GDP versus Standard of Living

In my opinion, the average watcher of financial cable TV and reader of the financial press can be forgiven some confusion. Experts are found at opposite extremes of many issues. For example,

*We need more spending, but budget deficits are bad.

*Debt is bad, but we are adding debt at a record pace.

*Consumers and investors need a strong dollar, but won't a strong dollar slow the recovery from recession?

The beginning of clarity on these and related issues is to get clear on the distinction between GDP and related measures of current output and income on the one hand and our standard of living on the other hand. To some extent the distinctions correspond to the difference between the Classical (pre-Keynesian) approaches to macroeconomics, which assumed full employment rate of GDP generation, and Keynesian economics, which is all about getting back to a full employment rate of GDP generation. During a period of deep recession, the Keynesian focus on spending levels, including using government spending to fill any gaps, is appropriate. In more normal times, the Classical focus is more appropriate.

We need more spending, but budget deficits are bad.

In the fourth and first quarters (2008-2009), total spending that generates real GDP (C+I+G+X-M) declined at about a six percent rate. The unemployment rate has risen sharply to 8.9 percent and is likely to rise above 10 percent. Under these circumstances, the economy is losing potential output. There is great waste. A budget deficit under these circumstances will have negative long-term consequences, but most economists would say this is a lesser negative than a failure to return to a full utilization of our productive resources. The lost output/income from a deep recession is lost forever – also a long-term negative.

This doesn't mean that the need for Keynesian stimulus obviates the need to spend prudently and tax efficiently. It is not a license to throw caution to the winds. What it does mean is that a deficit should be tolerated to restore full employment output. Ideally, of course, the deficits should fall as the economy recovers, and turn into surpluses for a while when full employment is restored.

Debt is bad, but we are adding debt at a record pace.

This is similar to the previous question. If two alternatives are bad, you chose the "least worst" and prepare to change course as circumstances change. Debt is insidious because it makes the here and now better at the expense of the future. Creating new debt by stimulating the economy with budget deficits is a GDP-enhancing measure. Living with the debt in future years is a drag on our standard of living, because future taxes will be diverted to paying interest on debt whose benefits are in the past. The immediate need is acute; the long-run cost is chronic. There is no free lunch, but keeping these distinctions in mind will help clarify our choices and policies.

Which is better, a strong dollar or a weak (competitive) dollar?

If I had to choose with no qualifications, I'd choose the strong dollar. A strong dollar benefits consumers by holding down the price of imports while it keeps the pressure on producers and exporters to keep costs down and productivity up. A strong and stable dollar or a dollar whose prospects are for greater future strength attracts foreign investment. A strong dollar is good for our standard of living over the long term.

On the other hand, during a deep recession, a stronger dollar – made stronger by forces other than a rising demand for exports – will slow the recovery by reducing demand for our exports relative to our demand for imports. The growing trade deficit will divert demand to our trading partners. Touting a "weak" dollar under certain circumstances still doesn't seem right. Substitute the term "competitive" to get closer to the point.

These examples may be helpful in sorting out what appear to be conflicting policy proposals. However, there is a more fundamental difference between GDP and standard of living that will be a topic for future discussion.

Comments (2)

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  1. Walter says:

    Wealth is a relative term. Relative to what the person next door has. Since economic growth is measured in dollars, in order to have economic growth in real terms doesn’t the growth rate have to be outpacing the dollar index. It seems otherwise we are just changing the yardstick by which the growth is measured.

  2. Lingerhale says:

    Multy,Great point about the NBER using total employment as the beanhmcrk for calling the start and end of recessions. You are absolutely correct in stating that the NBER declared the start of the recession as being the peak in employment (November 2007 peak). Likewise, their call for the start of the 2001 recession was March 2001 when employment peaked at 137.783 million even though industrial production peaked in September 2000. The recession was determined to be over in January 2002 when employment bottomed at 135.701 million. When this recession started in November 2007, employment peaked at 146.665 million. In Sept 2009, employment was 138.864 million. Even though GDP will show positive growth in 3Q09, the number of people employed will still show a sharp drop (1.3 million in the quarter). We have had two positive quarters of GDP growth during this recession. Based on the numbers the NBER have used for the past several recessions, we still have not seen the end of the recession until employment starts to rise. This has still not occurred yet. Great post Multy!