Tuesday, March 15, 2011

Stocks and flows: Why Larry Summers is right...but should be ignored

It's not often that I write in favor of an avowed Keynesian. But much of the criticism of Summers on his remarks about the economic impact of the earthquake that has caused severe destruction in Japan is based on stuff that he simply did not say (put it down as a case of "What you read, and what you don't read! :). 

Here's what he said: 

If you look, this is clearly going to add complexity to Japan's challenge of economic recovery, it may lead to some temporary increments, ironically, to GDP, as a process of rebuilding takes place."

Predictably, this has led to a lot of severe criticism from right-wing economists. (See here and here, for instance)

Many have pointed out (with accompanying apoplectic rage) that Larry Summers has fallen for the "Broken window" fallacy (popularised by French writer Frederic Bastiat in his celebrated essay Ce qu'on voit et ce qu'on ne voit pas ("What you see and what you don't see"

So, has Summers (winner of the John Bates Clark medal, former Treasury Secretary, former Chief economist at the World bank, and director of the White House National Economic Council) been outed as a neo Keynesian ignoramus? 

Not really. It's a simple point to understand, really. GDP is the total value addition to the economy in a given year, and is derived as the sum of private and Government consumption, investment and net exports. 

What would you do if your house was destroyed in an earthquake? Rebuilding it would be first priority. What is you cannot finance it from this year's income? Well, then you would borrow to finance it. 

Simply understood, this is what will happen at the aggregate level in Japan. There has been large scale destruction of assets. There has to be investment and consumption to rebuild. Investment and consumption are components of GDP. Hence GDP may be (temporarily) boosted (especially if it is financed through borrowing). 

Wow,this seems like an easy route to prosperity. Just destroy your property and keep boosting GDP. How can this be the route to prosperity? (as the critics of Summers have demonstrated to show the absurdity of the claim)

The answer is this: GDP is NOT prosperity. GDP is a "flow" quantity, what has been destroyed is the "stock" of assets. You are prosperous due to your wealth and assets (stock) as well as your incomes (flow). Japan is NOT better off due to the earthquake, however its GDP this particular year may be boosted. The critics are right, you would otherwise have spent the money on something else. However it is still feasible that this year's GDP would be higher since you would borrow to spend (think of a simple 2 good model- the only goods in an economy are food and a house. Now if your house is destroyed, you would spend to rebuild, but you would not stop eating! Where is the extra money coming from? Borrowing against future incomes (which then have to be paid back). There is no money machine, but this shows how there can be a temporary increase in this year's GDP, which will (to a first approximation) be compensated by the repayments of borrowings.) 

Larry Summers should be criticized. Not because what he said was wrong, but since it is supremely uninsightful (the right response to saying there may be a temporary increase in GDP is not to say "That is wrong", but to say "So what"?) and since it makes the noneconomist population gibbering idiots believe one of the most persistent economic fallacies- that destruction brings about prosperity. 

Larry Summers did not say it does. But that's how it would be understood. He should know better.

In any case this is a useful "teaching moment" (to use an Obama phrase), especially for the class of journalists who have a superficial understanding of economics. GDP is not prosperity, GDP is an "accounting entity" it is not a metric that you can look at in isolation and conclude the levels of prosperity of an economy. It is a useful measure, but to see it as a be all and end all objective function to maximise leads to the idiocy of things like "stimulus spending" that must be avoided.   

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