Arnold Kling  

Spending vs. PSST

More Predatory Education... GDP and Well-Being...

Mark Thoma articulates the conventional view.

It's useful to break down the economy into four major sectors -- households, businesses, government, and the foreign sector...lower consumption growth will be a substantial drag on the economy...looking to housing to lead the recovery is likely to lead to disappointment....Business investment does not provide much hope either ...As for foreign exports, which is one of our best hopes for growth in the long-run, it hard to see that sector leading the recovery since the rest of the world is having troubles too. ...So there's very little besides government that can provide the needed boost to the economy in the immediate future.

I would argue that this is like saying, "Our football team's players are too small to win in this league. They can't get any taller. Their bones can't get any thicker. And they can't add enough muscle. So what we have to do is make them fatter."

The problem with the conventional view is that it is focused on spending, as measured by GDP. As Mark points out, this consists of spending by households, businesses, government, and the foreign sector. Everything seems to follow logically from that.

My alternative is to say that economic activity = PSST, meaning patterns of sustainable specialization and trade. GDP is one indicator that you can use to measure PSST, but it is not the best indicator.

There are many problems with using GDP as a measure of economic well-being. These are well known. They include the fact that some purchases are negative indicators--more burglar alarms, for example. GDP does not take into account positive and negative externalities. Ed Leamer points out that perhaps the most important omission in GDP is consumers' surplus. The market gives us many goods and services at prices far lower than what we would be willing to pay for them. That is the virtue of competition.

I wonder how much consumers' surplus is provided by government-provided goods and services. There are no market forces that lead the government to provide consumers' surplus. In fact, there is nothing to stop the government from providing negative consumers' surplus, in which the value of the goods and services is less than the dollar amount spent.

The focus on GDP might be justifiable if GDP were tightly related to employment. However, as we have seen, they are only loosely linked, at least in the short run.

I would like to see less emphasis on measuring economic activity as spending. I would like to see more effort put into understanding economic activity as patterns of sustainable specialization and trade.

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CATEGORIES: Macroeconomics

COMMENTS (19 to date)
pj writes:

Yes ... Why is GDP growth "needed," and at what cost? People lived just fine a few years ago at a 5% lower GDP per capita, and do it in most of the world ... If satisfying the "need" costs more than the benefits it brings, maybe the "need" is not a "need" at all.

Or maybe it is a political need, a widespread desire, rather than a need.

Your football analogy is great, and the consumer surplus point is important. The relation between GDP and public welfare is not as tight as Thoma seems to presume.

(Extending your analogy: GDP is the weight of the football team, government is the blubber, consumer surplus is the won-loss record ... what do we maximize?)

saltmanSPIFF writes:

I agree, but I find myself at a loss as to how a PSST model would look. How would you measure sustainability? A good answer would be profits, but unsustainable activities too can make a pretty penny (at least for a short while), as we've seen.

Models based on GDP and spending lend themselves well to a high degree of mathematical formalism; I can't see the same as being true for PSST. This is not a failing, but it certainly will make it harder to gain mainstream acceptance.

Then again, Minsky's business cycle theories weren't mathematically rigorous, and I must've seen the phrase 'Minsky moment' a half-dozen times these past two weeks in the blogosphere.

Dr. Kling, if you were teaching a course on macro and wanted to introduce PSST, how would you teach it? What readings and other source material would you recommend?

jsalvatier writes:

For those of us who think of macro in terms of monetary disequilibrium, GDP is significant because it says something about monetary equilibrium, not because it says something about welfare.

Silas Barta writes:

I agree, Arnold, and I'm glad to see the issue of "relative merit of different kinds of spending" get more attention. Concidentally, the above poster, jsalvatier, and I are having an exchange over this issue. (Background.)

Vinnie writes:

I love the analogy. Also, is it ironic that the libertarian economist is the one having to give the "GDP does not equal value" lecture to the left-leaning economist?

mark writes:

For examples, the price of a Kindle has falled by more than 50% from its introduction. Or, I could download a free Sudoku application or pay for one. In all cases, the seller's decision to reduce or abandon pricing is deflationary and GDP falls. Yet each transaction leaves the consumer in the same place with the same good.

Hyena writes:

Of course, alternative measures of economic activity are unlikely to be popular in the US for a decade or two. When China's economy is larger than ours by GDP, we'll be interested in alternatives.

Various writes:

I couldn't agree more. I think in terms of "productivity" in measuring sustainable economic growth. I don't necessarily mean productivity in terms of how economists define it, in which I believe they essentially solve for it by substracting employment growth from GDP growth. I define it more conceptually. Bottom line....spending money to take big rocks and break them into little ones doesn't translate into sustainable economic growth.

Ted writes:

In the perfect neoclassical world of frictionless markets and prices, recessions are only caused by things like aggregate supply shifts, aggregate preference shocks (which obviously really don't exist), technological regress (which also is dumb, except maybe in the case of war destroying infrastructure and technology), incorrect expectations of future capital needs leading to a investment slump, or expectations of lower TFP (the last two being the so-called 'news driven business cycles').

However, we don't live in that world. We live in a world where the overwhelming majority of our recessions are actually caused by changes in the money supply or the demand for money (though what causes that is a different story) and due to the frictions in markets and prices (mostly nominal rigidities) prices do not adjust immediately to accomodate this shift and so recessions ensue. Eventually, the prices will re-adjust, but that can take a while (especially because of downward nominal wage rigidity). What monetary policy attempts to do is smooth this process out, to minimize the frictions and adjustment by providing enough money such that wages and prices don't have to fall out of equilibrium and we don't have to suffer the painful adjustment process. This is the goal of "the government" here. It's not about increasing nominal GDP just for the sake of increasing nominal GDP. NGDP (and more generally, nominal income) just happens to be a good variable to target to achieve the first-best outcome that prevents adjustment. Remember that economists originally thought we could target the money supply and prevent these type of recessions for these vary reason. This turned out not to be correct for a whole host of reasons (like rational expectations, for example), but the general thinking behind it is still correct.

Increasing NGDP is a means to an end. Not an end in and of itself. RGDP is the appropriate measure of "growth" since you could have high NGDP by creating 1000% annual inflation - but that's not the point. The point is to keep NGDP growing at a stable rate as to prevent the painful adjustment of wages and prices that come with a recession in a world where nominal rigidities and market frictions are realities.

Rebecca Burlingame writes:

Per your last paragraph: this is something I especially want to have a better understanding of in the years ahead. Having lived in a small community for the last nine years, it is easy to see when economic flow between various economic segments of the locale becomes stymied. It seems that certain averages of income by most of the economic players is necessary for flows to remain continuous.

Silas Barta writes:

@Ted: How do you know those painful adjustments of prices and wages don't reflect a genuine economic reality? In other words, how do you know the policies you're advocating aren't doing the equivalent of "keeping people from having to spend more for their tomatoes when a disease has ruined most of this year's crop"?

saltmanSPIFF writes:


You have it backwards. Wages and prices aren't falling out of equilibrium; they're tending to a new one. Recessions are accompanied by contractions in the money supply as banks call in loans and individuals demand to hold more money due to uncertainty. What these individuals are waiting for is greater purchasing power for their held money, which is achieved via a contraction of the money supply and a general fall in prices.

In cases where the economy needs to weed out fundamental structural problems, expansionary monetary policy can stabilize the economy in the short-run only at the expense of a long-run decrease in the economy's signal to noise ratio.

jorod writes:

Problem with government spending is it comes from consumers. How can you expect more spending from consumers when government is leaving them with less income? It would seem to be an antithesis. No matter how much you increase government spending, consumers will have to spend less.

dWj writes:

Incidentally, the Gulf Oil Spill is expected to produce a net increase in GDP. Broken windows.

Mike writes:

Moving from GDP to PSST would be positive, but how about taking it a step further and moving to a measure of accretion to national wealth/capital, rather than economic "activity"? Activity is not, after all, an end in itself. Cycling money through the economy doesn't make us wealthier, although it increases GDP.

To say that low consumption is a drag on the "economy" (i.e., economic activity) is to put the cart before the horse. The economy should be of a size that will satisfy demand. Rather than trying to pump up demand, we should be trying to help the economy adjust to the new, reduced level of demand. This may require some deflation before we get to a sustainable balance of consumption and savings.

F.A.Hagen writes:

I took Macroeconomics from Mark Thoma. He has always believed that government spending is the most efficient way to create economic growth. In order to get a good grade, you have to answer "true" as to statements suggesting that government spending is the best way to create economic growth. Never took another class from him after that horrible experience.

Eric Hosemann writes:

I've wondered along the lines of "making our team fatter" too.

A few days ago I was driving along a local road and saw an ARRA sign. The road was in need of repair--in some places. In other places, stretches of a half-mile or more, it was either in fair condition or quite good.

As far as I know, before the downturn, there were no plans to completely resurface this road. After the downturn, someone--yes, some person--determined the road needed just that.

My line of work has made it abundantly clear to me that the private sector is quite capable of compensating for the shortcomings of public sector roads. Advances in packaging and suspension design make transportation in a wide variety of conveyances comfortable for goods and people, regardless of how pockmarked or freshly paved the road.

Yet now, the roads need to be paved. Why? What value have freshly paved roads added to our daily economies? If any value has been added, has it been large enough to exceed the billions of dollars worth of molded Styrofoam, corrugated cardboard and gas-filled shock absorbers the private sector created on its own to smooth public roads?

Certainly packages and people arrive at their locations no more jostled now than before the mass paving.

Bob Murphy writes:

Tyler Cowen had a great post a year or so ago, criticizing someone who had asked him, "What sector should we expect to lead the recovery?"

Tyler said something like, "That's like asking what ZIP code will pull the economy out of recession." (Tyler said it kinder and gentler.)

George X writes:

Arnold wrote: I would argue that this is like saying, "Our football team's players are too small to win in this league. They can't get any taller. Their bones can't get any thicker. And they can't add enough muscle. So what we have to do is make them fatter."

Stuff like the above is half the reason I read this blog. Keep the analogies coming.

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