Sat, Jan 22, 2005 - Page 8 News List

Deficits boost GDP but not growth

By Christopher Lingle

Taiwan's economic growth rate of about 5.9 percent for last year was the best performance in seven years. At the same time, the unemployment rate improved to just over 4 percent, its lowest level since May 2001.

Despite these improvements, policy makers insist that they have the means to make it better. It is expected that they will use public spending on the "10 New Major Construction Projects" plan to raise the nation's economic growth rate to 5 percent.

However, there are several flaws in their reasoning on policy responses to economic down-turns. In general, the aim is to manipulate overall demand. The methods used to achieve this goal are increased public-sector spending -- most often relying upon budget deficits -- and/or monetary expansions to cut interest rates.

In the first instance, government spending is not the driver behind economic growth. As such, public-sector deficits cannot bring a permanent improvement in economic trends.

Sustained economic growth requires more investment from the private sector, not more spending by the public sector. The false expectations of higher growth from more government spending are supported by the notion of demand-led growth that has deep roots in GDP calculations.

Calculations of GDP focus on the demand for final goods and services that implies that goods emerge simply because people desire them. If all that matters is the demand for goods, then the supply of goods can be taken for granted.

Thus, the various stages of production preceding the provision of final goods would be irrelevant. However, intermediate goods must be produced and used to produce tools and machinery until the final stage of production is reached. These stages of production must involve capital formation that depends upon the real stock of savings in an economy. Contrary to the GDP-mindset, it is savings and not consumption that drives an economy. And the best way to encourage private investment is to lower the tax and regulatory burdens imposed by government policies.

So, the first step in abandoning the assumption that the demand for final goods and services is at the heart of economic growth requires rethinking about GDP.

The exclusive focus upon final goods and services of GDP estimations implies that the availability of goods arises out of the desires of consumers. Yet these desires can only be accommodated if they are preceded by an act of production that provides their supply and income to labor as the means to satisfy demand.

By taking the supply of goods for granted, the GDP framework ignores the various stages of production that lead to the arrival of a final good. For example, interme-diate goods required in the produc-tion of final goods are not readily available and must precede the demand for the eventual output.

Ignoring these crucial aspects of commercial activity contributes to a misunderstanding of how an economy works. In particular, developments in the earlier stages of production are important determinants of business cycles, since they are especially responsive to changes in interest rates and technological innovations.

In the first instance, focusing on final output leads to the mistaken belief that consumer spending is more important than capital investment in an economy. This false conclusion is drawn from the fact that consumption expenditures account for around two-thirds of measured GDP.

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