“Measurement theory shows that strong assumptions are required for certain statistics to provide meaningful information about reality. Measurement theory encourages people to think about the meaning of their data. It encourages critical assessment of the assumptions behind the analysis.
“In ‘pure’ science, we can form a better, more coherent and objective picture of the world, based on the information measurement provides. The information allows us to create models of (parts of) the world and formulate laws and theorems. We must then determine (again) by measuring whether these models, hypotheses, theorems and laws are a valid representation of the world.”
“In science, the term observer effect refers to changes that the act of observation will make on a phenomenon being observed. This is often the result of instruments that, by necessity, alter the state of what they measure in some manner.
“It was, perhaps, the most unusual episode in the long running duel between the two giants of 20th century economic thought. During World War Two, John Maynard Keynes and Friedrich Hayek spent all night together, alone, on the roof of the chapel of King’s College, Cambridge. Their task was to gaze at the skies and watch for German bombers aiming to pour incendiary bombs upon the picturesque small cities of England. …
“Night after night the faculty and students of King’s, armed with shovels, took it in turns to man the roof of the ornate Gothic chapel, whose foundation stone was laid by Henry VI in 1441. The fire watchmen of St. Paul’s Cathedral in London had discovered that there was no recourse against an exploding bomb, but if an incendiary could be tipped over the edge of the parapet before it set fire to the roof, damage could be kept to a minimum. And so Keynes, just short of 60 years old, and Hayek, aged 41, sat and waited for the impending German onslaught, their shovels propped against the limestone balustrade. They were joined by a common fear that they would not emerge brave nor nimble enough to save their venerable stone charge.”
– Nicholas Wapshot in "Keynes Hayek: The Clash That Defined Modern Economics"
“I picked the wrong week to stop sniffing glue.”
– Lloyd Bridges in "Airplane!"
I write these words feeling a little bit like the Lloyd Bridges character in "Airplane!" With global markets going crazy, I obviously picked the wrong week to go on vacation.
On the other hand, maybe it was exactly the right week. I decided last week that I would rerun something from the archive for this week’s "Thoughts from the Frontline." That freed me to think about the week’s events from a different perspective. It also gave me time for some long conversations with friends who are real experts. I learned some things I will share with you in due course.
This week’s letter will deal with the problems of determining what GDP really is, and I’ll throw in a few quick remarks on what the recent GDP revision means for the Fed and whether they’ll raise rates.
GDP is far from the rather exact number most people think. There are lots of ways to measure GDP; and recently, what is not measured has been the cause for some controversy, at least among economists who care about such things. Given that second-quarter GDP was revised up substantially on Thursday to a surprisingly high 3.7%, it is even more appropriate to look at how that number is created. Bloomberg ran a short article pointing out that if you took the oil slump out, it was much higher still:
The U.S. clocked its fastest rate of economic growth in nine years. Well, at least if you strip out the effects of a battered energy sector.
Oil and exploration companies this year have cut back on investment in response to a plunge in crude prices that gathered steam as 2014 drew to a close. If it weren't for such a dramatic reversal in demand for drilling rigs and wells, the economy would have posted its strongest pace of growth since the start of 2006.
Gross domestic product, which includes what consumers, companies and governments spend and invest, increased at a 4.5 percent annualized rate in the second quarter when outlays for exploration, shafts and wells are excluded.
Can that really be true? Even without taking out the oil industry, GDP growth this quarter was about as good as it gets these days. It gets even better when you realize that nominal GDP was 5.85%, with a 2.09% implicit price deflator.
Let’s review that for a second. Well above 3% growth, 2% inflation, the most popular measure of unemployment is down to 5%, and interest rates are still held to 0%? What is wrong with this picture?
How in the name of holy righteous monetary policy can the Federal Reserve not raise rates at its next meeting? If they use the recent market turbulence as an excuse, they will lose all credibility as to being focused on monetary policy rather than looking at the stock market to determine what policy should be. They told us they wanted 2% inflation? Bingo – got it. Unemployment is moving in the right direction; and unless we get some disaster of an employment number in September (which doesn’t appear very likely), we have to be as close to the sweet spot for an interest rate hike as the Fed has been in seven years. Truly, I can see no reason for a delay other than some very misguided understanding of how the economy works. This zero interest rate policy is creating all sorts of malinvestment and inappropriate financial behavior, and we need to begin to move towards normalization.
A relevant thought comes from Mr. Yao Yudong, head of the People’s Bank of China’s Research Institute of Finance and Banking, who asserted recently that it’s not China that is causing the current market chaos so much as it is the Federal Reserve generating confusion around whether it will “lift off.” Further, he pointed out that the Chinese devaluation was very modest – only a few percentage points – and came after several years of strengthening of the renminbi.
I suspect that much of the rest of the world agrees with him. It’s quite easy to say that all problems are caused by someone else; but frankly, the Federal Reserve is the keystone of global monetary policy, and when there’s confusion emitting from the FOMC, a little market turbulence here and there should be expected. In reality, though, the recent global market turbulence is undoubtably due to a combination of things.
Whatever; let’s just hope the Federal Reserve finds some backbone and raises rates, if only by 0.25%. If an economy growing at +3% – smack in the middle of the Fed’s inflation target, with falling unemployment – can’t handle a quarter-point raise in rates, then we’re in sorry shape indeed. Now let’s move on to the topic of how GDP gets calculated.
Weapons of economic misdirection
The problem we have today in economics is that many people, and not a few economists, seem to regard economics as “pure science,” as described above by Gauri Shankar Shrestha. If you delve deep into measurement theory, you find that all too often the way in which you measure something determines the results obtained from your experimental model. How you measure the effectiveness of a drug can sometimes determine whether it gets approved – apart from whether it actually does any good. The FDA actually works rather hard at measurement theory.
And if you’re using models, as we do in economics, to determine policies that govern nations, your efforts can result in economic misdirection that seems for a time to work but that all too often can lead to a disastrous Endgame. A shortsighted economic policy is not unlike a drug that makes one feel good for a period of time but ultimately leads to further weakness or collapse.
In this week’s letter we look at the construction of gross domestic product (GDP). As we will see, GDP is a relatively late-to-the-party statistic, thoroughly malleable in its construction and often quite contentious in its application. Yet the mainstream media regularly releases GDP numbers with the implicit assumption that they are in fact an accurate reflection of the general economy. We shall soon see that GDP is instead a fuzzy reflection of the economy, derived from a model that is continually readjusted in a well-intentioned effort to understand the scope of the economy.
GDP is one economic model among several that could serve the purpose, but its use conveniently leads to policies that reflect the thinking of a particular school of economic monetary and fiscal policy advocates.
We all know that in operating a business we need to be able to measure the profits of our company and then adjust our prices and production to make sure that there are enough profits to adequately fund the company. That is a relatively straightforward process, since the amount of money in the bank at the end of the month is a real number.
Hayek versus Keynes
When most people see the release of the GDP number, they equate the precision of that statistic with the bottom right-hand number in their bank accounts. And news anchors and journalists rarely acknowledge the rather significant caveats that the Bureau of Labor Statistics publishes along with that data.
What we are going to find is that developing the concept of gross domestic product was more than a dry economic and accounting undertaking. At its very core, GDP is John Keynes versus Friedrich Hayek writ large. And their debate explains a great deal of the current tension between those who would make final consumption – or what we call consumer spending – the be-all and end-all of economic policy, and those who feel that productivity and income should instead be the focus. The very act of measuring GDP as we do gives the high and easy intellectual ground to those of the Keynesian persuasion.
Let me hasten to note that I have no problem with the concept or the calculation of GDP in general. It is absolutely a number that we need to have in order to understand the workings of a part of the economy. But it is just one tool in the economic toolbox. If the only tool you use to affect (determine, guide – choose your word) economic growth and the creation of jobs is the hammer of GDP, the world ends up being a very strange-looking, rather deformed nail, bent time and time again by the imprecise blows of those wielding the hammer.
GDP is an important concept, perhaps one of the more important that we have looked at in quite a few years. I urge you not to roll your eyes at the attempt to understand yet another dry economic statistic, but instead to look deeply at how the attempt to measure GDP affects everything in our lives.
GDP: A brief but affectionate history
The subtitle above is taken from the title of a recent book by Diane Coyle. (For economics wonks, she writes an interesting blog at http://www.enlightenmenteconomics.com.)
"GDP: A Brief But Affectionate History"Â is a fascinating 140-page book that I cannot recommend highly enough. This is simply the best book on GDP that I’ve ever seen. You can read it on a few hours’ plane ride or a lazy Sunday afternoon. And Ms. Coyle actually makes a relatively dry subject interesting and at times a page-turner. She has a true gift. (Now that she has conquered the GDP mountain, might I suggest she move on to CPI?)
Ms. Coyle starts with the predecessors to Adam Smith and takes us through the 17th century right up until today with the development of GDP, so we see the ebb and flow of ideas through time. Who knew the early developers of the model did not want to include defense spending, as they saw it as a wasteful, nonproductive activity? Or that Adam Smith thought the inclusion of services in the concept was misleading. “The provision of more services was a cost to the national economy, in his view. A servant was a cost to his employer and did not create anything. Importantly, money spent on warfare or the interest on government debt was also being used unproductively. The nation’s wealth was its stock of physical assets less the national debt. National income was what derived from the national wealth.”
continue reading: http://www.mauldineconomics.com/frontlinethoughts/weapons-of-economic-misdirection
