By The Formula

Let's talk GDP, in particular the role of government spending and how it impacts it.

First, here is the equation for how GDP (gross domestic product, the preferred measure of a country's economic output):

GDP = C + I + G + (X-M)
where:
C = consumption
I = gross private investment
G = government spending
X = exports
M = imports

Consumption is what the private sector spends on stuff: necessities like food, rent, and medical expenses, but also iPods, BMWs and espresso machines.

Gross private investment is what companies and individuals invest in the economy. Whether it's a business buying a new copier, a company building a new plant, or you or me buying shares of Google, it's included here. (New home purchases fall into this category too.) It's called "gross" because depreciation on that copier or plant is not counted against the value.

Government spending should be pretty doggone obvious at this point, and exports and imports are intuitive.

So basically, it's what we spend, both in the public and private sectors, what we invest, and what we make and sell abroad minus what we buy that's made abroad. Makes sense, right?

Okay, let's make some observations. First, our economy, since the late 1980s, has been driven by the "C" component. It wasn't always this way, though, so don't let the newbies in Washington and the talking heads on Bubblevision fool you. Most of them think US economic history started in the mid-'90s. Every sustainable period of growth in this country has begun when the savings rate was high. "I" is the engine of economic growth. "C," when pursued too long, requires increasing amounts of credit to sustain it, until the leverage becomes unbearable and the house of cards collapses.

Second, the net exports equation (X-M) has been negative for some time now. It was the only thing keeping economic growth positive for the first half of last year, as the cheap dollar boosted exports while our weakening economy was generating less demand for imports. But when the biggest economy in the world exhibits contracting consumption, other economies are going to slow too, and even faster, because they're smaller and more dependent on the US market. For all the talk of de-linking in the global economy, the old truism still holds: when the US sneezes, the world catches a cold.

But all the boost in net exports did was make a big negative number a smaller negative number - in other words, we still had/have a trade deficit. It just became less of a drag on GDP than usual, and made tepid growth look a little better.

Another thing that can artificially inflate GDP is when "I" is too high relative to "C." I don't mean this in terms of saving and investing in long-term growth, but in producing right now. That results in an inventory build-up, and can make GDP positive all by itself (as almost happened in the third quarter of last year, when GDP declined by 0.5%, and inventories grew 0.8%). But it's not healthy; it demands an ultimate reduction in output to reduce the inventory overhang, unless demand turns around quickly. And we're headed for even worse news to come: not only did the inventory growth in the third quarter approach 1%, it was 1.3% in the fourth quarter, when GDP contracted by 3.8%. So, had inventories been flat in the second half of 2008, GDP would have fallen by 1.3% and 5.1% in the third and fourth quarters, respectively.

To clear that run-up in inventories will require a correction that will make first- and probably second-quarter GDP look like crap. It will take a while; inventories are falling rapidly as companies scale back, but sales are falling even faster, as the inventory-to-sales ratio continues to rise. We'll see this persist through at least this quarter.

Okay, now for the economics lesson in all this. What happens when "I" and "C" go in the crapper? Keynesians think you can just boost "G" to offset it. The thinking is that this will provide jobs, infrastructure improvements, yadda yadda yadda. There are several problems with this thinking, especially in the current environment.

First, that's going to take a might big boost in "G." GDP in the fourth quarter was a little over $14 trillion. "C" accounted for about $10 trillion of that, "I," another $2 trillion, and net exports subtracted a half-trillion. Now, let's say "C" and "I" fall at their prevailing rates all year. That's a trillion-dollar hit to GDP. So the government is trying to replace it, dollar-for-dollar, with "G."

The problem is that private capital is far more efficient than government capital. That's why we're unlikely to see a multiplier effect from this, where a buck of government spending produces greater economic benefit, say, a buck-and-a-half's worth.

Especially with this bill.

Also, there's the deficit. Again, we're creating more problems than we'll solve (not hard, since the latter number is zero) by doubling a deficit that's already double the previous record.

Finally, it's just another Ponzi scheme. We wrench the money out of taxpayers' wallets - maybe several generations' worth - and give it to the government to spend as they will, to replace the free-choice saving and investing and spending decisions those individuals would otherwise make with their hard-earned money.

By definition according to the GDP formula, we gain nothing as an economy. But we lose free choice as citizens.