In Part 1 of this series, we saw how hedonics can alter GDP and inflation data. Here we look at some additional problems with GDP. After you read this piece, I hope you will agree that the misuse of GDP data as an indicator of economic strength has been one of the biggest errors made in the field of U.S. economics.

by Mike Stathis

Washington likes to remind critics that Americans enjoy the highest living standard in the world. As evidence of this, government experts discuss statistics such as GDP growth, employment, wealth, income and wage growth, and other economic data without defining exactly what they are referring to or explaining all the assumptions used.

I can make a strong case that over the past six years there has been virtually no GDP growth other than maybe three quarters. After adjusting for hedonics, the use of debt and the other gimmicks, its clear the U.S. economy has grown little since 2005.

Sound crazy?

Sure it does, but only if youve accepted the data from Washington at face value, as the media always does. But this grand illusion cannot remain hidden much longer. Already, we are seeing just some of the effects of Washingtons deception the real estate meltdown and banking crisis.

Since the ecomomic collapse began, Bernanke has been trying to mop up the mess by encouraging the Bush administration to hand over $1.2 trillion to the banking system in addition to nearly $30 trillion in loans and guarantees to the global financial system. President Obama has served as a loyal puppet to America’s fascist cause as well, by pumping nearly $800 billion into the economy as part of a stimulus package.

In addition to billions of dollars passed out to banks for real estate stabilization funds, Obama has uped the ante much higher with homebuyer and relocation tax credits. As was apparent to me when these funds were allocated, each of these plans have been a complete failure. In fact, they have worsened the duration and severity of America’s Second Great Depression. Already, the failed policies from Washington and the Federal Reserve have caused the further devaluation of the dollar in the face of soaring oil prices.

Since the stock market fallout in early 2000, Washington has been desperate to keep consumers spending at any cost. The crime syndicate in control of America likes the fact that consumers are spending, even if it has been for imported goods and even though these purchases have been made using credit. As far as theyre concerned, strong consumer activity keeps GDP numbers high, pointing to the illusion of economic growth.

After the Internet meltdown in 2001, Alan Greenspan smashed rates down to 1% because consumers had no real money to spend. But even that wasnt enough, so Bush issued rebate checks hoping consumers would head for the stores to buy more of what they really didnt need more electronic gadgets and other imports. In 2008, Bush issued an even larger rebate for consumers to inflate GDP, all while nearly doubling the federal debt in his two terms in office.

These irresponsible actions by the Fed and Washington have created more damaging consequences in exchange for superficial, short-term gains. Americans need good jobs and affordable basic necessities food, energy, and healthcare. A few hundred dollars passed out by Bush didn’t do much, nor did the various other stimulus packages passed by Obama. However, these very costly and highly useless spending packages boost GDP data so economists can claim that the recession ended in June 2009, as they have. Never mind this money has to be borrowed. Its all a game of numbers to Washington.

Many politicians extinguish any criticisms of large federal and trade deficits, insisting they have no real meaning. Rather than point to deficits as an indicator of economic vulnerability, many of our elected officials highlight GDP as a direct measure of economic growth and thus living standards. These misguided souls believe debt (and therefore deficits) is good for the economy because it helps add to GDP growth.

In reality, the massive trade deficits created under the Bush administration and heightened further under Obama have been responsible for the acquisition of critical U.S. assets by China and the Middle East. Meanwhile, the U.S. economy remains highly leveraged and now faces a situation whereby its creditors may soon refuse to hold onto U.S. Treasuries due to their rapidly diminishing value and credit quality.

The gross domestic product is a measure of the value of all goods and services produced in the national economy available for consumption. But GDP numbers say nothing about the source of consumption, whether its from cash on hand or mounting debt. As well, GDP numbers include government spending, such as that for Katrina and the wars in Iraq and Afghanistan. It doesnt take a genius to realize that these expenditures havent led to better living standards for most. Just ask victims of Katrina if their living standards have improved. And how can anyone claim that spending trillions of dollars in Iraq to blow up buildings and rebuild them will improve the living standards of Americans? Even worse, this is money that is added to Americas ballooning record debt.

Meanwhile, Americas own infrastructure continues to be neglected bridges and highways have collapsed, underground water pipes have broken, all public drinking water is toxic and contains, among other things, numerous pharmaceutical drugs, from sex hormones to anti-depressants. Even Washingtons U.S. Army Corp of Engineers has estimated it will take at least $2 trillion to restore Americas infrastructure to good condition. Other groups have stated these estimates to be much higher. Of course, if America does receive these needed funds, they will count toward the GDP data, although living conditions will only be restored, not improved.

Besides the loose assumptions of GDP, the methods of calculation are also flawed. For instance, nominal GDP is deflated using a chain-type inflation metric which significantly understates the real inflation rate. This leads to inflated GDP data. And of course Washington fails to adjust GDP growth to the annual population increase, which once again results in a higher GDP.

Finally, GDP can be calculated using constant or current dollars; the former doesnt consider the effects of inflation while the later does. When making comparisons of GDP data over time, investors should only use constant dollar GDP data. Unfortunately, when GDP data is plastered throughout the media, rarely is the source of this calculation been mentioned, leaving investors to assume constant dollar GDP data has been reported, adjustments for population growth have been made, and realistic adjustments for inflation are included.

Problems Measuring Living Standards

The importance of GDP as an economic indicator is reflected by its frequent use as a measure of living standards within an economy or nation. However, there are many weaknesses in the use of GDP as a measure of a nations living standard. In short, GDP only provides an overall measure of economic output of a given nation, but speaks nothing of individual living standards or the overall well-being of a population. As an example, consider that a nation which exports 100 percent of its production (Iraq for instance, due to oil exports) might have a high GDP but not necessarily a high standard of living.

As it turns out, many other factors are involved in determination of living standards, such as employment and wage data, inflation, interest rates, currency exchange rates, debt levels, fiscal and monetary policy, and government benefits. Finally, quality of life (which is a significant component of living standards) is determined by other factors unrelated to finances such as life span, work week, minimum required vacation days, social factors, and many other variables.

The counterargument is that while GDP may not provide an accurate measure of living standards, trends in living conditions tend to move in the direction of changing GDP data. While that may be true over a long time frame, in my opinion that cannot be said necessarily for less than a five-year period. Yet, when GDP figures are released each quarter, the stock and bond markets react as if this number has provided an accurate picture of the economy. In reality, this is rarely the case.

And when Washington wants to assure consumers that the economy is strong, officials remind us that the U.S. has the worlds largest GDP, and thus highest living standards. What they fail to mention however, is that the methods used to calculate GDP are flawed. As well, the productivity gains have not been equally distributed to all Americans. If in fact GDP data serves as an accurate measure of improvement in living standards, it only applies to the top 10% of wage earners.

Failure to Account for Deficits

Because consumer spending accounts for about 66 percent of the GDP, and since the majority of goods purchased in the U.S. are produced overseas in full or in part, GDP growth indicates the extent of exportation of Americas asset base when its running large annual deficits. In order to better understand this rationale, recall that each federal budget deficit is added to the national debt, which is financed by selling U.S. Treasury securities. Foreign nations have financed 50 percent of this debt, so America has been trading ownership rights for imported goods. Thus, even if GDP data indicates net productivity, this data does not factor in the deficit incurred as a result of government spending or the trade imbalanceall of which adds to the national debt and decreases Americas net worth or wealth.

As well, consider that the annual deficits have been financed by foreign nations to the tune of 99 percent in 2004, by 81 percent between 2003 and 2005, with similar numbers since then.

If you were selling your goods and services to a customer who couldnt afford to pay using cash, wouldnt you extend them credit? Sure you would; youd benefit two-fold in receiving profits from sales and financing charges. But theres credit risk involved based upon the debtors ability to repay the principal with interest. Along with the weak dollar, the increased credit risk of U.S. Treasuries threatens to increase the global push for dethroning the dollar as the universal currency.

For many years, America has maintained the highest credit status in the world. Its high standing as a debtor is directly tied to its perceived ability to repay debt obligations. But if the dollar loses its position as the universal currency, this perceived repayment ability would falter, causing foreign holders to dump dollar-denominated assets. And U.S. Treasury securities would be the first to go. This would easily trigger a global catastrophe. Understand that most nations already want out of the weak dollar. If one or more large holders of U.S. Treasury securities begin to sell, such as China, this could cause other nations to do the same in anticipation of a price drop. Thus, what might have been intended as a benign and gradual liquidation of U.S. debt by one nation could snowball into a collapse quickly.

Prior to the begining of the current recession, many pointed to Americas annual 5.0 percent GDP growth rate over the past decade as a sign of its continued stability and economic dominance. During that same time period, Americas trade deficit has grown by over 25 percent per year, household debt as a percentage of disposable income has doubled, and household savings has declined by 75 percent.

What does that tell you?

To me it says Americas growth has been fueled by credit spending thats been grossly disproportionate to this growth. Credit spending is certainly no indicator of wealth, but lack thereof.

America has been consuming much more than it produces for three decades. Early on, this excess consumption was buffered by the enormous wealth surplus generated after WWII. But now Americas dangerous consumption trends from the past two decades have surfaced due to the depletion of its post-war wealth. As a result, it faces a huge debt burden financed largely by foreign central banks and financial institutions. In fact, Americas global competitors have been transformed into its bankers and suppliers, providing financing for its undisciplined government and consumer spending practices.

This chronic behavior has allowed foreign nations to gain more influence over America, both economically and politically. And when they decide to no longer lend the U.S. government money, interest rates will skyrocket to double digits and the dollar will nose dive. Thats right. The real dollar crisis is ahead of us. You might have noticed as of late, several nations are telling Washington how they should be running things – nations with a huge financial stake in the U.S. economy. The U.S. is now dependent on these nations for economic sustenance. Therefore, America can no longer push other nations around.

Failure to Account for Savings and Debt

Calculation of GDP also neglects to factor in the external effects of saving versus spending. Japans case is particularly illustrative of this point. The savings rate in Japan has been high ever since the NIKKEI collapsed more than twenty years ago. As a result, while the GDP is not as high if Japanese had spent more of what they earned, they are not slaves to debt. As well, Japanese companies have been investing large amounts of capital overseas (e.g. auto facilities, insurance and media in the U.S.) resulting in a much lower GDP than one might expect.

In the case of America, decades of declining savings and increased debt burdens are not factored into GDP data. But borrowed money falsely inflates this data. Likewise, economies experiencing asset bubbles (eg. real estate, credit, and the stock market) tend to show higher GDP figures than in reality since consumption is higher than can be maintained over an extended period. And during these asset bubbles the total credit bubble grows along with the GDP. This is the current state of America.

In fact, it appears as if the Federal Reserve will continue creating bubbles as its only way to prop up GDP data. But we all know what happens to bubbles. They eventually burst.

A few years ago, we experienced unthinkable devastation as a result of Greenspans Internet bubble. Today, we are seeing the early stages of the implosion of Greenspans real estate-driven credit bubble. And since Bernanke refuses to let events run their normal course, we will no doubt experience a more catastrophic correction down the road as a result of his misuse of the printing presses.

Failure to Adjust for Net Output

Another shortcoming of GDP is that it measures output that produces no net change or productivity, such as that seen for reconstruction of New Orleans after hurricane Katrina. While capital was pumped into the region to help restore living standards, no net improvements were made relative to before the disaster (unless you count the estimated $1.5 billion stolen from FEMA by some). Yet, GDP data assumes these expenditures resulted in improvements. In fact, one could argue that living conditions in New Orleans are worse now than before the hurricane hit. Im sure those who have been exposed to the formaldehyde-laden mobile homes would agree.

GDP counts government spending at all levels, from the war in Iraq and hurricane Katrina to homeland security. Even before America’s financial apocalypse when Bush was still in office, despite his enormous spending spree, tax revenues as a percentage of GDP had not been so low in many years.

What does that tell you?

The government has been borrowing money to pump up into the economy without registering commensurate returns. If these investments had been successful, America would have net job and real wage growth, and a strong dollar which would provide affordable energy, utilities, and healthcare. Even prior to America’s financial apocalypse we saw a much different picture despite record federal and trade deficits, as well as record consumer and national debt. The overall impact of these trends were seen earlyon monitoring the weakness of the dollar.

Thus, its easy to see that a nation that is increasing its debt can show healthy GDP numbers when in fact the picture isnt as rosy as reported. This is especially true when credit spending has accounted for a large amount of the GDP growth, as in Americas case. Therefore, when examining GDP data, one should investigate where and how the productivity occurred, whether there was net improvement to the majority of Americans, and what costs (debt or deficit) were incurred, rather than focusing on the magnitude of the number.

Failure to Account for Resource Depletion

Growth sustainability cannot be predicted by looking at GDP. Upon initial examination it appears that some nations (eg. in the Middle East) are able to maintain high GDP numbers despite the lack of industrialization. In the Middle East, productivity is almost exclusively dependent upon the amount of fossil fuels remaining as well as the cost and efficiency of crude production. Since oil reserves are limited, some nations disregard environmental protection laws in favor of increasing production (United States, China, Europe, and Canada). However, in the long run huge expenses could be incurred for cleaning the environmental mess that was made decades earlier.

Accordingly, short-term gains in GDP are inflated since the economic activities that have led to GDP data have created future liabilities that have not been reflected in a nations financial statements. In Americas case, the massive liabilities for mandatory expenditures (the $51 to $72 trillion shortfall) are not shown in its financial statements. Thus, in order to properly account for the total net costs of GDP growth, GDP data should be adjusted for estimates of contingent liabilities that may be incurred as a result of say, a nations disregard for maintaining a clean environment and government benefits that have been promised or guaranteed – similar to the practice required by all publicly traded corporations.

Failure to Adjust for Annual Population Growth

Since GDP growth is a measure of productivity, and productivity is influenced by population growth, doesnt it seem reasonable that GDP should be adjusted to the annual population growth rate? From 1990 to 2002, the annual growth in the U.S. population was 1.2%. Since 2002, it has slowed a bit down to around 1.0 to 1.1%. If we subtract this from the GDP data, the economic growth over the past few years does not appear to have been so robust. And if more accurate measures of inflation were used to adjust nominal GDP, it paints a very worrisome picture.

Failure to Report Year-over-year Changes

When the Commerce Department reports GDP figures each quarter, the data isnt reported like a U.S. corporation. When a corporation provides an earnings statement, it shows comparisons of revenue, earnings, etc. from the same quarter of the previous year (called year-over-year reporting). In contrast, the U.S. government reports changes in GDP relative to the previous quarter. In addition, each quarterly GDP figure is annualized or multiplied by a factor of four, which implies this quarterly figure will continue over the next three quarters. Why do corporations report year-over-year numbers but the U.S. government reports a rolling, highly inaccurate, annualized number?

According to Washington, GDP can be used to compare living standards with other nations. This would imply that all nations calculate GDP in a similar manner. As far as I am aware, all other developed nations report GDP changes as year-over-year.

Why does this matter anyway?

Consider that year-over-year numbers minimize the effects of business and economic cycles. All businesses (and therefore government operations) experience changes in business health and earnings due to seasonal or business cycle fluctuations inherent to their industry, the dynamics of the company, and the economic cycle. Therefore, in order to minimize the effects of these variables, companies report the year-over-year changes.

For instance, lets take a look at Mattel, a toy manufacturer thats known to generate the majority of its revenues during the month of December. Lets assume the fourth quarter is responsible for 70 percent of the firms annual earnings (an accurate assumption), while subsequent quarters contribute 10 percent equally to earnings. If Mattel reported fourth quarter earnings like the U.S. government, it would appear as if its growth was exploding during the first quarter of earnings announcements. In conclusion, because each quarterly GDP figure is extrapolated over 12 months, its virtually impossible to detect GDP trends accurately even if the numbers, when reported were accurate. But as we shall see next, accurate reporting is rare.

GDP is Inaccurate for up to Five Years

If the previous considerations havent been enough for you to question the accuracy of GDP data, you should keep in mind that Washington provides GDP revisions for up to five years after the data was first reported. Thats why you often hear adjustments to GDP numbers long after they were first released. Its also why the government often changes the dates of recessions several months and sometimes many years later. While these adjustments might be a valuable exercise for historians, they do nothing to alert consumers and investors of the current and future expected economic environment. Theres no way to consistently and accurately predict future growth trends using GDP data due to these inaccuracies.

Washingtons official definition of a recession is two consecutive quarters of negative economic growth, as measured by GDP data. As a recent example of the inaccuracy of GDP numbers, on July 30, 2004, the Bureau of Economic Analysis (BEA) issued its revised GDP data for 2001. According to the definition of a recession, we now know that there was none during 2001 since the latest numbers do not show two consecutive quarters of declining GDP growth.

The reality is that we did indeed have a recession in 2001; a severe recession in my view. As the National Bureau of Economic Research (NBER) points out, recessions can be defined by data other than looking at GDP. A recession is defined by a decline in economic activity. In many cases GDP says nothing of this, especially when much of the GDP has been due to a war, cash-back financings (home equity loans and cash-back mortgages) during a real estate bubble, and the overall increased economic activity fueled by this bubble. In fact, according to the Federal Reserve, 40% of the GDP growth during the 2005-2006 period came from cash-back financings from homes that were greatly overvalued.

This same follow the leader mentality by pundits and journalists has led them to believe that America was not in a recession as of July 2008. Recall that the “establishment” economists did not conclude the U.S. was in a recession until December 2008, exactly one year after it began.

As I wrote back in July 2008 in the original version of this article, “Anyone with a brain knows we are in a recession that most likely began in early 2008.”

If we adhere to Washingtons very restricted definition of recession, it is possible that these economists missed numerous recessions in the past. Relying solely on GDP data that is subject to revision for up to five years is too inaccurate to provide a reliable measure of economic activity. But when you consider how poorly GDP data reflects real economic activity for consumers, it becomes even more dubious.

In conclusion, the basic rules of reasoning never change. When one tries to paint an accurate picture of a complex variable such as the health of the economy or living standards by looking at one number, theyre fooling themselves and those they represent.

The best way to measure economic growth and changes in living standards is to examine other macroeconomic indicators in addition to GDP, such as interest rate (yield curve) and inflation trends (the CPI and PPI, core and non-core), trade imbalances, currency exchange rate trends, job loss and recovery, underemployment, real wage and benefit growth, debt and money flow trends. And if you do elect to use GDP as a measure of economic activity, at least measure it accurately and make the appropriate adjustments.

With thousands of economists working for the government or in academia serving on government committees or as consultants for government agencies, it seems strange theyre unwilling or unable to provide a comprehensive analysis of the economy based on other data.

Then again, the current system of illusion and confusion serves Washington just fine. Most serve as parrots, mimicking the same lines they hear from myopic economists in their ivory towers.

Consumers and investors dont need economists to tell them what the data of the day means based upon flawed calculations. They need economists to report realistic data. Only then will they stand a chance to come up with accurate forecasts. If they cannot achieve this then they are only serving as record-keepers at best and partners in deception at worst.

With all the forecasts economists make, I know of not a single one who has made a fortune in the stock market as a result of these timely and valuable forecasts.

Note: this article has been modified as needed to reflect any relevant changes in data from its original publication in July 2008. However, the body of content was borrowed from Americas Financial Apocalypse