For many years now it seems that the state of a nation’s economic health has been reduced, at least in the establishment press, to one metric—Gross National Product (GDP). Despite rising prices, increasing public and private debt, and other indications of a nation’s economic problems, governments and the legacy press everywhere hang on the latest GDP figures. If the number—always produced by government statistics offices—is positive, then all is well. If the number is on a downward trend, then government has an answer—increase government spending. This is the magic elixir. Why, didn’t you know that the government can “fine tune” the economy through more spending? This is so because GDP is a measure of spending!
All Three Major Components of GDP Relate to Spending
The three major components of GDP are consumption, plus investment, plus government spending. Just think about that for a minute. An economy is no longer evaluated by what it produces, but by what it spends. This may have made some sense in the past; i.e., before money was delinked from gold and became completely fiat. In those pre-Keynesian days spending was an indication of wealth and wealth was generated by production. So, if your neighbor bought a new Buick, it was logical to think that he must be doing rather well. One could assume that he was spending the excess fruits of his own labor. In other words, he had produced enough goods and/or services that others desired in order to increase his standard of living by purchasing an upscale car.
In the public realm, the establishment financial press, such as the Wall Street Journal, regularly ran headlines of the increase or decrease of real national production, such as boxcar loadings (I haven’t seen this metric in half a century), megawatts of electricity produced, barrels of oil pumped, steel, auto, refrigerator production. The size of the corn, wheat, and soybean crops were regularly reported upon. All this probably is still available, but it no longer is considered headline news as is GDP.
The Great Change that Inaugurated GDP as the Premier Economic Metric
All this changed in the fall of 1971 when President Nixon “temporarily” suspended dollar redemption for gold. It is a story that has been told often in the halls of real economists as a black day that has led to so many ills. Not to repeat an oft-told story, but the last real-world discipline on a nation’s ability to expand money was cut. The world went on a completely fiat money standard.
A Keynesian criticism of the gold standard was that it prevented government from smoothing out what is now called the “business cycle.” It used to be said, as a criticism of course, that prior to 1971, the Fed would take away the punchbowl just when the party was getting started. In other words, the Fed would raise interest rates when the stock of gold backing for the dollar started to decline. As is proper, the central bank would control a nation’s gold stock through proper interest rate management. When the gold stock declined, the central bank would raise rates to stop its exportation to pay for excessive imports. When the gold stock was stabilized and growing nicely, the central bank lowered rates.
Now, the Austrian economists reading this article would remind me that a central bank isn’t really necessary, and they are right. The world, and especially the US, managed its currency and gold stock very well prior to the establishment of the Fed in 1913. It is no coincidence that the biggest financial crash in American history occurred fewer than two decades after the Fed started to intervene in monetary affairs.
Two Kinds of Money
Economic progress/betterment can be aided by but does not require an expanding money supply nor is it harmed by a contracting money supply. (Many thanks to Alasdair Macleod for this insight.) Basically there are two kinds of money under a gold standard—base money and credit money (what Mises called “fiduciary media”). Base money is composed of money claims (certificates and bank reserves) that are fully redeemable in gold. Then there is credit money that is manufactured out of thin air by the banks when they make a loan. The main metric of the total money supply is M1, the total of bank demand/checking accounts and travelers checks. Some of it is backed by base money but most of it is backed by credit money. M2 adds bank savings accounts that can be moved to checking accounts with minimal delay, sometimes only a home computer click away.
Bank Credit Is Neither Good Nor Bad
The important point is that, under a gold standard, an increase or decrease in the bank credit money component is neither good nor bad. Most Keynesian economists consider an expansion of bank credit to be good and a reduction to be bad. This is false. Banks expand credit, whether for production or consumption, with the expectation of repayment. For example, a bank may extend credit to a manufacturer in order to finance inventory or receivables. It will examine the business very carefully before deciding whether to make such a loan.
Likewise, a request for a loan to finance pure consumption, such as an addition on a house, would require a close look at the borrower’s ability to repay over time, such as the stability of his job or the increase in value of his home after the renovation. (Any real banker will tell you that the best collateral for a loan is not physical assets but the borrower’s character. Unfortunately, this key element to good lending has been replaced by automation of the lending process.) Therefore, an expansion of credit assumes that it will be followed eventually by a reduction of credit as the loan is repaid. Therefore, a reduction in credit, which leads to a reduction in M1, is not necessarily a bad economic indicator. It is the financial health of the bank that is important.
Conclusion
In conclusion, the fixation of the financial press and the public on GDP is misguided and came to the fore only due to the delinking of fiat money to real money—gold. Under a gold standard, the stock of real money (gold) was stable. Bank credit money varied up and down as banks lent funds that they created out of thin air and were repaid at a later date. A return to real money will return our attention to what is really important, economic betterment through production and not the Keynesian be-all statistic of GDP.
