The GDP Illusion
The government's propping-up of the economy with borrowed money will cost us all later, as it increases the federal debt and delays the economic adjustments needed for the recovery
August 1, 2008
Fred Foldvary, Ph.D.

The U.S. federal government’s national income accounts reported by the Bureau of Economic Analysis show an increase in GDP, the country’s output, of 1.9 percent per year in the second quarter of 2008, April through June. That is up one percent from the .9 percent growth of the first quarter. The fourth quarter of 2007 was revised to a negative .2 percent, thus GDP fell at the end of 2007 but has been rising since then.

Usually, economic investment drives the business cycle. An economic investment is an increase in the stock of capital goods, such as machines, buildings, and inventory. Private investment has been negative during the last three quarters. It fell 14.8 percent per year in the second quarter, greater that the 5.8 percent fall of the first quarter. So why did GDP rise?

Private consumption rose by 1.5 percent. The purchase of durable goods, such as furniture, fell at a 3 percent rate, but the purchase of services rose by 1.1 percent and the purchase of nondurable goods rose by 4 percent. This can be explained by the rapid rise in the price of food and gasoline, which are rising faster than general inflation.

Consumption has also been stimulated by the checks the government has mailed out. The government has force-fed the economy with its policy to stimulate demand. The money for the checks has all been borrowed, since the federal budget was already in deep deficit. The economy is artificially being propped up by borrowing from abroad.

Rising exports also contributed to the rise in GDP. The low value of the U.S. dollar makes American goods cheaper for foreigners. The dollar is low partly because of the low interest rates caused by the recent expansion of money by the Federal Reserve system. The Federal Funds rate, the interest rate paid for loans among banks, has been pushed down to 2 percent, which is lower than the rate of consumer price inflation, making the real federal funds interest rate negative.

Government spending is one third of GDP, and it rose by a whopping 3.4 percent in the second quarter, following a 1.9 percent rise in the first quarter. There was a rise of 1.6 percent in state and local government spending, and a steep 6.7 percent rise in federal spending. “National defense” or military spending rose by a walloping 7.3 percent, as it did also in the first quarter. Civilian federal government spending rose by 5.3 percent.

So what we have is a huge increase in government spending plus government giving people money to spend, all borrowed. The government can keep GDP rising by borrowing ever more money from abroad and spending it directly or giving it to residents to spend, while keeping interest rates pushed down via money expansion.

One could argue that the government should indeed increase spending when the economy is down in order to prevent a recession or induce a recovery. This may be so for a short-term policy, but over the longer run, this intervention has a cost that will be paid later, as it increases the federal debt and delays the economic adjustments needed for the recovery.

House prices rose too high, and the real recovery cannot occur until the land value of residential housing has fallen to normal levels. The demand-side policy of greater government spending will not solve the fundamental boom-bust real estate cycle. When the economy recovers, the next real estate boom-bust cycle will occur unless governments replaces punitive taxation with public revenue from land rent to remove the subsidy from land values and land speculation.

These numbers are “real,” meaning adjusted for price inflation, so the real changes depends on how one measures inflation. The inflation of the consumer price index in June 2008 was 5.02 percent, up from 4.18 percent in May. But the government use an index called the GDP deflator for calculating real GDP.

The federal government is using a GDP inflation index of only 1 percent, while the consumer price index (CPI) is now 5 percent. In the first quarter, the government used an inflation index of 2.6 percent. With an inflation index of 5 or even 4 percent, the economy would be calculated as having been in recession since fourth quarter 2007. The CPI index includes imported goods such as gasoline, while the GDP deflator only uses goods produced in the country, but still, higher prices for imports such as oil will push up the cost of domestic production. Thus, the small 1 percent GDP index is suspicious, and will most likely be revised upward, just as it was revised up for the fourth quarter 2007.

Swedish economist Stefan M.I. Karlsson ( points out that the numbers for the index of coincident economic indicators show that a recession began in November 2007. He also argues that a better GDP price index is Gross Domestic Purchases, and that index does show falling GDP. The purchases index measures what we buy rather than what we sell, and the purchasing power of Americans includes what they buy from abroad.

Thus the Government is inflating the GDP data with its misleading inflation index, and the government is inflating output by borrowing and spending. Maybe that game can continue until the November elections, but eventually economic reality will hit home and the revised data will show lower real growth. Few people question authority, and both political parties have an interest in making the voters think that the government is “doing something,” so for the time being, folks will be fooled into thinking that government has rescued the economy from recession.

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Fred Foldvary, Ph.D.

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.