Dismantling the Most Dangerous Equation in the World

Why does Paul Krugman and other “Keynesians” always get economic policy wrong?  They believe consumption drives the economy.  In other words, they think it is possible to consume something before it has been produced.  In real life, we all must produce before we consume, or in order to consume.  Production pulls consumption along the way an engine pulls the caboose.  But don’t think for a second that just because they travel at the same speed, the caboose could be pushing the train!  From an economic policy perspective, it never makes sense to put fuel in the caboose. Ever! No_Equation.png

How could seemingly smart guys be so wrong?  In their defense, it is what they were taught. 

A major culprit in perpetuating the myth that consumption drives the economy is the standard textbook equation for measuring GDP. This equation only measures what was produced and is inadequate for understanding how GDP gets produced.

The standard textbook equation goes like this:  GDP=C + I + G + (X – M) where C=Consumption, I=Investment, G=Government Spending, and (X-M)=Exports less imports. 

This simply counts GDP.  Counting GDP differs from making GDP; just as counting money differs from making money. Or, just as a pay stub only accounts for where a paycheck ends up, it is useless for determining how to actually earn a paycheck in the first place.

To extend this analogy further, imagine a comparable equation that measured your personal income. It would be equivalent to the above equation, except it represents your income instead of the nation’s income. It would say your income (I) = direct deposit (D) + savings (S) + benefits (B) + taxes (T) or I=D+S+B+T. This is essentially the layout of your pay stub. It says nothing about how you earned the income, and offers zero insight into increasing your earnings.  

Now, imagine if those same “intellectuals” who claim that increasing government spending increases GDP, looked at the equation and concluded to increase “I”  (your income) you just have to increase “T” (taxes). Would you take them seriously? Ever?

It’s an optical illusion that increasing government (G) is one way to increase GDP. Government doesn’t produce output, so increasing government can only mean that more of the existing output is redistributed. It is a necessary part of the equation because, to properly count production, we must account for production taken by government that would have otherwise fallen into another category.

Another optical illusion is that increasing consumption will increase GDP.  This is the equivalent of someone looking at your pay stub and saying to maximize your income all you have to do is just increase “D” (the amount of your direct deposit).  Welcome to the Ivory Tower my friends.

Finally, it creates the optical illusion that imports (I) are inherently negative since they subtract from GDP. They are subtracted from GDP only because they are already included in consumption so the subtraction merely prevents double-counting. We should welcome imported goods as long as they compete on a level playing field with domestic goods.

Because the most dangerous equation in the world is standard issue in every basic economics textbook it’s no wonder the country has spending and debt problems, a non-recovering economic recovery, stagnant wages, and joblessness. What it costs to “learn” this stuff in college pales in comparison to the cost to society when it is misapplied.  Memo to the “intellectuals:” rather than double down on a failed model, get a new model. 

Fortunately, there is a much better way to look at the economy if the goal is to maximize GDP. Enter the Woodhill Equation.

Introducing the Woodhill Equation

The Woodhill Equation properly respects the fact that production drives the economy, and identifies a clear-cut path for maximizing GDP. I named it after entrepreneur, economic growth guru, Forbes columnist, and fellow economic adviser to the Herman Cain presidential campaign, Louis Woodhill. Had it been standard issue in every textbook over the last 40 years, GDP would be at least $25 trillion today instead of $16 trillion,[1] we would have a budget surplus despite the reckless spending, and median income would be more than $80,000 instead of $48,000.  If that were the case, how many of our current problems would still be problems?  Given that, aren’t our so-called problems really only symptoms of our true problem: a lack of robust economic growth, caused by leaders who are clueless about economic growth.  

Rather than looking at who consumes GDP, the Woodhill Equation looks at what produces it and how. More precisely, it looks at the stuff that produces the stuff that makes up GDP. It looks at the economy as a whole the way an investor might look at a single company using a return on assets calculation. Only in this case, the numerator is not profit or revenues but rather GDP. The denominator is still total assets, but they represent the nations’ asset base rather than an individual company’s.

To arrive at the numbers, you separate GDP and assets into residential and non-residential components. Next, divide the residential component of GDP by residential assets to calculate the “GDP return on residential assets.” Then divide the rest of GDP by non-residential assets to calculate the “GDP return on non-residential assets.” The Bureau of Economic Analysis reports separate figures for residential assets[2] and non-residential assets (e.g., commercial buildings, machines, equipment, computers, structures, etc.)[3]  Residential GDP is reported in table 7.4.5[4] as Gross Housing Value Added. The rest of GDP is deemed to be non-residential. At this point, simple division allows us to calculate the GDP return on residential assets and the GDP return on non-residential assets.

The Woodhill Equation states that GDP is a function of the “GDP return” on residential assets plus the GDP return on non-residential assets. Over the last 60 years[5], the return on residential assets has averaged 7% and the return on non-residential assets has averaged a whopping 48%.  Thus, we can express the Woodhill Equation this way:

  

woodhill_equation_(2).png

 Now we’re in a position to understand how to maximize GDP, which should be the goal of every economic policy. The first thing that leaps off the page is the 48% GDP return on non-residential assets. The next thing that becomes apparent is the low yield on residential assets by comparison. (Does this shed new light on the financial crisis, which was about government-directed “investment” in the residential sector that caused a misallocation of resources away from higher-yielding non-residential assets?) 

The Woodhill Equation proves there’s only one definitive way to expand GDP: Increase the stock of non-residential assets. This
is best accomplished via business investment.

woodhill_equation_graph.png

Non-residential assets not only define the productive capacity of the economy and its growth potential but also support employment. For every $210,000 of non-residential assets, one average job is supported. Higher-paying jobs are supported by more assets, and lower-paying jobs require fewer assets.

At this point, we can work backward to solve both our growth and employment problems. To increase GDP ($16 trillion) by an additional 1% requires $160 billion more GDP. Since every dollar of business investment generates 48 cents of GDP, $333 billion of additional business investment ($160/.48) will increase GDP by 1% more. Want to increase GDP by another 2%? Business investment of an additional $667 billion will do that. That much business investment will also create 3.2 million new average jobs. To create the 15 million jobs necessary to reach full employment would require roughly $3.1 trillion of new business investment over time. (This amount is roughly what has been squandered on failed stimulus programs that put precious fuel in the caboose rather than the engine.)

By now, it should be intuitive. If we want to expand GDP, we start by expanding the productive capacity of the economy, the equipment and machines that produce GDP. This is entirely consistent with the way that households and businesses grow and prosper, by converting after-tax income which is not spent into capital, which is then used to accumulate productive assets. The economy is merely the sum-total of those entities and neither a business nor household can spend or tax its way to prosperity.

Although the official recession ended in June 2009, this recovery is the weakest in terms of employment and GDP growth as Recovery.pngmeasured against other sharp recessions in the post-WWII era.[6] Although many excuses have been given, and much blame dished out, there is really only one culprit that makes this the worst recovery. As you may have guessed by now, this is also the worst recovery in terms of business investment, which drives both GDP and jobs. The graph to the right compares the decline and rebound in investment for the current recovery to a composite of the other sharp recessions in 1949, 1973, and 1981.

The dotted line shows what the current recovery would look like if typical of the other recoveries.  

This suggests business investment should be about $3.125 trillion today, instead of the present level of $2.525 trillion. Applying the Woodhill Equation, we see this difference of roughly $600 billion would mean 1.8% more GDP growth and about 2.86 million more average jobs per year.

current_recovery_vs_48_(2).pngThe fact that the current recession was sharper is no excuse for the lagging recovery. Typically, the sharper the decline, the sharper the recovery, as illustrated in this chart comparing the 1949 decline and rebound in investment to the current cycle.

Notice the declines are similar, making the lack of recovery in this cycle more damning, not less. Had we matched the recovery,
 investment would be one-third higher today, roughly $840 billion more, equating to 2.5% more GDP growth and 4 million more average jobs per year.

Unfortunately, among other problems, the U.S. stacks its monetary system, tax code, and regulatory apparatus against investment. Our wrong-headed policy, espoused by those using the wrong economic model in the first place, punishes most harshly the very thing that drives economic growth.

“Tear Down This Wall”

As in all of nature, growth occurs when a fertilizer comes in contact with a seed. In the economy, the fertilizer is capital and the seeds are the ideas and solutions incubating in the minds of our entrepreneurs. Unfortunately, government policy creates a wall separating those with ideas from those with capital. It makes no sense to wall off those with ideas — they are the source of innovation, new business formation, job creation, and wealth generation. The wall is composed of a tax system that retards new capital formation and double-taxes whatever capital does form. The wall is fortified by a monetary system that scares capital away from productive investment into hedges that shelter it from the chaos caused by an unstable unit of measure (i.e., a floating paper dollar). The wall is guarded by regulators who treat the union of capital and ideas as though it is a hostile act. Finally, the wall is sealed by a veneer of political correctness that says the wall represents progress.

All of this takes place without regard to the patent unfairness of the way it damages the economy, employment prospects, and income of those needing help the most. If we want economic growth, if we seek full employment and rising income, we must, to borrow a phrase from Ronald Reagan: “Tear down this wall.”



[1] Assumes continuing growth of 3.9% over the last 40 years rather than 2.8%

[2] http://www.bea.gov/national/FA2004/details/index.html Bureau of Economic Analysis, Detailed Data for Fixed Assets and Consumer Durable Goods, Section 1: Residential Detailed Estimates.

[3] Bureau of Economic Analysis, National Income and Product Accounts, Table 5.9. Changes in Net Stock of Produced Assets. 

[4] National Income and Product Account Tables, Housing Sector Output, Gross Housing Value Added http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&903=280

[5] These figures have been calculated using GDP before the recent revisions which included certain intangible assets.  If intangibles are incorporated in accordance with the new GDP figures, the GDP return on non-residential assets is roughly 44%.

[6] Comparing the sharp recessions of 1949, 1953, 1957, 1973, 1981 and 2007 using tools provided by http://www.minneapolisfed.org/publications_papers/studies/recession_perspective/index.cfm


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