EDITOR NOTE: What we’re about to say goes against the grain of mainstream investment thinking: if you take the Fed’s preferred barometer of economic growth--the Gross Domestic Product--as a reliable means to see our nation’s recovery, then you’re getting only a “partial” picture of the economic reality surrounding the “real” state of crisis we’re in. GDP is a Keynesian metric that privileges spending over production while completely eliminating the impact of savings which, as you know from a personal standpoint, is extremely important. Furthermore, GDP is weighted toward short-term retail spending, not in the long-term spending that measures long-term or even intermediate-term “production.” In our current context, GDP measures price increases--in short, inflation--and not the production of real goods and services. And the best measure of inflation is the increase in the M2 money supply--a metric that can forecast future growth far better than the backward-looking GDP metric which, in our current case, is “hiding” the real damage to the economy. Money printing has helped bump up GDP, but the long-term cost of this bump can never be revealed by the positive figures that cherry-pick the angles highlighting growth.
Do not believe government pronouncements that the economy is rebounding from very minimal damage caused by unprecedented covid-19-inspired closures of businesses. Government will use its favorite statistic of the health of the economy to justify its actions—gross domestic product (GDP).
GDP is supposed to represent the total of spending on final goods and services in the economy. It is a Keynesian term that elevates a concept called "aggregate demand" as most important. Not production and especially not savings. In fact Keynesians fear savings most of all. Now, you and I know that we can become wealthier only by saving some of our income and investing it wisely for the future. But Keynesians invented a concept called "the paradox of thrift," whereby they claim that the economy enters a death spiral from reductions in spending caused by an increase in savings. Individually, savers may be better off, they say, but collectively the economy suffers. For example, the new auto that we savers do not buy, rather keeping our old one in good repair for a few more years, denies the automakers and all who work for them the money they need to continue production. Layoffs and plant closings ensue. The reduction in aggregate demand ripples outward, bankrupting more and more support businesses and their employees. This is the simplistic Keynesian view of savings.
But what happens to the money that we do not spend on as many new cars? Is it thrown down a rathole? No, of course not. It is invested in longer-term production processes that will yield even more wealth than if we had continued our former practice of buying new cars more often. Austrians call this phenomenon a change in the "structure of production." We may produce few automobiles now, but later we'll have access to products and services that would not have existed without our previous investment. We see this in our personal financial profiles. Our savings accounts increase at a compounding rate, allowing us to live a more comfortable existence later in life. This is the truth that used to be drilled into all of us before governments' in-house economists propagandized that by being frugal we were denying our fellow citizens what was rightfully theirs: i.e., our money and our future. It's nonsense.
But, you may ask, where does GDP enter the picture? Remember, aggregate demand is measured by spending on final goods and services, which becomes GDP. There are two critical problems with GDP. One, it does not capture a lot of spending on longer-term and intermediate-term production, but rather mostly retail sales. (For a quick explanation of how the government calculates GDP, listen to the twelve-minute narration of Mark Brandly's Mises Wire article "Calculating GDP Correctly." In his summary of key points, Brandly states that intermediate goods and services are not generally included in GDP unless added to inventories.) Headlines that retail sales are up are supposed to generate confidence that all is well with the economy. But is it? If you and I spent all our savings and even borrowed more, we would soon find ourselves in the poorhouse. But Keynesians would say that our individual financial difficulties were good for the economy. Anybody buying that? I certainly hope not!
GDP Captures Price Inflation and Calls It Economic Growth
But the biggest problem with GDP is the most obvious one—that GDP measures price increases, not increases in the production of real goods or services. For example, in the past month or so the price of a gallon of regular gasoline in my home state of Pennsylvania has gone up from just under $2.50 to around $3.00. That's a 20 percent increase in price. Since gasoline consumption changes little in the short run, selling the same volume of gasoline at a higher price causes GDP to go up. But our standard of living just went down! Our increased dollar spending on the same amount of gasoline had to come from somewhere. We had to cut back somewhere else, either some other consumption item or, most likely, a reduction in savings. Whereas government says that the increase in GDP means that we are better off, actually we are worse off.
Increases in the Monetary Base and M2 Are Harbingers of Future Price Inflation
The best measure of long-term price inflation is not necessarily measuring retail prices in the short run but measuring the increase in the money supply over time. If the money supply increases, eventually this increase will work its way into the price structure. It can do nothing else. The two statistics that best measure the money supply are the "monetary base" and "M2." The monetary base consists of all cash, wherever held, plus bank reserves held at the Federal Reserve Bank which may be converted into cash on demand by the banks. It is called the monetary base, because banks can create money out of thin air by pyramiding loans on top of their reserves at roughly a ten-to-one ratio. Just after the 2007/08 subprime-lending debacle the monetary base was $0.910 trillion. The Fed juiced the monetary base to bail out the banks, so that in January 2020, just prior to the covid-19 lockdowns, it stood at $3.443 trillion. That's a 278 percent increase. After the covid-19 lockdowns the Fed juiced the monetary base again. Today it stands at $5.248 trillion, a further increase of 52 percent over the already inflated January 2020 level. And we haven't seen the effect of the recently passed $1.9 trillion stimulus bill! Since this government helicopter money will be funded completely by money printing by the Fed—a process called "monetizing the debt"—the full amount will go directly into the monetary base as the checks are either cashed or deposited to the recipients' bank accounts.
M2 is the broadest measure of the money supply that can be accessed by the public on demand. It comprises cash in the hands of the public (but not cash in bank vaults) plus money in checking and savings accounts. M2 has exhibited similar meteoric increases. M2 stood at $7.215 trillion in 2008, then was juiced to $15.419 trillion by January of last year. It now stands at $19.384 trillion. That's a 169 percent increase, and tracks well with inflation in asset prices like stocks and housing. The $1.9 trillion third stimulus program will add dollar for dollar to M2 initially. If the banks pyramid more lending on top of this increase in their reserves, M2 will continue to grow beyond the $1.9 trillion. This is exactly what the government wants, because it will goose GDP.
The lesson is this—don't be fooled by government statistics, especially GDP, that the economy is recovering nicely from the covid-19 lockdowns. The covid-19 lockdowns have caused immense damage to the economy. Government money printing may goose GDP, but It will do nothing to compensate for the deadweight loss that millions have suffered.
Originally posted on Mises Institute