GROWTH WITHOUT SUBSTANCE?

Candyfloss – known as cotton candy in the United States – is a long-established confectionary product, much enjoyed by young and not-so-young visitors to fairgrounds and the seaside. Traditionally sold on a stick, it consists (apart from some flavouring and colouring) entirely of sugar. It is made by spinning a relatively small amount of sugar into a much larger confection of very low density. It is, then, a fluffy, largely hollow product whose apparent volume far exceeds its substance.

The resemblance between candyfloss and the modern developed economy is a lot closer than you might think. Using the United States as a representative example, this analysis takes readers through a deconstruction of reported growth in GDP. As you’ll see, Western economies, in particular, look increasingly like candyfloss, with an ever larger volume of fluff disguising a remarkably small kernel of solid value.

Some numbers and some caveats

Let’s start with the headline numbers, and two important caveats.

American GDP was $18.6tbn in 2016, which compares with $13.9tn in 2006. Adjusted to constant (2016) dollars, the 2006 number equates to $16.3tn, so the economy expanded by 14% over the decade to 2016. Over the same period, the population of America increased by 8%, leaving reported GDP per capita ahead by 5.8%.

Regular visitors to this site will be familiar with a number of critical caveats around economic “growth”. For starters, the $2.3tn (14%) increase in American GDP between 2006 and 2016 was accompanied by an $11.1tn (31%) rise in debt over the same period, so each $1 of reported growth came at a cost of $4.75 in net new borrowing.

Meanwhile – and primarily because of the collapse in returns on invested capital in an era of ZIRP (zero interest rate policy) – huge pension deficiencies have emerged right across the world economy. In its recent report warning of a “global pension timebomb”, the usually-conservative World Economic Forum (WEF) identified a shortfall in pension provision in the United States of $28tn in 2015, adding that this number is worsening by $3tn (about 17% of GDP) each year.

Back in 2006, before returns on investment were crushed by ZIRP, the equivalent shortfall was very small. Between 2006 and 2016, the gap in American pension provision increased by about $22tn. For each $1 of growth over ten years, that’s a further $9.50 in balance sheet damage, on top of the aforementioned $4.75 increase in net indebtedness.

Two types of activity, differently priced

These debt and pension caveats, of course, are familiar fare to regular readers. When all is said and done, Americans are still left with growth of 14% in their economy, aren’t they?

Well, no.

Deconstruction of the numbers suggests that even this recorded growth number is extremely questionable.

To understand why this is, we need to divide the economy into two broad streams of activity. The first of these streams is termed here globally marketable output (GMO). This consists of output traded at prices set on world markets. Agricultural and extractive products are examples of world pricing. Even if sold at home, wheat, oil and copper are still bought and sold at prices set globally.

The same is true of manufactured goods, because the customer isn’t going to buy a home-produced car or refrigerator if he or she can get better value from an imported alternative. Services which are exported are also, by definition, globally-priced – customers in, say, Europe, aren’t going to buy American financial services if the equivalent, supplied at home, or imported from a third country, is better value.

The second economic stream is known here as internally consumed services (ICS), and is the difference in amounts between GDP, on the one hand, and GMO, on the other.

Critically, these services are priced locally, not globally. A customer in Boston might very well purchase a German-made car, or a refrigerator manufactured in Romania. But he isn’t going to book a taxi from Berlin, or go to a dentist in Bucharest. ICS, then, is priced locally, which is very different from pricing in the full rigour of global competition.

Moreover, these internally consumed services are a residual. Customers’ primary requirements are for purchases which are priced globally, including food, energy, manufactured goods, and anything requiring components and materials, which themselves are priced on world markets. Customers buy these things first, before spending what they have left on discretionary purchases such as taxi rides, meals out, cinema visits and trips to the hairdresser. These discretionary purchases are priced locally, by the interplay of domestic supply and residual spending capacity.

These services then, are residually priced and, in a very real sense, are “soft”-priced, too, compared to the “hard” pricing characterising globally-competitive price-setting.

Additionally, GMO and ICS have very different value-additive characteristics. Building a new car plant in a given location has very substantial knock-on benefits in terms of components supply, materials, distribution and ancillary services. The same isn’t true of setting up a lot of hairdressing salons, estate agencies and government administrative offices, even if their annual turnover matches that of the car plant.

Whilst it’s true that 100kg of feathers weighs the same as 100kg of lead, $100 generated by a car plant is not the same as $100 generated by a pedicurist. The difference lies partly in how the underlying pricing is determined, and partly in the much higher value-additive characteristics of the globally-priced activity than the locally- and residually-priced alternative.

Governments, historically, haven’t grasped this point, which is why relocating activities like tax and benefits administration to depressed locations turns out to be a lot less beneficial than is often anticipated.

The implications of differential pricing

The distinction between GMO and ICS gives very important insights into changes in economic activity. In the United States, globally-marketable output contributed $160bn, or just 7%, to the $2,340bn increase in GDP between 2006 and 2016. All of the rest came from services which can only be sold internally.

Equally tellingly, the whole of the modest GMO contribution to growth came from increased exports of services. Together, agriculture, energy, extractive industries, construction and manufacturing contributed nothing at all to growth over the decade – their aggregate output actually declined, to $3,414bn in 2016, compared with $3,501bn in 2006.

With GMO deducted, the remaining 93% of all growth – totalling $2,180bn – came entirely from internally-consumed services. These services themselves richly repay further analysis.

For starters, a full 15% of all growth over the decade – $342bn – came from “imputations”, which, it is strongly arguable, do not really exist at all. Imputations are values attached by statisticians to services for which no charge is actually made. One of the biggest is “owner equivalent rent”, a notional sum which, the statisticians say, a home owner would have paid in rent (presumably, to himself) if he didn’t own his home. Other examples of imputations include banking services and employee benefits supplied free of charge. All of these are services for which no money changes hands, so nobody earns anything out of them, or pays any tax on them. Yet these imputations account for 16% of all American GDP.

Who needs farmers, miners or factory workers, when statisticians can add so much more to economic output?

Then there’s the FIRE sector, comprising finance, insurance and real estate. These are worthwhile services, but we are entitled to wonder quite how much value is actually created by selling houses to each other, paying each other rent, or moving money around. This activity looks a lot like “doing each others’ washing”. Yet increases in FIRE sector activity accounted for more than a quarter (27%) of all growth in the American economy between 2006 and 2016, adding $628bn to GDP. As of 2016, FIRE activities accounted for 21% of the American economy, contributing far more than manufacturing (12%) and construction (4%) put together. Of course, a significant proportion of imputations arise in real estate and finance, which means that these sectors overlap.

Government, of course, is also a major component (in America, about 13%) of GDP, but its activity really amounts to recycling taxpayers’ money. This 13% component isn’t the same as total public expenditures, by the way, because those include a lot of activity which simply transfers money between taxpayers and the recipients of benefits. Actual activity by government increased by $272bn between 2006 and 2016, accounting for 12% of all growth between those years. This alone is telling since, together, activity in manufacturing, construction, farming and the extractive industries added nothing at all to GDP over that period.

Before we move on from the numbers, the following table summarises contributions to growth in American GDP between 2006 and 2016.

A misleading confection

As we’ve seen, then, almost all (93%) of growth in the GDP of the United States over the last decade has come from services which Americans can sell only to each other. It must be stressed that the US is by no means unique in this. Rather, America has been used here as an example, because of the importance of its economy, and because of the exceptional availability of economic data.

The picture in other developed economies is pretty similar, with ICS activities (such as finance, real estate and government) contributing even more to growth in Britain, where manufacturing output is barely 9% of output, compared with 12% in the United States, and almost 18% in the Euro area.

What emerges is an economy which produces very little that can be offered to overseas customers at world market prices. The bulk of the economy – in the United States, 80% – consists of services which people provide to each other, either privately or through the government. Within this ICS component there are further question-marks, most notably over “imputed” output dreamed up by statisticians, and over financial and real estate services which, whilst dwarfing activities like manufacturing, are of limited value-adding capability.

Together with this goes the important observation that there are two distinctive pricing mechanisms at work. One-fifth of American output is “hard” priced by international markets, whilst the remaining four-fifths are priced locally, in a way that is both “soft” and residual. In an era of ultra-cheap money, we are entitled to question the relationship between hard and soft pricing.

All of this, of course, is on top of our understanding that “growth” is being created by spending borrowed money, and by unwinding (through ZIRP) collective provision for the future.

We can summarise the situation like this. Essentially, we in the West are deluding ourselves about how much value our economies are really adding, because much of what we do is residual activity, delivering output that cannot be marketed at prices set by world markets.

Even as they grow – courtesy of mortgaging the future – Western economies are taking themselves ever further down the gradient of added value.

You might think, considering this, that we are in a self-delusional state that isn’t sustainable. If you did think that, you’d be right.