The most important indicator of economic growth in the UK
What are the effects of inflation on your wealth? Where does economic power come from? What main economic indicators tell you the most about UK economic growth? What is GDP and is it useful for economic and investment analysis in 2018?
These are all important questions. But let’s start with the first one.
What is GDP? What does GDP mean?
GDP stands for Gross Domestic Product. It’s a number. It’s actually a result of a basic formula that is supposed to help economic analysis by determining who is growing (and thus, which countries have economic power). Here is the equation:
GDP= C + I + G – (surplus/deficit)
The letters in the formula are each, themselves, a kind of economic indicator. ‘C’ means consumption, commonly measured by consumer spending. When consumers spend money, it leads to economic activity and sometimes growth. It’s an important indicator and a key part of economic forecasts (and also closely watched by the central bankers who make monetary policy).
The ‘I’ is for business investment. Businesses borrow money from banks (or from investors if a bond is issued). This money builds factories, new goods and services and, in theory, creates new jobs, incomes, and improves economic growth and wealth. Investment, then, is a key component of GDP.
‘G’ is for government spending. In some economies, the government spends large amounts of money on key industries (aerospace, defence, farming). It also invests in major infrastructure projects like roads, airports, rail and housing. The government is also a large employer in some countries, contributing to incomes and the well-being of tens of thousands of citizens.
Those three components of GDP – consumption, investment, and government spending – are added together. Then, if a country has a trade deficit, the size of that deficit is subtracted from the sum. If a country has a trade surplus, the size of that surplus is added to GDP. This is why trade deficits (part of a larger group economists call the ‘Current Account,’ are often an indicator of economic strength or power.
Is GDP a useful indicator for UK investors?
In 2016, Britain had the fastest growing GDP of any G7 country (the G7 being industrialised economies like France, Germany, Italy, Japan, Canada, and the United States). As an economic indicator, then, GDP would tell you that the UK economy is strong and economic growth is positive. But is it?
Our view is that modern economists have it all wrong – especially the Keynesians School. Why? Because they see the economy as a machine that must be kept in balance. The GDP equation itself is fairly modern. It was invented to try and quantify the impact of Franklin Delano Roosevelt’s Great Society spending programmes on the US economy.
Another way of saying that is that the equation was invented to show that FDR’s spending was good for the economy. The best way to show that was an equation which showed a nominal (or quantitative) increase in economic activity. That quantitative increase was deliberately equated with qualitative improvements in the economy and quality of life.
Here’s the problem: by expressing the economic model as a sum, you create the impression that if one element in the sum goes down (consumer spending) another element can go up (government spending). Thus, the sum total is still the same, or larger!
Keynesians focus on GDP, Austrians do not
That’s the idea behind Keynesian stimulus. You grow the economy at the aggregate level – and thereby human happiness at the individual level – by carefully managing the individual elements of the equation. If investment is too low, tweak interest rates. If consumption is too high and trade deficits result, tweak interest rates. When all else fails, “stimulate” final consumer demand with government spending.
Using GDP as an economic indicator is based on a kind of equality or equilibrium in the system. Because it begins by looking at the economy from the top down as a sum total, this world view wants to make sure things don’t become too unequal; that the “product” of all that labour is fairly and evenly distributed; and that the whole system remains stable and predictable for everyone who operates within it.
This last point is important because it’s a philosophical preference. The model doesn’t really describe the world as it is, or human beings as they are. It describes the world as the designers of the model would like it to be, or believe that it ought to be, based on their own preferences about equality, liberty and wealth
Focus on savings, production
The main opponent of the Keynesian school is the Austrian school of economics. Many of its early proponents were, in fact, from Austria. But anyone can be an ‘Austrian’ provided they believe in the general principles of sound money, limited government, and an emphasis on saving and production over borrowing and consumption.
The Austrians believe credit should not exceed available savings. Thus, the savings rate and the interest rate are two important economic indicators in Austrian thought. All investment by businesses is accomplished by accessing savings in the banking system accumulated my private investors who are willing to save and live beneath their means.
Key economic indicators to watch in 2018
For UK investors, the key economic indicators to watch in 2018 are the trade deficit, the savings rate, and GDP growth. If GDP growth is driven by borrowing and consumer spending, the Austrians would call in non-productive and possibly dangerous. Government ‘stimulus’ spending boosts GDP. But it’s always a short-term boost, usually employed in an economic crisis, when businesses are reluctant to invest and consumers reluctant to spend.
Another key factor for UK GDP growth will be economic news that either confirms or disproves that Brexit is good the UK economy. Britain hopes to erase a trade deficit with the European Union by expanding trade with the rest of the world and thus producing more UK economic growth. Time will tell!