In the last quater of 2012, real U.S. Gross Domestic Product (GDP) fell by 0.1 percent, after a third quarter increase of 3.1 percent. The decrease is attributable to a few factors: a drop in private inventory investment, a decline in government spending (in particular military spending), and a drop in exports. This was partially offset by increased consumer spending, nonresidential fixed investment, and a decrease in imports.
Is the fourth quarter drop in GDP an indictment of “austerity,” implying that more government spending is needed to boost GDP? As economist Garrett Jones writes at EconLog, it’s important to recognize that GDP is an accounting identity with some measurement peculiarities. Consider his example:
Scenario 1: ExxonMobil hires an unemployed petroleum engineer for $100K per year. After a year, the engineer finds no oil.
GDP does not change. No oil is found. No consumer goods are purchased. Thus, there is no extra GDP. GDP captures personal consumption expenditures purchased by persons. It doesn’t count private sector employee compensation.
Scenario 2: The federal government hires an unemployed petroleum engineer for $100K per year. After a year, the engineer finds no oil.
GDP increases by $100K. Here, the government does the hiring. Government expenditures which is counted in GDP includes public employee compensation.
In sum, when the government hires people, it raises GDP by virtue of how GDP is defined.
This hints at the artifact in the accounting. But what about the economics? Would more government spending stimulate economic growth?
This claim rests on the Keynesian theory that in economic downturns government can create jobs and put idle capital to use. Unfortunately, without the information contained in profit and loss, government agents are in a position of guessing; and borrowing funds from the private economy where wealth is actually created. Moreover, these decisions are driven by the interests of politicians and not by what is revealed by consumers in the marketplace. My colleague, Matt Mitchell takes a look at the recent claim that fiscal stimulus almost always has positive effects. The evidence is very mixed, and where stimulus is found to be effective, the results are nuanced. One of the biggest problems with government stimulus is that over the long run, government spending eventually crowds out private consumption, investment and borrowing, leading to low growth. Even stimulus advocates, including President Obama’s former advisor, Larry Summers, point to the need for “timely, temporary and targeted” stimulus spending.
The notion of a permanent stimulus to boost GDP on the books is not unlike over-dosing the patient with painkillers while failing to treat the underlying disease: you eventually end up with a corpse.