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In this lesson we are going to try clarify why is that "normal" economic data makes no sense to you and why is that such data does not reflect how you "feel" the economy. Be warned. By the end of this lesson you will probably end up leaving even more confused than when you entered!

ECONOMIC MUMBO–JUMBO

We have all heard the pseudo–scientific mumbo–jumbo that government economists routinely spin in support of their masters: the politicians.

– This parameter is up 5% since the beginning of the year and therefore the economy is doing well… yet, prices are going up and you have been unemployed for more than one year.

– Then, on the other hand, the other parameter is down by 3.674 % which indicates with a moderate degree of certainty that the business cycle will probably be in a downtrend at some point in the year and hence the Central Bank will have to lower the interest rate by a few points. However, you just got a salary rise and your company is making record profits. Go figure.

That's right. Economists always go figure; they never figure out anything with any degree of certainty. Actually, it would be a safe to bet that standard economists are incapable of forecasting anything with any degree of certainty (see The Economy Cannot Be Forecasted).

Among the prime parameters that Keynesian (or monetarist) economists refer to is the GDP. If we want to understand what's going on, we have to review this measurement.

CLASSIC GDP

Definition

The GDP (Gross Domestic Product) is the market value of all the final goods and services manufactured by a country in a year.

This is, the value of all the stuff and the services people have bought or can potentially buy throughout one year. Now, every time that we see the word "potential" in an economic calculation we know that some data will be made up. This is so because if a good or service is not actually bought in a market, we have no idea of its real market value. Think of a can of beans sitting on a supermarket shelf. It's marked at 1 Ruble. Does this means that its price is 1 Ruble? No. It only means that is being offered at 1 Ruble. People may buy it for 1 Ruble or the supermarket may discount it to 90 cents at which price it is actually bought. So, until the transaction actually takes place, the market value of a good or service is unknown.

Therefore and from the beginning, it is clear that the GDP is a flawed measurement since involves guessing market values.

Monetarists assume the GDP is a reliable measurement!

We will suspend disbelief and for this lesson we will agree with their assumption purely for analytical purposes.

Meaning
What is the meaning of the GDP?

Technically speaking, the GDP is a measure of the manufacturing output under a given set of circumstances, in a given territory over a given period of time.

Practically speaking, economists use it as a measure of a county's wealth. In other words, it is an approximation based on a flawed measurement… but we digress…

The GDP is revered by Monetarists as a measure that allows for comparison between countries. My GDP is larger than yours! Take that!

But what's more important than the GDP is the percentage difference between last year's GDP and the current GDP. This is so because this is the difference in wealth between last year and this year. But this difference is coming from the manufacturing of final goods and services. Therefore if we have less final goods and services this year this means that manufacturing has decreased.

And so, percentage GDP (%GDP) is used as an indication of manufacturing activity or economic health.

This is why mainstream economists speak about the GDP rising "only" 1% this year or "overheating" with 10% growth.

Composition

The logistics of how the GDP is actually calculated is not important. What is important is its composition. This is, who is creating said final goods and services in the market. In general terms it is assumed that its composition is roughly:

  • 70% Consumer Spending
  • 20% Government Spending
  • 10 % Private Investment

This would mean that the GDP depends mostly of how much you, us and every other person spends in year (%70) plus of how much the Government spends in a year (%20) plus of how much Corporations spend in a year (%10); all in final goods and services.

Operation

The composition of the GDP provides Monetarists with insight as to how to manage the economy. They reason backwards; if the %GDP = manufacturing activity, anything that will increase this percentage will increase manufacturing and therefore economic wellbeing.

If we then notice that 70% of the GDP is due to people's spending, anything that increases people's spending will increase %GDP and therefore economic activity. So, for the Monetarists the first golden rule to economic heaven is:

People must spend, spend and spend!

But this is not the whole story. Remember that the other 20% of the GDP is due to Government spending. And so, if the Government spends, spends and spends; this spending will increase the GDP and with it the %GDP. Therefore for Monetarists the second golden rule to economic heaven is:

The Government must spend, spend and spend!

We must now also consider the third Monetarist's golden rule: money multiplication. When the Government prints, this money will subsequently be multiplied by roughly 10 times by the banking system. This money will then be spent by Corporations or people. Therefore the third Monetarist golden rule to economic heaven is:

Print, print, print (and then spend)!

GDP Growyh by Government Printing and Spending

Analysis

For Monetarists the way to economic heaven is therefore spending. However the funds to be spent must come from somewhere. There are only to possible sources: people's savings or government printing. But people's savings are limited; once you have spent your savings there is no more. Government printing on the other hand is unlimited. Government can always print more. Therefore it is the basic Monetarist belief that printing money out of thin air can create economic wealth!

In other words, if the South African Central Bank would so desire, they could print let's say a 1.000.000 Rand for every citizen in the country and give this money to them. Presto! Everybody becomes rich overnight! Poverty? Gone! Work? Unnecessary! All South African citizens can, from now on, sit back, relax and enjoy life. And when the money is gone? No problem! The Central Bank can repeat this trick as many times as necessary!

Does this makes any sense to you? No, right?

Yet, this is the basic Monetarist belief. Of course, they never take this tenet to this extreme, but the conclusion is inevitable. Some ideas are actually that stupid.

Of course, Monetarists do acknowledge that if the Central Bank would to do so, inflation would go through the roof and the entire South African economy would collapse overnight. Remember that inflation is simply a lot of money chasing a fixed amount of goods. Therefore they believe that printing is a good thing to increase the wealth of nations as long as inflation is kept low.

But there is a fundamental contradiction here!
How is it possible to print and not have inflation!!??

This is, of course, impossible. It's like saying that a lot of rat poison is bad for you, but taking small quantities over long periods of time is good! Crazy? Right?

It is clear that eventually, as all this printing makes its way through the economy, prices will simply go up to accommodate all the extra money that was printed. The barter value of one thing for another will remain the same (e.g. 1 apple for 1 orange) but its "money" value (or price) will be higher (e.g. 1 apple = 1 orange = 1000 Rands up from 500 Rands). As you can see, neither new apples nor oranges were created by printing more money; our wealth has not increased at all! A lengthy explanation for this phenomenon can be found in Real Money For A Real Economy and Fake Money For A Fake Economy.

Business Cycle

Based on this "understanding" of the economy (principally on the GDP and other "macroeconomic" parameters), Monetarists feel "100%" confident (this is a direct quote from a Central Banker) that they can "control" any negative effect that Central Banks may possibly have on the economy.

Therefore they go and mess around with "liquidity" (i.e. quantity of money), interest rates, rules, regulations and a myriad of other "economic levers" to ensure the smooth operation of the economy. Furthermore, thanks to these wonderful insights they can now control and ameliorate all the negative economic effects of the evil, evil Business Cycle.

Result? We are experiencing and will continue to experience ever larger and more catastrophic Booms and Busts thanks precisely to Central Banks meddling with the economy thus creating Business Cycles!

GDP Fluctuation by Government Printing and Spending

As you can see, once the printing and spending process is over, the economic activity decreases drastically losing any gains that may have gained before. In this example the GDP growth in Year #2 over Year #1 is less than the GDP loss between Year #1 and Year #3. In other words, what was gained in Year #2 was lost in Year #3 and then some!

Remember, there is no free lunch.

But by now the government is trapped. To prevent the GDP drop in Year #3 they keep printing and spending. The boom and bust cycles that follow were explained in more detail in Deficits Debts And Inflation.

Note: please see the Glossary if you are unfamiliar with certain words.

Continue to GDP: Keynesian's Voodoo Economics - Part 2

 

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