What Is Economic Growth?

A couple posts back I criticized the notion of “recession” for being not well defined, in part because it rests on another construct, “growth” that is itself shaky. Economists toss the term around constantly as if they know exactly what it is, but I contend that even if it it well defined, it is not well measured. The entire foundation of policymaking is built on this quicksand.

This thing called “growth” is assumed to be something desirable. It’s presumed to correlate with people’s perception of their material standards of living. Emphasis here on “assumed” and “presumed”, because if there’s any such thing as actual proof, its discussion is as absent from economic dialog as references to “growth” are present.

It’s not hard to find flaws. An easy one is that growth has to be adjusted for inflation to be meaningful. This is widely recognized … “real” growth is widely published and cited. Another less high profile adjustment is for population. If for instance gross domestic product (GDP) rose by 5% over a period in which the population that produced and benefitted from it rose by 50%, a deep decline in material living standards is implied. Each person has 30% less. So even “real GDP” is only a partial accounting … per capita real GDP is required to eliminate these distortions.

Yet even GDP adjusted for both inflation and population remains problematic. The reason for this is flawed accounting for inflation. It’s assumed that domestic consumer prices are the final word in inflation, but here again, we have just an assumption. I’ve addressed this a number of times, for example recently in The Big Takeaway.  Not only do our gauges of “inflation” systematically understate its magnitude, but they also lag in time.  So “real GDP” is not only broadly overstated, but also is more overstated during periods in which inflation is rising.  

Conversely, when inflation is declining rapidly, real growth may even be understated, creating the appearance of negative growth.  Moreover, because wages are very slow to adjust, a period of dollar appreciation (deflation) may temporarily result in labor being overpriced.  As we know from Econ 101, when the price of something is artificially high, surpluses develop.  In the case of labor, we call this unemployment.

In the early stages of inflation the opposite happens … inflation drives down real wages and temporarily makes labor cheaper, leading to increases in employment.  

This is what accounts for such economic lore that inflation results from the “economy running too hot”.  Because of this lag with which inflation is recognized, during periods of rising inflation it is more understated than usual, resulting in real growth being more overstated than usual.  In short, in terms of conventional econometrics, inflation at first looks like growth.

As a result, most “growth” is inflation, and this is even more the case early in the inflationary cycle.  

So if most “growth” is actually inflation, what is real growth?

Is there even such a thing?

That material living standards have generally risen over time is indisputable.  It just doesn’t have anything to do with monetary policy.  Rising living standards are due to the advance of technology.  None of the levers central planners can pull can sustainably accelerate that process.  Only economic freedom, the rule of law, and monetary and political stability can lead to real improvements in standards of living.