Gross Domestic Product (GDP) is a common statistic used for measuring the growth (or contraction) of the economy in a particular area.  It is most commonly used in measuring a country’s economy.

GDP is often used to measure whether a country is in recession.  Many go by the theory that two consecutive quarters of negative GDP means a recession.

There are some libertarians who think the statistic is completely useless and only serves to mislead us.  The more – shall we say – mainstream economists pin a lot of their assumptions on GDP and its usefulness.

I suppose you could call me a moderate on this one.  I think GDP has many faults, and it can be misleading, but I don’t think it is completely useless.  You just have to consider it in context.  You have to be aware of its weaknesses.

One of the main issues with GDP is that it is largely a measure of spending. Unfortunately, this can also include government spending, which is really just a misallocation of resources. But it wouldn’t be completely accurate to ignore government spending.  When the federal government consumes $4.5 trillion worth of resources in a year, some of that money is going to end up doing some good for someone.  Even if they build a bridge to nowhere, a few people will find it useful.

It is obvious that GDP can be useful in telling us about the mood of people.  If spending is way down (and GDP with it), then it likely means there is heightened fear.  It means people are tightening their collective belts.  It means that people are trying to save or cut back on debt.

I don’t really like to use the term “contraction”, even though I used it above.  A decrease in consumer spending is a contraction from the average economist’s point of view.  But I prefer the term correction.  It is the market economy’s attempt at reallocating resources in accordance with consumer demand.  It is a liquidation phase of the malinvestment.

I think the main problem is that people misunderstand what is going on.  The so-called contraction is a correction, if it is allowed to happen.  The correction phase is quite painful, as that is the time that it becomes obvious that people were overextended in their spending.  It is the phase where unemployment tends to increase, as resources are reallocated.

But the correction isn’t really the bad part.  That is just the part where we feel the bad effects.  The bad part was the misallocation in the first place, likely due to monetary inflation and artificially low interest rates. The massive government spending is also a misallocation, but that can often sustain itself without a bust.

Judging a Household By Its Spending

Imagine you are observing your next-door neighbor.  He puts in a new swimming pool in his backyard.  He comes home one day with a brand new Porsche.  He tells you he recently joined the expensive country club down the road.

You probably think to yourself, “This guy must be doing really well financially.”

But do you really know how he is doing?  We can probably make certain assumptions, but we don’t really know how he is doing.

He might have purchased the new pool and new car by writing a check.  Maybe he got a major bonus and raise at work.  Or maybe he bought these things with debt. He may have just gotten a 10% raise at work, and he was expecting the good times to keep rolling.  Or maybe he didn’t get any raise at work and decided to just max out his credit cards, although that is not likely.

It is most likely a combination of getting a higher income and taking on some additional debt. Individuals tend to be more responsible than politicians with debt.  Individuals tend to manage it well enough that they are able to make payments without taking on more debt to finance the previous debt.

There are certain assumptions we can probably make about this neighbor with his new toys. Assuming he didn’t come into some kind of windfall, he is probably not working a job paying near the minimum wage.  Even if he is not being what we would perceive as responsible by taking on some debt, he probably has a pretty good income.  The banks aren’t going to loan this kind of money to someone making minimum wage.

If I drive into any neighborhood with multi million-dollar homes, I can assume that most of the people living there are doing well financially.  Some may be overextended, but they are still probably living really well.  Assuming the housing market doesn’t crash, they could always sell their house and move somewhere less expensive but still nice.

It is a little harder on the other end.  There are some really rich people who live in fairly modest houses.  But if you drive through a rundown area with dilapidated houses, you can assume that most of the people there are not financially well off.

I say all of this as a good analogy to GDP.  Spending does not tell us everything, but it can still be a useful measuring stick.  It can really show us trends over time.  If you don’t make much money, you are not going to be able to sustain a lifestyle of high spending.  Over the long run, spending can give you a decent picture of how someone is doing financially.  But it can be misleading at times, especially if you are spending more than you are earning or will be earning in the future.

When you look at the United States as a whole, the per capita GDP is much higher than most other countries.  But some of the spending is probably not sustainable, so we may hit a period where GDP actually goes down.  Americans will still be far richer than the people in some country in central Africa, but they may experience a decline (hopefully temporary) in living standards.  If the current consumption cannot be sustained, then this is what must happen.

The GDP in Japan for the last quarter of 2019 was negative 6.3%.  This is a sign that the previous savings can no longer sustain the current consumption.  People are finally being forced to cut back, and hopefully the government will be forced to scale back as well.

I expect a negative GDP to hit the United States in the not-too-distant future.  It is better to cut consumption now than wait until everyone else does.