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GDP Economics: Fat or Muscle? – Article by David J. Hebert

GDP Economics: Fat or Muscle? – Article by David J. Hebert

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The New Renaissance Hat
David J. Hebert
November 1, 2014
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Recently, Italy “discovered” it was no longer in a recession. Why? The nation started counting GDP figures differently.

Adding illegal revenue from hookers, narcotics and black market cigarettes and alcohol to the eurozone’s third-biggest economy boosted gross domestic product figures.

GDP rose slightly from a 0.1 percent decline for the first quarter to a flat reading, the national institute of statistics said.

Italian officials are, of course, celebrating. In politics, perceptions are more important than reality. But such celebration is troubling for several reasons, which have less to do with headlines or black markets and more to do with fat.

One of F. A. Hayek’s lasting insights was that aggregate variables mask an economy’s underlying structure. For example, a country’s GDP can be calculated by summing the total amount of consumption, investment, government spending, and net exports in a given year. The higher this number, the better an economy is supposed to be doing. But adding these figures together and looking only at their sum can be wildly misleading.

One way to illustrate why is through the following example: I am currently six foot one and weigh 217 pounds. As it turns out, Adrian Peterson, a running back for the NFL’s Minnesota Vikings, is the same height and weight. Looking at only these two variables, Peterson and I are identical. Obviously, this isn’t true.

Likewise, cross-country GDP comparisons are difficult to make. If two nations grow at the same rate, for example, but one nation “invests” in useless boondoggles while the other grows sustainable businesses, we wouldn’t want to claim that both countries have equally healthy economies.

But what about comparisons of a country’s year-to-year GDP? Is this valuable information? Well, yes and no.

If we know that more stuff is being produced this year than last year, we can infer that more activity is happening. However, this doesn’t mean that government should subsidize production in order to increase activity. In that case, all they’re accomplishing is increasing the number of things that are being done at the expense of other things that could have been done.

What economists should be looking for are increases in economically productive activity from year to year. For example, digging a hole and then filling it back in does increase the measure of activity, but it’s not adding any value to society. Digging a hole in your backyard and filling it with water is also activity, but it’s productive because you now have a swimming pool, which you value enough to employ people to create.

It’s no mystery that Italy is seeing a higher GDP as a result of its change in measurement and that as a result it’s avoided a recession on paper. That is, it’s counting more activities as “productive” than it was previously. It is wrong to conclude, though, that more production is actually happening in Italy. These activities were happening before; they just weren’t being counted in any official statistics.

There are many problems with using GDP as a measure for an economy’s health. Changing what counts toward GDP only introduces yet another confounding factor. When I step on the scale, I can get some basic idea of how healthy I am. But when I take my shoes off and step on the scale again, I didn’t magically become healthier. I just changed what’s counting toward my weight. It would be wrong for me to conclude that I can skip the gym today as a result of this recorded weight loss. Similarly, citizens of Italy should not be celebrating their increased GDP. They still face the same problems as before and must still address them.

David Hebert is an Assistant Professor of Economics at Ferris State University. His interests include public finance and property rights.

This article was originally published by The Foundation for Economic Education.

Oklahoma: The Economic Storm – Article by David J. Hebert

Oklahoma: The Economic Storm – Article by David J. Hebert

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The New Renaissance Hat
David J. Hebert
May 25, 2013
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A tornado ravaged Oklahoma last week, destroying hundreds of homes, killing dozens, and injuring hundreds more. Unfortunately, it looks like the citizens of Oklahoma are about to be ravaged by another storm brought on by the Oklahoma Attorney General, Scott Pruitt.

According to ABC News, Mr. Pruitt and his staff began “aggressively combing the region for fraud just hours after the tornado … and immediately [found] businesses violating the law. ”

What laws were the businesses accused of violating?  Anti-price-gouging laws. Using powers granted by the Emergency Price Stabilization Act, Mr. Pruitt is hoping to help the people of Oklahoma by preventing businesses from profiting off of the suffering of the townspeople, many of whom just lost their homes. He goes so far as to say, “[the townspeople] never anticipate or expect that someone would take advantage of them right now, but this situation is what criminals prey upon. ”

While Mr. Pruitt no doubt intends to help the local citizens, his misunderstanding of the workings of the price mechanism will lead only to folly and the prolonged suffering of the very people that he is trying to help. What he is effectively arguing for is a price ceiling on basic commodities, such as water (which is reportedly being sold for $40 per case today as opposed to only $3-$4 just a few weeks ago).

This has very predictable results: a shortage.

When prices are held below their market value, the effect is that there will be a large number of people who are willing to purchase water at that price but very few sellers willing to sell the water at that price. This means that people will compete on non-price margins to acquire water, that is, they will queue, sometimes for hours on end. The time that they spend waiting in line, however, is a deadweight cost as it is value that is forgone but is not captured by anyone. So now, instead of contributing towards the reconstruction of the town, the people are stuck waiting in line for water.

The beauty of the price mechanism is what it accomplishes in situations like this, assuming, of course, officials allow it to function properly. In this situation, demand in Oklahoma rises and producers, seeing an opportunity to profit, reroute trucks/planes to Oklahoma, thus increasing the quantity of water supplied in the area that needs it most.

Absent the rise in price, we would have to rely on the benevolence of these companies to help the people in need (and assume that they knew what the people of Oklahoma wanted to begin with).

This isn’t in and of itself terrible. Obviously companies DO send extra water to places that experience disasters, and the Red Cross DOES send volunteers and such. But notice that nothing in the preceding analysis precludes this benevolence. Why rely merely on benevolence when we can also rely on self-interest? If the goal is to help people get clean drinking water, it stands to reason that we ought to incentivize producers as many ways as possible, be they other-regarding, self-regarding or both.

David Hebert is a Ph.D. Fellow at the Mercatus Center at George Mason University.

This article was originally published by The Foundation for Economic Education.

Ice and Economics – Article by David J. Hebert

Ice and Economics – Article by David J. Hebert

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The New Renaissance Hat
David J. Hebert
July 21, 2012
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What can ice teach us about economics? We’ll see, but let’s begin with some fundamentals.

Prices, property rights, and profit (and loss) lead to information, incentives, and innovation. This simple statement contains nearly every lesson necessary for a free and prosperous society. But what do these words mean?

Prices convey information about relative scarcities and communicate to us the relative value of competing uses of a resource. They also economize on the acquisition of knowledge. When we see the price of a resource rise, market actors understand the need to use less of the resource. What they don’t know, however, is whether this rise is due to a disaster that destroyed some of the stock of that resource (an inward supply shift) or if a new, more valuable use for that resource has been discovered (an outward demand shift). These facts are irrelevant for a person who is currently using the resource, but from a societal level, her using less is necessary. If there is a disaster, we would want people to use less of it so that everyone else can still use some. If there is a new, more valuable use discovered, we would want the original users to use less so that more could be allocated towards this new use.

The Right to Exclude

Property rights refers not only to the right to use a resource, but also to the right to exclude others from its use. In this sense property rights provide the incentive to allocate the use of a resource efficiently across time, for example, to conserve it for later. With firmly established and enforced property rights, not only does the owner not have to worry about someone else taking his things but he also doesn’t have to rush out to gather the resources as quickly as he can. A situation where there are no property rights is susceptible to what is called the “tragedy of the commons,” where the resource gets depleted too quickly and never has a chance to replenish.

Profit (and loss) leads to innovation. Earning a profit is akin to being rewarded for doing something good. Suffering a loss is the opposite, a punishment for doing something wrong. In this case, the deed being done is the attempt to allocate scarce resources to where their will earn their highest return. People who successfully do this are rewarded with monetary gain, which we call “profit.” People who fail to do this experience what we call “loss.” In doing so, economic actors learn what works and what does not. Reducing the profitability of an activity through taxes or legislation or sheltering people from losses, therefore, acts to retard this learning process and stifles innovation.

This lesson is exemplified in early nineteenth-century Boston with the rise of the American natural ice trade. In 1806 Frederic Tudor sailed a ship full of ice from Boston to the Bahamas. Two years earlier Tudor had begun experimenting with insulation with the goal of bringing ice to the Bahamas.  When he was ready to set sail, he found that the ship captains refused to carry his cargo for fear of damaging their vessels. So he bought his own brig, the Favorite, and set sail February 10, 1806. He arrived in Martinique with a large quantity of ice still intact and began selling. The Bahamians loved the ice, which they had never seen before. Yet that first year Tudor lost a substantial sum of money, although he proved that ice could be shipped to the Bahamas. Now the objective became doing it at a profit.  Convinced his idea would be wildly successful, he continued his attempts to drive down costs and increase demand.

Higher Return

Meanwhile, as the price of the ice on the ponds rose, the people of Boston gained the information that the ice would bring a higher return in the Bahamas, thus they used less themselves and sold the ice to the Bahamians. In 1840 the ponds in the Boston area were explicitly divided, giving each person on the lake the right to exclude everyone else from harvesting any ice that wasn’t theirs. This allowed Tudor, for example, to invest in his ice and let it freeze longer so that it could better survive the long journey from Boston to India, which entailed crossing the equator twice and sailing around the tip of Africa. As Tudor earned profit from his venture, more people were attracted to the ice.

To continue to earn a profit, therefore, he had to find a way to outcompete everyone else. In 1825 Tudor enlisted the help of Nathaniel Wyeth, one of his suppliers. Tudor noticed that Wyeth’s ice was always significantly cheaper than everyone else’s and was cut in neater blocks which packed more easily. Wyeth had converted some old farm plows into ice-cutting plows and had fastened horseshoes with spikes to allow horses to pull these modified plows across the ice. By scoring the ice in such a fashion, Wyeth could break uniform sized blocks much quicker than his competitors, who were using hand saws that produced very rough and uneven edges.

These wouldn’t be the only contributions of Wyeth, as he went on to invent many other cost saving techniques. For example, Wyeth developed a conveyor-belt system that would haul the ice from the pond into the waiting icehouse.  He also invented bigger plows that could cut more blocks at once and poles that were used to guide the floating ice blocks onto the conveyor belt;  refined the above-ground icehouse, which allowed ice to be stored anywhere in the world for months on end without any external source of refrigeration.

New Insulation

Tudor and Wyeth also experimented with new means of insulating the ice from the heat, discovering that sawdust was not only a fantastic insulator but was also cheaply available from the sawmills around Boston. They also taught their customers new ways to use the ice, including making ice cream and storing the ice in iceboxes to preserve foods longer.

In short the three Ps lead to the three Is: Prices, property rights, and profit (and loss) lead to information, incentives, and innovation.  With these firmly in place, a free and prosperous society will follow.

David Hebert is a Ph.D. Fellow at the Mercatus Center at George Mason University.

This article was originally published by The Foundation for Economic Education.