In this post, I claimed that Gross Productive Domestic Product = Consumer Spending + Investment Spending – 2 times Government Spending, or GPDP = C + I – 2G.
Tyler Cowen explains why during this EconTalk podcast:
Considering our economy right now: about 17% of it is health care; about 6% in terms of GDP is education; and with some overlap, 15-20% is what we call government consumption–government activity, not just transfers. At all levels of government, including state and local. Add those all up, take out the overlap, and it’s a pretty big chunk of the economy, like 20-30%. Those are all sectors where there are massive subsidies, massive distortions of incentives, a lot of bad policy; and it’s hard to measure value.
So, when we talk about biases in measuring output and living standards, the bias I worry about the most is we’re spending a lot of money and simply writing it down as value added when it might not be.
GDP measures how much money was spent in the economy, not how much value is created.
What do you do when you spend money that destroys value? You try not to do it again.
If you buy something and you don’t think the value you received was worth the price, you stop buying it and you might warn others to save their money or spend it elsewhere. As I pointed out in the post, What is a job?, when we spend our own money we typically think in terms of cost vs. benefit relative to the cost vs. benefit of alternative choices for the spending. This is the engine of value creation.
But, what happens when third parties, not just governments, spend money and it destroys value? Often, money continues to be spent because it is being spent for reasons other than value creation. Sometimes more is spent to try and fix perceived problems.
Third party spending doesn’t have to hold to the same rules as first party spending. As I also pointed out in What is a job?, there are many reasons for third parties to spend money that have nothing to do with value creation. This is the engine of value destruction.
This is why I don’t believe C + I + G is a good representation of value created in the economy.
This is also why we should carefully consider the change in incentives when we make changes that moves payments from first parties to third parties, like in the areas Cowen points out — health and education.
Given the incentives around G, I’d rather keep as much of the economy as possible in C and I transactions and use C + I as the measure of the productive, or value creation, estimate for the economy.