundamentally and deeply flawed. What do we say about economics education when modelling is the core of the development of economic science? May I say “Heaven help us”?

An economic depression is not a bad thing

Most people I speak to think that an economic depression is a problem that needs to be solved. Take a look at this article, for instance. This notion is far from correct. An economic depression is a period of necessary correction. An economic depression is necessarily and always preceded by an inflationary boom.

The real problem is the inflationary boom for which the bust is the cure

During the boom, policies targeted at interest rate depression allow the banking system to expand credit way beyond the available pool of real savings. This results in massive investments into projects that never would have been invested in on the free market. At the very least, new investments would need to be accompanied by
1. additional net saving by consumers
2. movement of capital from lines of production of other less preferred goods
These prevent the possibility of an inflationary boom. These conditions are a logical necessity for the new investment to happen.

However, an inflationary boom creates malinvestments. The process of creating the inflationary boom necessarily also includes the pins required to prick the bubble at some unexpected point in time. When this happens, the market reassesses all the investments made and sorts them into good and bad investments. This is done through the profit/loss mechanism and made explicit through the phenomenon of business bankruptcy. While this process involves pain, without it, the market cannot realign investments to be in line with consumer preferences, especially across time periods.

Economists would say that the boom causes intertemporal discoordination while the bust corrects those errors and brings about the highly necessary intertemporal coordination once again.

The free market is capable of keeping the inflationary boom in check

Even if the banking industry or a segment of it were to engage in fractional reserve banking by emitting far more paper, plastic and electronic forms of money than the real money commodity that they have on hand, the free market has a built-in mechanism to keep this under check. This is called bank failures.

Let us take, for instance, a region that uses dollars defined as a 1 ounce coin made of sterling silver as the unit of money. If a bank with $1 million in real dollars issues $10 million in paper dollars, the over-supply of paper dollars can easily be identified by the market. Further, the fact that on this market, every bank’s notes would be clearly identified with the bank (they would be printed as XYZ bank notes) and the market would easily be able to establish different rates of discounts for notes issued by different banks.

A more inflationary bank’s notes would be more deeply discounted than the notes of a less inflationary bank. Prices of goods might be quoted in dollars but one would have to fork out more $1 notes of an inflationary bank than the quoted dollar price. For instance, if an inflationary bank’s notes faced a discount of 50% on the market, a customer wishing to buy a good priced at $50 by paying in notes of the inflationary bank will need to fork out notes of $100 face value. If the discount were 75% because the bank is perceived as highly inflationary, he will need to fork out notes of $200 face value. Thus, the greater the inflationary condition that the market sees in a bank, the less valuable would be the money substitutes emitted by the bank.

Further, the more inflationary a bank is assessed to be, the more likely it is to be brought down by note and deposit holders walking into the bank’s branches and asking for real money in exchange. While this could be due to a loss of trust in the bank, it could also be because a trusting customer has issued a cheque to the customer of another bank that is asking the inflationary bank to pay in real dollars (which it does not have).

Such failures of fractional reserve banks would lead to a more cautious public wary of inflationary fractional reserve banks. Fractional reserve banks would then have to incentivise people to place money in their accounts, which in turn would raise the cost of their funds available for loans. In addition, being rated as a non-inflationary bank would make a bank more attractive to a public seeking greater safety of their money. In this process, the very service of getting rated on inflationary practices would become a valuable service that could be offered by rating agencies. Thus, we see that on the free-market, there exist many possibilities of mechanisms to keep fractional reserve banking in check.

If fractional reserve banking is in check, so is the inflationary boom. Thus, we see that an inflationary boom of the kind that we see today is impossible on the free market and that it is only fractional reserve banking with no market controls that causes the inflationary boom.

When we will encounter massive inflationary booms

Massive inflationary booms necessarily require massive interventions that prevent the functioning of market mechanisms. These typically take the form of government action aimed at protecting the inflationary segments of the banking industry. Today, these take the following forms
1. Central Banking with a monopoly on money issue and bank licensing
2. Central Banking as a source of lending of last resort to failing banks
3. Deposit insurance that is politically motivated and priced
4. Legal tender laws that force acceptance of inflated money substitutes at par
5. Capital gains taxes on alternate forms of money
In the absence of these forms of protection, it is impossible for a fractional reserve banking system to become as prevalent as it has become today.

The conclusion

We need to stop fearing or hating the economic depression. What we really need to be wary of is the inflationary boom that forces the pain of the bust on people at large. We also need to fear all the interventions that make the inflationary boom possible and the periodic pain of the depression a “necessary” feature of our lives.

How inflationary banking creates economic depressions and recessions

In response to my post of yesterday , a student of mine, Sankalp, had asked this question to which I responded thus. Sankalp raised an important point that I am sure a lot of people believe. With a little elaboration from my side, his question becomes this

What is the problem in banks being inflationary by nature if by engaging in such inflation, they will be able to lend much more and a lot more investment can happen? Would not an economy where lending is constrained by the actual amount of cash experience highly hampered growth in comparison?

Ordinary people see no problem in this state of affairs. Those with an exposure to mainstream economics would in fact jump to a fierce defence of this system and argue that growth would become highly constrained if the banking system were to allow cash to sit idle in the bank’s vaults while thousands of investment-worthy projects gather dust and go to rust.

The Austrian School of Economics in the tradition of Carl Menger, Böhm Bawerk, Ludwig von Mises, Friedrich Hayek and Murray Rothbard takes a radically different view of this situation. Austrian School economists explain that the much dreaded economic depression (including its modern semantic avatars, the economic recession, slowdown, downturn or whatever you wish to call it) is caused by the inflationary banking system.

The explanation, known by the name Austrian Business Cycle Theory, originated in the work of Ludwig von Mises in his book, The Theory of Money and Credit (1912) and was further developed by his student, Friedrich Hayek, in his books Monetary Theory and the Trade Cycle and Prices and Production. In fact, Friedrich Hayek went on to win the Nobel Prize in Economics in 1974 for his Business Cycle Theory, the only Austrian School economist to do so till date.

The brief version of Austrian Business Cycle Theory

In an earlier post, I had presented a stylised representation of a production system in which the original means of production, labour and land, are applied across various stages of production and eventually transformed into consumers’ goods. We saw in that case that the consumers’ goods output worth 100 oz was made possible and supported by a total capitalist saving of 318 oz.

What would happen if consumers were to decide to save 20 oz? Two things happen.
1. Consumption now falls to 80 oz
2. Capitalist savings go up to 338 oz
But what is the use of greater saving being available from capitalists when people have decided to consume less? The trick is to recognise that saving is a deferral of consumption, not permanent abstinence from consumption. In simpler terms, the saving is intended as future consumption. Saving is a decision to change the time of consumption.

This decision by consumers gets communicated to producers through a fall in the rate of interest. Producers take a cue and decide to rejig their production for a more distant future. In doing so, the production system becomes longer, with more stages of production. Hayek presented this in a highly stylised form using what are today known as Hayekian triangles as shown below.

Fig 1 - Hayekian Triangles representing the effect of new capitalist saving on the structure of production

Originally, a total saving of 160 oz churned out an output of 80 oz worth consumers’ goods. Now, a total saving of 180 oz churns out an output of 60 oz worth consumers’ goods. In our 6-stage production structure, a similar outcome would occur with a corresponding increase in the number of stages of production.

Many outcomes result. The immediate fall in demand for consumers’ goods leads to a fall in their prices. This is transmitted up the production structure, but the lower consumption does not put factors out of employment. The lower interest rate causes remoter stage capital goods prices to rise on account of much lower discounting (lower interest rates) of their imputed future contribution to revenue (called their discounted marginal value product). In the long run, greater availability of savings results in increased demand for factors in remoter stages of production.

The addition of stages implies greater specialisation and division of labour implying more efficient production thus leading to greater volume of consumers’ goods output in the future. This leads to a further fall in consumers’ goods prices in the future. However, when the greater output of consumers’ goods hit the market, the saved funds are now available to support their consumption. For the same 60 oz of spending, consumers get to consume the greater output of the longer and hence more efficient production system. This is the normal process by which an economy advances and standard of living improves.

Inflationary credit expansion and the production structure

When the banking system inflates money supply, it does so by injecting credit into the production system in the form of loans made to producers. This injection, however, takes place without saving by consumers. An injection of 80 oz of credit makes the production structure as long as in the earlier case with the 80 oz of consumers’ goods output being supported by a total apparent capitalist saving of 240 oz.

Fig 2 - Hayekian Triangles representing the effect of credit injection through monetary inflation on the structure of production

To achieve this credit expansion, the banking system will need to depress the interest rate. This lowered interest rate raises the prices of remoter stage capital goods as in the case of real savings, shifting factors of production there. However, the greater availability of capital without a fall in the demand for consumers’ goods results in a rise in the prices of factors of production. When the greater income is spent on consumers’ goods, their prices start going up as well, though after the prices of capital goods and their factors of production go up.

A general feeling of prosperity is created all around as capital goods prices, consumers’ goods prices, wages and rents go up and profits emerge in the economy. This is the inflationary boom like the one we experienced from 2001 to 2007.

However, inflationary pressures soon catch up and the system is forced to raise interest rates. Production processes that started in the reduced interest rate regime suddenly become impossible to continue further. To make matters worse, when the greater output of the more efficient, longer production structure hits the market, savings are not available to be spent on them. Unsold inventory piles up and businesses rack up huge losses.

The result is widespread business failure including failure of financial institutions that made loans to borrowers who end up defaulting. This is what we understand as the bust, commonly known as an economic depression or recession.

What we see

The lengthening of the production structure caused by genuine saving was stable and sustainable in the long run. Lengthening fuelled by credit expansion, however, is unstable as the manner in which it is done creates pressures that force an untimely increase in interest rates resulting in the depression stage of the business cycle. We see that once the inflationary boom is triggered by credit expansion through monetary inflation by the banking system, the bust is inevitable.

Thus, Austrian Business Cycle Theory helps us understand that it is the inflationary banking system that is the primary cause of all the misery created by the phenomenon of economic depressions. The key question now is

Are these boom-bust cycles inherent to the capitalist system of production or are they a result of intervention in the economy? Is it at all possible to eliminate the business cycle?

These important questions shall be the subject of another post on another day.

Fixing Inflation

This article raises an issue very relevant to the times we live in – fixing inflation. Summarising what Mr. Subbarao says, inflation is a supply side problem. That means that according to him, inability of the system of production to keep up with the ever-rising demand for goods and services is responsible for steadily rising prices. This inability, he implies, is due to fiscal policy failures and a slow pace of reform dragging economic growth down. The responsibility for fixing the problem, as per Mr. Subbarao, lies with the government. In his opinion, there is precious little that the RBI can do to stimulate growth without stoking the fires of inflation.

Mr. Chidambaram, on the other hand, believes that he has done what he could and was expected to do, i.e., keep fiscal deficit under control, to keep inflation under control, and that the ball is now in the RBI’s court. He believes it is time for the RBI to cut interest rates and tinker with other parameters in its control (like CRR and SLR) to boost growth.

What do we, as ordinary people, make of this debate happening in rarefied environs? Let me make a beginning by focusing, in this article, on inflation.

What is inflation?

The commonly accepted definition of inflation is the steady rise in prices, which is measured through price indices like WPI and CPI. The Classical (Original) definition of inflation, however, is the increase in money supply. This might come as a surprise to many of you because all you may have heard is the commonly accepted definition given above. So here, here, here and here are some links that confirm what I am saying.

Which of these is meaningful and useful?

Only the Classical definition of inflation is meaningful and helps us understand real world phenomena like ever-rising prices while the commonly accepted definition is utterly useless.

Why is the Classical definition meaningful and useful?

Money is a commodity like any other. It has a price too. That price is determined, like it is for all other commodities, by the forces of supply and demand. When money supply increases, the price of money falls. When the price of money falls, the prices of goods and services denominated in that money rise. A steady rise in the supply of money causes a steady rise in prices. Thus, the Classical definition of inflation helps us understand the real world phenomenon of rising prices from fundamentals and is therefore meaningful.

Why is the commonly accepted definition of inflation useless?

Defining inflation as the steady rise in prices tells us nothing about what caused prices to rise in the first place. Explanations like the demand-pull and cost-push theories, and structural/built-in inflation are based on elementary economic fallacies and errors. For instance, if we say that prices are rising because demand is rising, what caused the demand to rise in the first place? If we say prices rise because costs rise, aren’t costs prices themselves? Are we then not bound to explain what caused THOSE prices to rise first? If we do not, would we not be guilty of engaging in circular reasoning by saying that rising prices cause prices to rise? And is saying that some price rise is “built-in” not a negation of economic theory itself, especially price theory, which seeks to explain prices from fundamentals?

A small point of caution while using the Classical definition of Inflation

It often happens that productivity improvements send supply of goods and services up so rapidly that we do not see rising prices but stable or even mildly falling prices. In such cases, it is important to bear in mind that in the absence of inflation, prices of these goods and services would have been much lower than they currently are. So, merely observing stable, slowly rising or mildly falling prices in the face of increase in money supply does not negate the Classical definition of inflation.

What causes money supply to increase steadily?

As explained in my previous post, the banking system that we live with is the fundamental and most proximate cause of inflation. Fractional Reserve Banking is based on creating money many multiples of the monetary base we start with. A banking system with a 10% reserve ratio can multiply every Re. 1 into Rs. 10. The Rs. 9 is addition of money supply by the banking system.

Central Banks (like RBI) make matters worse. They have reserve ratios of their own based on which they lend reserves to banks. The US Fed, for instance, has a reserve ratio of 35%. This means that the Fed multiplies the banking system’s monetary base by 1/0.35 or 2.9 times. Combined with the banking system’s reserve ratio, every $1 can be multiplied into $29. The inflationary potential of the banking system is thus magnified by Central Banks.

Government spending draws resources from the private sector through taxation and borrowing. All this leads to a pressure to keep increasing money supply.

It is these 3 factors – the Banking System, Central Banks and Government – that are responsible for causing inflation (as per the Classical definition).

What does this help us do?

At the very least, it helps us pin the blame for the phenomenon of ever-rising prices. At a deeper level, it gives a solution to the problem. All it takes to solve the problem of inflation is for the triumvirate identified above to stop engaging in inflation (as per the Classical definition).

The question is, would they? And if they would not, why is it so? These are important questions that we will find answers to in subsequent posts.

The humble idli, politics and economics

The Indian politician has never been the symbol of economic wisdom. I am truly privileged (/sarcasm) to live in a part of India where politicians never cease to be funny and do hilariously stupid things. The latest in the line of economic foolishness is this

http://articles.economictimes.indiatimes.com/2013-03-02/news/37389936_1_idli-subsidised-canteens-dmk-government

No matter what economic theory says, politicians will play politics and this is just one more example.

First, prices of goods are determined by the forces of demand and supply. Demand and supply, in turn, are determined by the subjective preferences of all the individuals who constitute the market. No one’s whim can supplant the will of the market as a whole.

Second, every unit of every factor employed in the production of a good will be paid its Marginal Value Product. In simple terms, if an additional unit of a factor earns a firm Rs. 5000 per month, Rs. 5000 per month (or a suitably discounted amount to account for the time difference) is what will be paid to the factor. Employers do not whimsically decide what they wish to pay any factor, be it land or labour. In the long run, those who decide on whim will either be put out of business or be taught a lesson by the market.

Third, in the long run, there is no such thing as profit except for the entrepreneur’s act of wisdom in identifying underpricing of factors in the market. Even such profits are short-lived because they attract capital into that line of production leading to falling price spreads and the eventual elimination of profit. All that capitalists earn, in the long run, is the interest income for waiting to consume.

Finally, the real cause of steadily rising prices is government and the politicians themselves. It is government that is responsible for steadily increasing money supply sending prices of all goods and services perpetually upward except for occasional blips. If a politician really wants to address the burning issue of rising prices making essential commodities unaffordable to the poor, he needs to make difficult political decisions and bring government expenditure to the bare minimum, if not to zero. All subsidies and other forms of welfare have to be stopped. Government should, at the worst, limit itself to policing, national defence and judicial services (Frankly, there is no argument for government having a monopoly on these as well, but let me rest that argument for another day).

If idlis currently cost Rs. 3 apiece even at the road-side eateries, that means that no one can afford to sell them at a price below that and hope to stay in business for long. Government may think it is beyond the laws of scarcity, supply and demand but in reality, it is not. Someone will have to bear the cost of these cheap idlis and who better than the tax payer. As the government creates a deep hole in its pockets, what else will it do but dig deep into the pockets of ordinary, hard-working, honestly earning citizens. More taxes are on the way!

And taxes mean that we all pay the price in more ways than one. First, we consume less today than we would if we weren’t taxed. Second, we save and invest less. Therefore, production in the private sector suffers in the long-run. So through a relative shrinking of the production structure resulting in lower supply of goods and services and lowered employment of factors, we all suffer a lower standard of living.

If governments do not explicitly tax citizens to make up the additional deficit, they will have to implicitly tax them by inflating money supply. The consequence of this is the very price rise that politicians seek to contain by subsidising idlis.

The simple lesson that we have to learn and throw at our politicians is this – Prices are a market phenomenon that no politician can hope to control. Rather than engage in futile attempts to control prices, politicians should work towards shrinking government to the point where its existence does not impoverish ordinary people to enrich those in and connected to government.

GDP – A poor and misleading economic indicator

GDP or Gross Domestic Product is the most popular concept used to quantify the total output of goods and services in an economy. It is the sum total of the value of

  1. Private spending on consumers’ goods
  2. Private spending on durable capital goods (like plant & machinery)
  3. Government spending
  4. Net exports (Exports (X) – Imports (M))

The figure thus obtained would be called Nominal GDP or GDP at current prices. However, one of the primary uses of GDP is to compare economic output across different time periods. In such a comparison, we need to bear in mind that

Value of spending = Volume x Price

So, Nominal GDP can go up from one year to the next due to 2 reasons

  1. Increase in the volume of goods and services produced
  2. Increase in the prices of goods and services produced

Spending more for the same volume of goods and services does not indicate greater well-being. Therefore, to make GDP a measure of well-being, it is considered essential to adjust the Nominal GDP figure for the increase in prices that occurred from one period to the next.

This is called the inflation adjustment of GDP and the resulting figure is called Real GDP or GDP at constant prices. With this, economists feel that they have a good measure to track improvement in human well-being through the greater production and consumption of goods and services. The GDP growth rate figures we read about in newspapers and magazines are nothing but percentage changes in this Real GDP figure from one year to the next.

Why GDP is considered important

GDP is supposed to measure the total output of goods and services in a certain geographical region. The logic is that the more we are able to consume, the more ends we are satisfying as human beings and therefore the better off we are. Rich people (and rich nations) consume more while poor people (and poor nations) consume less. In fact, this is the reasoning behind using Per Capita Income (PCI) calculated as

PCI = Real GDP/Population

as a measure of the income of individuals in a geographical region. Typically, rich countries have high PCI and poor countries have low PCI.

Is GDP a good economic indicator?

GDP is definitely a popular and the most commonly used measure of economic output. Governments across the world, their economists and statisticians and even those in academia use it extensively a measure of economic output and prosperity. Despite all its popularity, however, the concept GDP is a deeply flawed measure of economic output.

Explaining why GDP is a very poor economic indicator

{This is going to be a fairly long explanation. So do bear with me and stay on and read it all (if you have come this far). I am taking as much effort as possible to keep it simple.}

Understanding the organisation of production

Consider an economy that uses silver as the money, where the unit of the money is 1 ounce of silver (1 oz = 31.1034 gms). Let us say that in this economy, the total output of consumers’ is goods is 100 oz. Clearly, these consumers’ goods have to be produced for people to consume them. Let us further say that these consumers’ goods were produced through a production process involving 6-stages of transformation. Of these 6 stages, only one stage, which we label Stage 1, churns out consumers’ goods while the others produce producers’ goods that are further transformed in subsequent stages to eventually get transformed into consumers’ goods in Stage 1.

Any production process uses 3 types of producers’ goods (also known as factors of production) – Land, Labour and Capital Goods. Of these, Land and Labour are considered the Original Means of Production while Capital Goods are understood as Produced Factors of Production. In our stylised view of the economy, Stage 6 (the stage farthest from the stage of consumption) applies only Land (L6) and Labour (l6) to produce a Capital Good. Let us label this CG5. In Stage 5, CG5 is applied along with more Land (L5) and Labour (l5) to produce a further Capital Good, CG4. Generalising this, in Stage i (i >1), CGi, Li and li are applied to produce CGi-1 till eventually, in Stage 1, CG1, L1 and l1 are applied to produce Consumers’ Goods worth 100 oz.

This may be summarised in an even more stylised form as shown below

Stylised representation of a 6-Stage Production System

Please note that in this construct, each capitalist is buying the services of the capital good and not the whole good itself. A simple instance of this is that land used in production is rented and not bought. This, however, does not present a challenge to economic theory, as the price of the whole capital good is just the net present value of its future rentals. Let us now assume the following table of prices of factors of production (their services).

Table 1 - Prices of Factors of Production

So, we see that the capitalist in Stage 1 gets 100 oz upon sale of his consumers’ goods but he immediately turns around and spends 95 oz on buying factors of production so that he may produce the next period’s consumers’ goods. This 95 oz is the saving made by the Stage 1 capitalist period after period. The same is true of capitalists in all stages. The table below illustrates the income and saving by capitalists in every stage of our 6-stage production system.

Table 2 - Prices of Factors of Production

The time element in production

One important aspect of production that is mostly ignored is the time taken to produce. All production takes time. We should not get misled by the fact that at the time consumers’ goods are being produced in Stage 1, producers’ goods are being produced in every other stage. These producers’ goods are intended to and will eventually be transformed into consumers’ goods in subsequent periods. If we take the time taken in each stage to be 1 year, the table below illustrates the important time element of production.

Table 3 - The Time Element of Production

We see that in order for 100 oz worth of consumers’ goods to be available now (Year 0), it is necessary that the Stage 6 capitalist should have initiated a round of production of CG5 6 years ago. Similarly Capitalists in stages 2 to 5 should have initiated a round of production of their capital goods 1 to 5 years ago respectively. In other words, the production process for the consumers’ goods that we buy today started 6 years ago. If those capitalists had not started the production process 6 years ago, we would have no consumers’ goods to consume today.

Similarly, the capital good of which the capitalist in Stage 6 starts production now becomes a consumers’ good only 6 years from now, i.e., at the end of year 6. At the end of each year, the capital good produced moves to the next stage of production till it comes out as a consumers’ good 6 years later.

Alternatives in organising production and the role of the capitalist

There are 2 ways in which this production can be organised.

  1. Joint ownership of the factors of production – In this case, the Land and Labour factor owners jointly own the capital goods till the last stage where they become the owners of the final consumers’ good at the time of sale. In this case, they will have to wait until the final sale to earn an income and be able to consume.
  2. Capitalist ownership of the factors of production – In this case, capitalists at every stage advance money (from their saved capital), and get to own the factors of production (their services in our construct) and hence the output of their stage. Further, the owners of Land and Labour factors get to consume right at the beginning of the process while the Capitalists do the waiting till the end of their stage.

Case 2 is the almost universal one, especially in more advanced economies. The important point to note is that the Capitalist in the production process plays a very important role. He offers his capital (created by prior savings or deferral of consumption) to factor owners and thus makes production without waiting (to consume) possible for others. For instance, the capitalist in Stage 1 offers savings of 95 oz (80 for CG1 and 15 for L1 and l1) and applies them to produce consumers’ goods worth 100 oz. This division of roles makes organised production more possible. The capitalist’s offer of his capital is made at the beginning of each stage while he gets income from sale of the output of his stage at the end of his stage.

The source of factor incomes and the importance of Capitalist Saving

A common misconception in economic theorising is to treat the economy as some kind of circular flow. This error is especially committed by proponents of the Keynesian School of Economics. This erroneous view leads most people to imagine incomes to factors of production as originating from consumers’ spending. The image many carry in their mind is of the capitalist getting income from the consumer and passing it on to factor owners while doing little himself and pocketing a portion of the income (some like the Marxists claim unfairly).

What really happens, as we have seen in our example, is that incomes to all factor owners come, not from consumer spending but from capitalist saving. This is true of every stage of production where the capitalist of that stage offers his savings to factor owners to make that stage of production possible without further waiting by the factor owners. Each capitalist at every stage makes a saving at the start of each round of production to buy the services of the factors of production, including those of capital goods produced in the previous stage. The table below illustrates this. Row 3 represents the Year with 0 standing for “now” and –i standing for i years ago.

Table 4 - Timing of Income and Saving of Capitalists at all stages

In the real-world case of a production system that produces 100 oz worth consumers’ goods every period, we see that such a production system is possible on a sustained basis only if the capitalists of all 6 stages keep engaging in the same saving period after period. In this specific example, the total saving required is (95+76+57+43+28+19) = 318 oz.

Without this saving, the production process will soon come to a standstill and there would be no consumers’ goods output to buy and consume. This total savings by all capitalists, also called Gross Savings, is the true measure of the magnitude of economic activity. While it appears as though adding together the savings of different stage capitalists involves some double counting (the payments made for CG2 are already included in the price of CG1 and hence of the consumers’ good), the error in this notion is that it fails to account for the fact that at any point in time, the payments made in different stages become part of the value of consumers’ goods output of different periods. For instance, while the Stage 1 capitalist gets 100 oz for the consumers’ goods offered now, the 95 oz that factor owners get now is for the 100 oz worth consumers’ goods output of Year 1. Further, it completely glosses over the fact that it is the cumulative saving by ALL capitalists that makes sustained production possible. The charge of double counting is therefore completely unjustified.

Under this system of thought, the total output of the production system is the total payments made at all stages of the production system, i.e., consumers’ goods payments of 100 oz + gross savings of capitalists, i.e., 418 oz. We may call this figure Gross Domestic Expenditure (GDE).

What is really wrong with GDP

Given this complexity of a capitalist system of production, the concept of GDP takes into account only the payments made by consumers and those payments by capitalists that are for durable capital goods. In our construct, since every capitalist buys only the services of capital goods and not whole capital goods, GDP in this system would be just 100 oz (the amount spent on consumers’ goods).  This view completely misses out the total advances made by capitalists towards the purchase of the services of capital goods, land and labour. By doing so, it misses out the heart of a capitalist economy and hence tells us very little about the real magnitude of economic activity.

Thus, we see that GDP is a highly deficient measure of economic output.

Things get worse for GDP

The onset of a recession is always marked by a spike in interest rates and a consequent sharp drop in spending in remoter stages of production. This results in a fall in spending on consumers’ goods, which manifests itself as a drop in GDP. Many modern governments looking at this and guided by Keynesian macroeconomic theory say “Hey! GDP is falling. So let the government spend more and boost GDP and thus income. After all, Y = C + I + G + X – M. If I has fallen inexplicably and C too as a result, then higher G will make up for these.” So governments spend more and boost GDP. A general feeling of economic recovery spreads. The truth, however, is that while GDP might go up, GDE still remains low because boosting GDP does not influence the underlying factors that caused capitalist spending on production in remoter stages to drop. The economy remains moribund or, worse, the recession deepens.

The conclusion

GDP is a poor measure of economic well-being. It does not even measure economic output well. To make matters worse, it is even misleading and guides policy makers towards wrong-headed policies. The sooner we get over this misplaced faith in GDP as an indication of economic well-being, the better off we will all be.