Fiscal policy and the fetishization of measured gdp

Fiscal policy can raise measured gdp without improving the economy
or human welfare.  Take a polar case where there is zero crowding out
and there is one unemployed worker.  Government taxes a rich man who is
initially hoarding liquidity and spends that money putting the
unemployed man to work.

Measured gdp goes up but is the new state of affairs better than the old?

Say the unemployed man had valued his leisure at 20K and was not
taking the previously available jobs for 19K.  The government now pays
him 40K.  For the new worker that is a gain of 20K in value but of
course the cash itself is a transfer and does not represent a net gain
from an economic point of view (though you may like the distributional
effects).

Let’s say the new public sector output is produced by labor only.
40K is spent to produce output which, in a market setting, would be
worth $20K.

Put aside money flows.  We have 20K more of output value and a 20K sacrifice of leisure value.

That’s no net gain, but measured gdp has risen by 40K.  Note that
the contribution of the public sector to measured gdp doesn’t very
effectively measure true value added.

Introducing some crowding out makes fiscal policy look worse, as
would considered the deadweight loss from taxing the rich man. You
could make many other adjustments to the example; some would favor
fiscal policy, others would not.  The most obvious adjustment to make
fiscal policy look good is to assume that the new output a valuable
public good.  Or you might argue that the resulting spending multiplier
is higher than the real balance effect which results from the rich man
holding the money (lower prices for everyone else).

But keep this example in mind the next time you see a measured
empirical connection between fiscal policy and gdp.  "Money spent" and
"gdp registered" are not the same as "value created."

Comments

Repost...

The effect also works the other way round: when people cite numbers how lower taxation encourages people to work and leads to higher GDP, the numbers ignore that people are trading free time for income, with the net profit in welfare much lower than the increase in GDP.

I always thought this explained to some extend why the income gap between the US and the richer parts of Europe doesn't feel as large as it looks on paper

" 20K and was not taking the previously available jobs for 19K. "
My god... do you truly believe that's what unemployment actually is? Like these people enjoying their time at home watching TV and spending time with their kids.

what about the effects of unemployment on all sorts of things that are vaguely related to hapiness, such as mental state (unemploymeny => depression), loss of health insurance, divorces, financial distress. I mean, if you want to argue that leisure time is not included in GDP calculations you cannot neglect these either.
And who said these 19K jobs are available in the first place?

Moreover, when you say
" 40K is spent to produce output which, in a market setting, would be worth $20K. "
So what? who said that the market is right?
Do you truly believe that there is no market failure going on in the economy, and that and kind of intervention that stimulates the economy is artificial and unproductive?

You don't mention the lost utility of the wealthy taxpayer. If you're doing welfare economics you have to aggregate utility of all the population.

So +20K in output -20K in lost leisure is a wash but the poor agent has an extra 20K so if the disutility to the rich agent is less then 20K the economy is better off. And this is an economic (though distributional) argument.

Another way of putting it is that Europeans tend to prefer to spend more of their wealth buying leisure time instead of objects.

The problem with this claim (which is often made) is that it seems to assume (a) there is a one-to-one mapping between individual preferences and government policy, and (b) that all individual preferences over all other individuals in the society are identical. Given different public policies, the fact that Europeans work less than Americans doesn't tell you anything about the preferences of individual Europeans vs. individual Americans.

If you're doing welfare economics you have to aggregate utility of all the population.

A better theoretical criticism of welfare economics I have not heard. Utility functions are neither a primitive nor unique (only unique up to a monotonic transformation, which is fine if you want to talk about individual welfare but definitely NOT fine if you're trying to add them up. Yes, you need to do this to do public finance economics, but it's still not very meaningful.

Ryan yin, people, especially managers, have to make decisions every day based on vague impressions of 'benefit functions' that are not quantified and might be impossible to quantify.

After all, not doing anything is a decision too. In case of welfare functions: if you base economic and fiscal policy purely on GDP or other measurable numbers, you have still made an implicit choice about welfare functions, and not one that is obviously better than the 'meaningless' other alternatives.

Until recently, I would have considered Tyler_Cowen's post obvious and uninteresting. My position used to be that, yes, GDP isn't a perfect measure, but can capture relative economic performance to a decent approximation, so long as you understand its limitations.

However, now I see how harmful it is to focus on GDP, and why it should be more of a footnote when talking about economies.

It ultimately measures how many times money changes hands, regardless of whether that purchase was sensible, whether it resulted from a new inefficiency arising, whether it's merely rebuilding damage, etc. So then when economists from the government and their sympathizers consider ways to "improve the economy", they're always thinking in terms of "how can me make this artificial measure go up?" which leads them to do things that have little to do with the *genuine* economic improvements Tyler_Cowen mentioned.

That's why we're in the bizarre position of the government pondering how it can make people act like idiots, seriously believing that "the economy" depends on that, and not bothering to render any judgment about an economy so predicated.

Economists of the world: if people want to produce *and* consume less, that's okay! Really!

Zamfir, it is certainly true that there is a lot of uncertainty in the world and we have to do the best we can with what we have. But the fact that we cannot prove a new policy is bad for welfare (because we can't define welfare) is no argument for the policy. I don't see why we have to be agnostic about state interventions in the economy; the burden of proof obviously has to be on advocates of intervention. Moreover, it's entirely possible to get a lot of mileage on just Pareto and near-Pareto improvements without specifying any particular welfare function. I recently read a optimal gas tax paper that gave rather specific numbers without assuming any sort of grand social welfare.

(As an aside, my criticism is not just epistemological or quantitative. It's not just that social preferences are poorly measured -- it's that they might not really exist. People have preferences. It's not clear why societies would. Call me a misanthrope, but just once, I would like someone to explain this clearly, or do something other than hand-wave at Arrow's Impossibility Theorem and say that we should ignore it because some nice policy would make ever so much more sense if there really was a General Will.)

--"Money spent" and "gdp registered" are not the same as "value created."

So (forgive my ignorance) why isn't there a GVC (gross value created) index? Too difficult to measure? Too subjective? (How do those VAT countries determine value added?)

How about a continuing series, a la "Markets In Everything": "Examples of Pointlessness of GDP"

Tyler, you assume that the market value of the public good is $20K. I'm not sure why you chose this number. I suppose that if the market price for this public good were greater than $20K then the fellow would not be unemployed in the first place. That seems reasonable. However, if the worker produces a public good, how is it that the market can price the value of the good correctly in the first place? For sure, unless the externality were somehow corrected/internalized, the market price does not reflect the true value to society, which is definitely higher.

Fetishization of GDP also rationalizes Bastait's broken window fallacy. Car accidents and hurricanes force people to empty out their savings and put some more people to work, making GDP look better, but clearly welfare has not improved.

Tyler provides a useful framework for thinking about whether we should increase public spending now.

Here's a slightly more interesting, and perhaps empirically-relevant version:

Suppose that the value of this particular public sector project is $30K (instead of $20K) but the other numbers are the same. Then overall welfare increases by $10K. What's interesting is that during a period of full employment, employing the worker at $40K would have crowded out $40K of employment in some other, private sector activity and presumably eliminated $40K of value. In that case, the public works would have been a BAD idea and destroyed value. However, when resources are sitting idle, funding the exact same project becomes a GOOD idea, creating value. This is true even if there is a zero multiplier. It's just a simple cost-benefit analysis with different opportunity costs in the two scenarios.

Bottom line: When there are slack resources, then many public sector project become welfare enhancing even if the identical project would have been wasteful during periods of full employment. By continuity, the more slack the resources, the more such project become beneficial. Gov't spending is more cost effective in recessions than booms because the opportunity cost is lower, and so it should increase.

Policy implication: Policy-makers should go down the list of projects they have been considering and fund the next projects on their cost/benefit list.

Unlike Tyler's analysis: under current conditions you are not transferring the marginal dollar from a rich, liquidity-hoarding guy. You are transferring the marginal dollar from someone 10 or 15 years in the future who is better off than we are.

So this is a case of "consumption smoothing." And if analysts are right about the psychological or coordination problem that panic begets panic, then this is not even "consumption smoothing" but more like taking some bricks from a section of wall that is not under attack, and redistributing them to a section of wall that is in danger of collapse, with the understanding that if the wall is breached anywhere, everyone on the inside is in danger.

Tangentially riffing off Brian's post:

What about giving everyone a "USA investment account", where you stick $10K in an account for every household, and they have to invest it in something (stocks or bonds). Use it or lose it: you don't invest, the money vanishes.

Is that likely to have a worse result than having the government spend $1T lending or giving money to companies (or public projects), according to the government's discretion?

In other words, is the government's role to solve a coordination problem (which might also be solvable by weird game-theoretical helicopter money drops) or is the government also endowed with clearer insight about the relative success of various potential projects?

Should we be thinking harder about game-theoretical helicopter drops of money?

"Economists of the world: if people want to produce *and* consume less, that's okay! Really!"

Silas nails it.

"Measured gdp goes up but is the new state of affairs better than the old?"

Yes. That's one less unemployed guy to mug the rich man.

Yancey: I've heard Krugman say that:

(1) People might hoard the money rather than spend it, which is bad [or that's my layman's interpretation of the "liquidity trap" idea], and
(2) We don't really want people to spend anyway, because there's so much consumer debt (discussion starting at about the 1:45 mark).

I think Yancy is pretty much right.

Money is just a counting device, we use it to measure human interaction. If people hoard the money, we just have to accept the fact that people don't want to interact.

However, I doubt that's the case. I think money has pooled in areas that don't produce value (first tech, then real estate, then commodities, then mattresses).

Spread it around and see where it does.

Rothbard of course argued that G should be subtracted in the GDP formula rather than added. That's obviously too extreme but at the margin it is often true.

"Leisure time has no monetary value, it only yields utility."
Someone clearly doesn't understand what utility is or what money is for.

A lower price level expands aggregate demand. Expectations of a lower price level in the future shrinks aggregate demand.

Getting to a lower price level from a higher price level involves deflation. A recovery requires that the price level get low enough that the first effect (that the price level is now low) overcome the second effect (that people people expect the price level to be lower still in the future.)

With a gold standard, it is the real gold stock which generates the increase in real weatlh. In a fiat standard, it is some quantity of some kind of government liability that counts. (Bonds might work as well as fiat currency.) Ricardian equivalence interferes with the "pigou" effect with
a fiat currency.

I don't believe in Ricardian equivalence, so.. I think it would work with a fiat currency.

An immediate return to equilibrium requires a discontinuity. The price level immediately adjusts to its new, lower, equilibirum level. And then, from that point, the expected price level is stable.

I don't think this is a wise policy in general. Ceraintly not in the context of a fiat currency. If you were strongly committed to a gold standard without devaluation, then it might be necessary.

In my view, during the Great Depression, Japan in the nineties, and the U.S. today, a central bank policy of targetting short term, low risk interest rates (that are approaching zero) is a horrible mistake. Anyone, especially working for central bank, who takes the attitude that monetary policy is "easy" because the interest rates they usually target are an historically low levels, _is incompetent._

It is like not knowing the difference between the real interest rate and the nominal interest rate. Or worse, an inabiltiy to understand the key role of the quantity of money and the desire to hold money in a market economic system--to take a title of a key paper on the matter, "Money and Credit still confused."

It appears that at least some people at the Fed realize that federal funds rate targetting is becoming useless. That it is time to target the money supply (and that might mean incresing it because of changes in velocity/the demand to hold money.) Or, to target interest rates other than the FF rate.

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