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Thoughts from the Frontline

Time to Put a New Economic Tool in the Box

July 26, 2014

[E]conomists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.

It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences – an attempt which in our field may lead to outright error. It is an approach which has come to be described as the “scientistic” attitude – an attitude which, as I defined it some thirty years ago, “is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.

– Friedrich Hayek, from the introduction to his Nobel Prize acceptance speech in 1974

Last week we took a deep dive into how the concept of GDP (gross domestic product) came about. We looked at some of the controversies surrounding GDP statistics that we use to measure the growth of the economy, and we noted that the GDP tool seems designed to reflect and serve an economic theory (Keynesianism) that prefers to focus on the demand side of economic activity. If your measurement of the growth of…

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Kenneth Harlan

July 27, 9:59 a.m.

Official Gross Output data as an additional or alternative optic for viewing economic activity could not have come at a better time as the weaknesses in Keynesian Economics (or more correctly, neo-Keynesian economics) become more apparent.  The mere argument that consumption leads and production follows has always baffled me as a serious economic argument stretching beyond the theoretical discussion.  Now, however, it is so commonly accepted as fact that it presented daily by journalist, commentators and politicians to support their urgent case for new/larger/additional Keynesian measures.  This week I even heard debate where it was being argued that this country only exists because the government was formed first which then allowed businesses to form and begin production.  For me, more evidence to support my personal belief that the relatively rapid adoption of Keynesianism was in a large part due to the fact that it supported the rising political narrative of the period that was based on government centric philosophy.
It seems obvious (at least to me) that production always leads consumption.  Individually we are each a micro-production mechanism which must first produce in order to consume.  That consumption is in the long-run limited to what we can produce.  Through borrowing we can bring forward production (much like the period from birth to productive individual in most species) at the expense of future production, but as individuals not exceed that production on a sustainable basis.  Only government is exempt from this constraint for a longer but still finite period, because a government is a multi-generational collection of individual producers and can borrow future production from all individuals over several to many generations.  History clearly illustrates, however, that this to has absolute limits.  Whether those limits are reached in a host of subject countries before the pendulum reverses swing in the prevailing government centric a philosophy is a most fascinating study.  It also keeps me looking forward to the work fine thinkers and writers like John.

July 27, 8:10 a.m.

I don’t always don’t have the time to read all of Mauldin’s letters but this one touched a nerve by only going halfway to what I view as the meat of the issue - capital creation.

He and Skousen are not wrong.  Both of them are correct, Gross Output (GO) is better than GNP at giving us in the very short term a clearer picture of how fast the economy is moving, but it falls very short is telling us where it’s going.

“[Skousen] believes that the GDP should not be used as the sole measure of economic activity,” but his vision only goes so far.  He goes on to say that that while “...GNP is a useful measure of .. standard of living…” and that “... it has led to the misguided Keynesian notion that consumer and government spending drive the economy rather than saving, business investment, technology and entrepreneurship.”

Mauldin takes up this ‘savings vs consumption’ theme as a driver of “private production and business spending” the “real driver of the economy”.

Both he and Skousen touch on the idea of ‘wealth creation’ but skirt around the issue of the macro capital base as wealth, without dealing with it directly.  They both fail to make the point that consumption is the diametric opposite of wealth and therefore capital accumulation.  I like to use the example of ‘the fork’, the most simple piece of capital yet an amazing and useful tool, and in my economic lexicon a iconic example of capital.

Once a fork is manufactured, it can be used virtually an unlimited number of times by an unlimited number of people, enriching the lives of all who use it, (a well as those around them not having to watch them use their hands to eat their meat balls and spaghetti like a monkey, or lap up oatmeal like a dog.)  The quantity of knives, printing presses, and aircraft carriers in existence have similar lasting civilizing effects which neither GNP or GO measure.

Of course GO is a better example of wealth creation than GNP, but it only tells us how many forks were sold.  What is ultimately more important is not how many were sold but how many knives, forks, spoons, printing presses, drop forges and nuclear aircraft carriers exist.  Capital is the real driver of the economy.  Savings are important not because they drive investment and thus GO, but because and to the extent that they add to the capital base of society and thus the growing wealth of humanity.

Only a fraction of investment creates capital - ask any angel or VC investor - a lot of it ends up as consumption, spent for labor and resources.  The ‘real’ standard of living measured by the choices of consumers is determined by the amount of capital available to create consumables, freeing up their time for increasingly productive or leisure activities.

The use of GNP is pernicious as a misleading measure of the economic health of the nation not only because it doesn’t accurately measure output let alone the ‘wealth’ of the nation, but because consumption beyond savings erodes the capital base, depleting productivity, making innovation more difficult, and so impoverishing society as a whole.

Skousen should be commended for trying to change the debate.  Both he and Mauldin are bring to our attention the newly issued GO index but the real debate needs to be taken to the enemy at every opportunity.  The Marxist Left continue to use Keynes to controlled the economy by controlling semantics and statistics, a la 1984, bowdlerizing the story of the economy.  Capitalism has been made a dirty word and even its strongest proponents, like Mauldin and Skousen, dance around the the idea of ‘capital accumulation’ by tangentially referring to it as ‘standard of living’ or ‘wealth’.


Alan Shaver

July 27, 7:31 a.m.

If a White House staffer reads this we will start hearing again about the need for a value-added tax in the US.  Imagine how much more economic activity there is to tax!

July 27, 4:43 a.m.

  I found the discussion of a new measure of economic activity thought provoking.  I remember in the late 1960s and early 1970s pondering the same.  I observed then that annual increases in GDP were roughly equal to the annual deficit.  The economy was essentially operating at a Keynesian balanced budget and not growing at all . . . GDP was lying.  This correlation seemed to disappear in the 1980s and into the 2000s. 
In 2008 as TARP and QE evolved I again pondered GDP as a reasonable measure of growth.  With a $16 trillion economy GDP was growing a 2% ($320 billion) while the deficit added 6% ($900 billion).  To me that indicated the economy contracted by 4%.
I’d love to see a Deficit Adjusted GDP dating back to the 1960 through to the present.  This seems like it would yield a reasonable measure of the health of the underlying economy.
Leave in the Public expenditure supported by tax collections and assume a multiplier effect of 1.0.


July 27, 2:32 a.m.

I agree.  GO is an important part of an economy which is complex and multifactorial.  But the question that begs to be asked is Why did GO move more dramatically negative than GDP during the 2008-09 recession?  The most obvious answer would be businesses are very sensitive to anticipated demand.

July 27, 1:35 a.m.

This is one of the best articles John has ever written. Now everything makes more sense. I always thought consumer spending was over-emphasized. It never made sense to me how consumers were goaded into taking on more debt to “help” the economy, since the economy is the sum of our individual balance sheets.

I certainly hope this article is read by economic planning busybodies in Washington, D.C.!

Karlheinz Ramm

July 26, 9:39 p.m.

If economists want to understand whats driving the economy they will have to understand that the economy is something like a thermodynamic machine.

If you think about it you find that the proper measure for the energy gradient thats driving the economy (and connects it to the real world) is the interest rate that’s imbedded in the price structure. This is different from the market rate of interest because the latter is affected by the actual money flow which includes new credit created the increase of which may deviate in value from the additional resources made available by investment (you have to correct the price structure for this effect). Artificially low interest rates can feign the impression that there are more future recourses available than there actually will be. This way (by paying people with claims to future resources that won’t exist) people can be tricked into producing things that are actually not worth producing (because they ultimately don’t add exergy available for humans). This is reflected in rising debt to gdp numbers. (People are effectively made to overestimate the present value of the payments they receive for their services which in an economy working with credit money consists of claims to future resources.)

GO doesn’t help this understanding. But the intuition that the efficiency of businesses matters is of course the correct one. In microeconomics economists get it sort of. The macro sort is generally hapless. Unfortunately.

Correcting these distortions requires an adjustment of the price system which requires some valid signal
about the actual deviations which is normally provided by a recession. Without such a correction there has to be an inordinate amount of credit to be created to keep the economy “going”. When the debt carrying capacity is reached this is impossible. So central banks have started to take the surplus credit necessary onto their balance sheets to keep the impression of a somewhat functioning economy.

Jack Hiller

July 26, 7:51 p.m.

Mauldin’s review of alternative measures of economic activity and output provides truly important concepts for improved economic systems analyses. But even so, the quote from Hayek, about the limitations of human knowledge, and ineffectiveness or even mischief of deliberate social planning, provides an essential counterweight to the hubris of government intrusion into business affairs and the markets.

Well done John!

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