Free Lunch (6 page)
Authors: David Smith
Welcome back. Before we broke we had made a lot of progress in trying to explain how, as individuals, we behave as economic animals, even when we are not aware of it. All very interesting, you might say (at least I hope you do), but how does this fit into the big picture? When people talk about ‘the economy’, what do they mean? This is a good time to start thinking big, to go from the micro to the macro.
So what is an economy?
This is one of those questions, a bit like ‘What is life, Daddy?’, you hope your children will not ask you. The best way of answering it, given that this is probably not the time for another food analogy, is by thinking of a football match. At one level, a football match is a game between two teams of eleven men lasting ninety minutes, the object of which is to kick a round object into your opponents’ goal more times than they do into yours. Everybody knows, however, there is more to it than that. A football match is about the contributions of individual players, and of the referee and crowd, about the goals, the goalmouth incidents, the fouls, the mistakes. Put like that, a football match consists of many thousands of actions that combine to make a whole. How do you explain that to somebody who was not there? They can read a match report in the newspaper. If they are real enthusiasts, though, they will examine the statistics – goals scored, shots on goal, red and yellow cards, the percentage of time each team had possession of the ball, and so on. The statistics can never be a perfect substitute for being there but they are the next best thing. So it is with the economy. At its most basic the British economy is what a nation of roughly 60 million people spend, earn and produce. At its most complicated it is the millions upon millions of decisions taken by individuals, either for themselves or on behalf of companies. Magnificent though this would be to observe, it would also be impossible. As with football, therefore, it is necessary to boil all these actions down to manageable statistics. For economists, as we shall see later, it is also necessary to develop models of the economy. These simplified or stylized versions of the real thing are similar in concept to architects’ models of buildings. An architect’s model does not try to capture every detail of the actual building – very few have running water or working miniature coffee machines – but they give a good idea of what the full-sized building will look like. Economic models try for something similar. Disappointingly, however, when economists say they are building a model of the economy, this does not mean they are getting out the hardboard, sticky-backed plastic and papier-mâché. Models of the economy are usually linked sets of mathematical equations that churn away in the recesses of computers. One of the exceptions, still in existence at the Science Museum in London, was built at the London School of Economics.
In the late 1940s A. W. ‘Bill’ Phillips was a New Zealander in his early thirties who had emerged from a Japanese prisoner-of-war-camp (Laurens van der Post, Prince Charles’s mentor, was a fellow prisoner). Phillips had suffered near starvation, as was obvious to fellow students when he came to study at the LSE. He also had difficulty understanding what he was being taught and in particular the flow of money around the economy. So, using Perspex tubes, levers, pulleys and windscreen-wiper motors scavenged from a wartime plane, he built a model of it. It was and is a device of extraordinary complexity. Not only was it a fully working hydraulic model showing money (water) flowing around the system but it also provided a primitive printout, as a pen attached to the machine plotted the results. When Phillips demonstrated the machine to a sceptical LSE audience in 1949 by pouring in red liquid at the top to demonstrate the effects of adding cash to the economy, there was general acclaim. The model, conceived in an age when computers were still the stuff of science fiction to most people, could simulate the effects of, say, cutting taxes or boosting government spending.
Punch
, the humorous magazine, said a Phillips machine should be installed in every town hall in Britain. ‘The machine is taller than the man in the street and wider and heavier and much, much cleverer,’ it said. ‘Using coloured water (a convenience denied the man in the street) it reacts obediently to every morsel of economic information communicated to it, and records, with its mechanical pens on its calibrated charts, the subtle impact of a slump in the second-hand ship market, the slightest hint of a boom in soap, emery wheels or white fish.’ Phillips did not make one of his machines for every town hall but he did make fourteen of them. The Ford Motor Company bought one, and so did Harvard. Phillips went on to become an influential economist. Computers, initially bigger and more unwieldy than his machine, took over the job of running models of the economy – which was a pity.
Anyway, let me return to the question of trying to pin the economy down a little more closely.
Adding it all up
Until about 100 years ago, economists knew, or thought they knew, what the economy was but they had no means of measuring it. When William Gladstone was Chancellor of the Exchequer in the nineteenth century he had no difficulty in finding things to talk about. Most modern Chancellors manage to get through their annual Budget speeches in about an hour. Gladstone made one last more than four hours, and this was without the benefit of the kind of macroeconomic statistics regarded as essential today. Britain’s Central Statistical Office, now called the Office for National Statistics, was not set up until 1941, because at the time it was recognized that there was an urgent need for accurate and timely statistics on production, particularly of munitions, and of the supply–demand situation for scarce food. During the war Britain effectively became a command economy, with 70 percent of it government controlled but the statistical tradition continued and was extended in peacetime. Nowadays, within a couple of months, we know to one decimal place how much the economy grew in the most recent quarter. The figures, like most economic statistics, are subject to revision but they are still testimony to how far the art of measurement has advanced.
Most people, understandably, do not worry overmuch about whether the economy grew by 0.2 or 0.8 percent in the latest quarter, leaving such matters to those whose job it is to pore over the statistics. It does matter, of course. The economy’s long-run growth rate is about 0.6 percent a quarter, or about 2.5 percent a year. If growth stayed at this rate, year-in year-out, you would expect unemployment to remain steady. Why? Because each year we become more productive, increasing our output by 2 percent or so compared with the previous year. A lot of people do not believe this and think of themselves as being about as productive as they have always been. Think, though, of the way technology has replaced, for example, so many basic clerking functions in offices. If the economy did not grow at all or did so only slowly, then rising productivity would mean fewer workers were needed, hence rising unemployment. If it grows roughly in line with productivity, unemployment remains stable. Higher growth rates should mean falling unemployment, and vice versa. If the economy shrinks even for a quarter (‘negative growth’ is the clumsy term most economists use for this), the worry would be recession. If it grew by 1.5 percent in that quarter, the worry would be the opposite one of ‘overheating’. All this will become clearer a little later.
The most useful thing about macroeconomic data, and in particular the national accounts, is not the precise information it gives us about any single quarter or year. It is, rather, that it gives us an invaluable framework for thinking about how the economy is constructed. If it were possible to observe the economy from above, it would consist of many millions of transactions by people spending, producing and earning. That is exactly what gross domestic product (GDP), the main measure of the size of the economy and of changes in that size – economic growth – seeks to measure. GDP is the sum of everything produced in the economy, hence gross domestic
product
. To avoid double counting, however, it is necessary to subtract at each stage the value of the inputs that have gone into producing a product. The chef in our expensive restaurant assembles and cooks the meal. He could not do it, however, without the vegetables supplied from the market that morning, the meat from the butcher or the gas or electricity supplied by the power company. His output, for the purposes of measuring GDP, is the value added to these various inputs. The same applies from the very largest company, making billions each year, to the smallest sole trader. The principle is exactly the same as value added tax, VAT. Some people, indeed, prefer to talk, not of GDP, but of ‘gross value-added’.
Hang on though, where do earning and spending fit in? Do they fit in? The answer is that they do. GDP is often known as national income. The two are not precisely the same but broadly similar. GDP, as well as being the sum of everything produced in the economy, or at least the value added at each stage of production, is also the sum of incomes earned. It is easy to see why this should be. The income of our chef, assuming he is also the owner of the restaurant, is the amount we have paid him for the meal less the wages of his staff, the income earned by his suppliers and, say, the rent for the premises (the landlord’s income), which he has been obliged to pay. The value of the income earned by the various players equals the value of production.
You may ask at this point how this relates to your own circumstances. Suppose you are a salaried employee for a profitable firm. Your income, plainly, goes to make up GDP. But what about the profit the company makes? What about the tax you pay? Profit is easy enough. That is either reinvested, in which case it generates income for the suppliers of capital equipment. Or it is distributed to shareholders in the form of dividends, which means income for them. Tax is a little trickier. On the face of it, it simply represents the income of government. In practice, the way to think about tax is in terms of the income it generates as the government converts tax into public spending, thus providing income for doctors, nurses, teachers and civil servants, as well as payments to state pensioners and people on welfare benefits. These last are known as ‘transfer payments’ because they are simply transfer money between taxpayers and beneficiaries.
It really does all add up. GDP is not only the value of everything produced (the value added) in the economy, but also the sum of incomes received. It is also, and I have left what I regard as the most useful until last, the sum of spending.
The most useful equation in economics
So how does spending fit in? Again, the important thing to avoid in measuring the economy is double counting. What we are therefore concerned with is ‘final’ demand. When you or I buy a car, we have probably read the brochure beforehand detailing all the features and accessories it comes equipped with. What we are concerned with, however, is the entire product. Few people would buy a car and then remove the radio to sell it, or the spare wheel. Similarly, the purchase of all these components by the manufacturer does not feature in GDP. Such purchases are known as ‘intermediate demand’. The car could not be made without them but they are subsumed in final demand.
Does that mean that spending by consumers is all that matters? After all, if we are talking about final demand, it would seem natural that most of that comes from you and me when we shop. Consumer spending, or household consumption as it is now known by the official statisticians in Britain, does indeed account for the lion’s share of GDP, but not all of it. In the year 2000, for example, UK consumer spending totalled £595 billion (that’s £595,000 million). That in itself is quite an interesting figure, being the equivalent of £10,000 for every man, woman and child in the country. GDP, however, was higher than this, at £943 billion. So consumer spending accounted for most of it, 63 percent, a typical figure. I have used the UK as an example but this is typical of most advanced economies. Consumers drive our economies. After the 11 September 2001 terrorist attacks on America the key question for economists was whether consumers would lose their nerve. Incidentally, you often hear economists and pundits gravely opining that whether the economy slows or not depends on the consumer. I have done it myself. As you can see, there is nothing terribly profound about this. As a matter of simple arithmetic it mainly does depend on the consumer and the rate of growth of consumer spending depends mainly on the rate of growth of income (this is known as the ‘consumption function’). But where does the rest of the spending that makes up GDP come from?
The next most important category, in Britain at least, is spending by government. Again, this is quite typical. The national accounts showed that for the year 2000 the government spent £175 billion. This is a big number but it is also a little puzzling. As a proportion of GDP it is a little under 19 percent but, as many people will know, both public expenditure and tax in Britain are usually thought of as being roughly 40 percent of GDP. If spending were really only 19 percent of GDP, taxes could be much lower. What has happened to the missing 20 percent or so? The answer, mainly, is that for GDP purposes it is necessary to exclude transfer payments, such as state pensions and benefits, which account for a lot of government spending but which, in economic terms, is money the government hands over to other people to spend. This is not true, by the way, of the salaries of public sector workers such as teachers or nurses. When the government pays them, it is buying the services of these professionals, just as your purchase of the services of a plumber counts as part of consumer spending.