A Political and Economic History of China, Part 26: The Republican Era of 1912-1928, Part 2—International Power Struggles

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues with the chaotic Republican Era of China, this time detailing foreign influence in the power struggles of the 1910’s and 1920’s including the opening chapter of the Chinese Communist Party.

Picture: Revolutionary founder of modern China Sun Yat-sen (seated) with young military commandant Chiang Kai-shek (standing, center).

After General Yuan Shikai’s death in 1916, Republican China was unable to establish an effective government. Not only was the central government’s army lacking to counter the regional warlords’ private armies, internal republican bickering and infighting produced fourteen different presidents in the twelve year period of 1916-1928.

And not only warlords vied for power in this era. Foreign governments exerted their own malign influence over China.

JAPAN

As most people know Japan invaded Manchuria in 1931 and China proper in 1937. But the fascist Japanese government had been planning these invasions for a long time, even positioning themselves for an eventual conquest of China back in the 1910’s.

As China descended into post-Qing chaos, Japan attempted to exert influence and gain pre-invasion footholds.

At the outbreak of World War I Japan declared war on Germany in a classic display of realpolitik. Tokyo couldn’t have cared less about Europe, instead leveraging entry in the war to expand its presence in Asia. 

While Germany was bogged down in the trenches of Europe, Japan invaded and occupied German territory in China’s Shandong Province. Japan also grabbed a few German territories in Micronesia which would gain notoriety during World War II: the Marshall Islands (including Kwajalein), the Carolines (including Truk), and the Marianas (Guam, Saipan, Tinian).

By making token contributions to the allied effort Japan successfully gained a permanent seat at the League of Nations. The Japanese also bribed a regional Chinese warlord into granting sovereignty over Shandong province, followed up by tacit albeit lukewarm consent from the allies at Versailles. Chinese government representatives only put up weak objections.

But the handover of Shandong unexpectedly triggered a watershed event in Chinese history: the May 4th movement of 1919.

Everyday Chinese were so incensed over their loss of territory to Japan that mass demonstrations began throughout the country. In what’s now considered the birth of modern Chinese nationalism, protestors criticized Japan, the Versailles Treaty, the allied powers, and the Chinese Republican government itself. Disillusioned with the continuing failure of China’s elites, the masses turned away from traditional Confucian deference to intellectuals, and Chinese who had formerly considered themselves “Sichuanese” or “Shanghainese” or “Cantonese” unified in a populist mindshift to being “Chinese.” 

The western powers, surprised at the level of outcry from the Chinese public, forced Japan to relinquish sovereignty over Shandong which was promptly returned to China.

However much of the social die was now already cast. Along with rejecting much of Confucian traditionalism many young Chinese were now searching outside the country for new philosophy, new ideas, and new direction.

One of the many strange and foreign ideas that found growing acceptance among everyday Chinese was the anti-imperialist credo of Marxism. In 1921 a small group of radical revolutionaries, anti-imperialist and drawn to Karl Marx’s promises of utopian equality and total peace, founded the Chinese Communist Party in Shanghai with the 27-year old Mao Zedong representing his native Hunan province.

RUSSIA/THE USSR

Vladimir Lenin and the Bolsheviks seized control of the Russian Empire in 1917 and, after a centuries-long history of border and territorial disputes in Manchuria and Xinjiang, watched with interest the chaos unfolding in China just four years later.

While attempts at establishing republican government in China floundered, none of the formerly imperialist western powers stepped up to help. Some European governments were concerned about continued reparations payments from the now defunct Qing dynasty. 

The extent of their interest in Chinese stability was usually limited to a desire to avoid total national disintegration, for that would put their business investments at risk. However, western powers also disliked the idea of a tightly unified China that might one day find the strength to say no to outside demands.

Sun Yat-sen, who by now had formed the Nationalist Party or Guomindang, looked to the foreign powers for help getting the new China on its feet, just as he had looked outside for help bringing down the Qing dynasty a decade earlier. But for the reasons just mentioned he found few takers.

The only major power that offered assistance was the Soviet Union, but as one might guess that help hardly came for free.

The Lenin government, concerned that capitalist countries might attack Russia to destroy the communist revolution in its fragile infancy, found the idea of a communist ally on its huge eastern border appealing. Ideologically Lenin also saw China as a fraternal century-plus target of capitalist imperialism and was sympathetic to Sun’s revolution to throw out the foreign Qing rulers.

Given Sun’s need for help, negotiations between Soviet and Nationalist officials led to an alliance in 1923. In exchange for financial and diplomatic assistance, the Nationalists agreed to welcome Soviet advisors who restructured the party with more rigorous discipline.

The Soviets also attached a condition for aid which would change the history of China: The Nationalists must agree to an alliance with the Chinese Communist Party and allow the small upstart movement into their ranks. 

After all, both the Nationalists and Communists were anti-Qing, both were anti-imperialist, and both wanted to build a new, modern China. To Sun, the Communists seemed harmless and possibly even a good fit.

In secret Moscow believed one day they would order the Chinese communists to usurp Nationalist leadership, take over the party for themselves, and transform China into a communist state. However the Soviets felt China wasn’t yet ready for communism—not having first passed through the key Marxist historical stages of capitalism and socialism—and for now ordered the CCP to simply cooperate with the Nationalists.

The Chinese communists, as the Soviets would later learn, had their own timetable which we’ll discuss in an upcoming chapter.

Sun agreed to integrate the Communist Party into the Nationalist Party, but one of his top young protégés—the commander of the party’s military wing—viewed the Communists with suspicion, although he didn’t yet possess the power or rank to act. 

This shrewd lieutenant was Chiang Kai-shek.

We’ll get more into the Nationalist/Communist alliance and Soviet influence ending with the 1949 communist victory later, but on a final note it’s important to contrast Sun and Chiang’s views on alliances and power which in turn informed their different views on the Communists.

For all his strengths, Sun was at heart an intellectual and often politically naïve. By contrast Chiang Kai-shek, mentored in his youth by one of Shanghai’s most notorious anti-Qing societies-turned-organized crime syndicate (the Green Gang), held more cynical and realistic views.

A story recounts how in 1920 Sun entered into another alliance with Guangxi warlord Chen Jiongming. Chiang, still a young protégé, calculated Chen had much to gain by betraying the Nationalist alliance and repeatedly warned Sun of the danger but was ignored. Sure enough Chen rebelled, shelling the Nationalist Guangdong headquarters in 1922 with Sun barely escaping with his life. Chiang, always loyal, made speed from Shanghai to rescue his master and they spent several weeks hiding out on a small riverboat during which time Chiang’s stock rose in Sun’s eyes.

Chiang viewed the communist alliance with similar suspicion. He believed, correctly, that the Communists would attempt to subvert the Nationalist Party from within and take over, but for now Sun sleepwalked into accepting Soviet demands, oblivious to the danger that his young disciple foresaw.

In the next installment we’ll discuss growing tensions between Nationalists and Communists against the backdrop of the campaign to finally reunify China.

A Political and Economic History of China, Part 25: The Republican Era of 1912-1928, Part 1—Domestic Power Struggles

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6 MIN READ - With the 2024 campaign and election over, the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff restarts his history of China series, picking up with the chaos that ensued after the fall of the last imperial dynasty in 1911.

Attached picture: Rough outline of regional Chinese warlord control in 1925. Blue areas are controlled by Sun Yat-sen’s revolutionary Nationalist (Guomindang or GMD) party.

In July we left off with the tireless efforts of Chinese revolutionary Sun Yat-sen whose work played a role in the collapse of the Qing dynasty (1644-1911).

The Qing’s disintegration was sudden and unexpected. Sun was himself in Denver, Colorado raising money when it happened and quickly returned to China to formulate a new, more modern government to fill the power vacuum that had so abruptly appeared.

Despite his revered place in history today, it’s important to understand that in 1911 Sun was only one of many players working to topple the Qing, an alien dynasty of outsiders that had fallen out of favor with its ethnic Chinese subjects. Upon Sun’s return to China he was still not very well known. Among the candidates to lead a new China Sun was viewed as lacking the strongman character needed to rule a provisional government during such a precarious time.

After deliberation among revolutionary leaders a fairly obvious choice was made to assume that role, at least temporarily: General Yuan Shikai. 

Sun assented to Yuan's presidency for the same reasons.

YUAN SHIKAI

Yuan Shikai is a shady figure in Chinese history and likewise loathed in modern China. Dubbed the “traitor general” for:

1) Betraying the young emperor Guangxu’s plans to reform China in 1898 by ratting him out to his aunt, the powerful empress dowager Cixi. Cixi then arrested Guangxu and later had him poisoned, and

2) Betraying the anti-Qing Xinhai revolution, something we’re about to get to.

A little background on Yuan.

During the great Taiping rebellion of 1851-1864 the scholar-general Zeng Guofan commanded Qing forces so skillfully that he was awarded control over most of the postwar imperial army. Zeng’s protégé, Li Hongzhang, assumed that role shortly after when the aging Zeng, who had been brought out of semi-retirement during the civil war, called it quits.

Over the next four decades the Qing weakened and Beijing increasingly lost its ability to govern the country. Subsequently regional military governors, generals previously appointed by Zeng and Li, took greater control of their provinces. By the time of the Qing’s collapse Li’s protégé, the aforementioned Yuan Shikai, was now general of the most powerful armies based in Beijing and it was only he who could keep the semi-autonomous provincial generals (later dubbed “warlords”) in line.

So in 1912 most anti-Qing revolutionary leaders viewed Yuan as the only man strong enough to prevent China from breaking up into military fiefdoms and he easily won appointment as provisional president by vote of the new provisional senate.

In theory China would become a republic with a democratically elected parliament and president sharing power. The Nationalist Party, or KMT (known as the “Guomindang” in mandarin) held the most seats in parliament with Sun Yat-sen as party leader.

However before long it became clear Yuan was interested in neither democratic government nor power sharing. He attempted to dissolve the republican house of representatives and senate, leading to clashes with the Nationalists and other democratic reform-minded parties. In response Yuan consolidated his power by granting even more autonomous powers to his regional military allies in return for support.

In 1915 Yuan made it official by arranging a puppet council vote to “offer” him the emperorship of China which he “accepted” as head of a new dynasty. He quickly ordered jade seals and imperial robes for himself.

It seemed after all the hard work and sacrifice to rid China of the Qing dynasty the imperial monarchy had returned.

But the political backlash against Yuan’s new dynasty was so great that even many of his warlord allies protested. A few provinces outright rebelled.

Surprised by the opposition Yuan delayed his coronation ceremony over and over again, attempting to appease his detractors enough to eventually carry through with his ascension, but after just 83 days officially as emperor he “abdicated” and restored the republic—in part due to growing revolts but also because his own health was failing. 

Yuan died just three months later of uremia.

China had dodged a restoration of the dynastic system, but Yuan’s death would leave behind an even larger power vacuum than the one he had filled. Now there was no obvious choice to control the warlords and China began its descent into regional and provincial chaos.

Once again, in theory a democratically elected republican government in Beijing—composed of a parliament and president—would run China. But in practice the republican government had no effective power to control the autonomous warlords and their personal armies.

Further complicating matters was internal bickering among republican politicians and a few political assassinations. Without clear direction no elected president held power long enough to challenge the warlords let alone build a new China, and the Beijing government often became a puppet of the strongest militarist warlord cliques. By one count after Yuan’s death Republican China had fourteen presidents from 1916 to 1928, the year Chiang Kai-shek officially became president and held power until the communist civil war victory in 1949.

WARLORDS

Hence the 1916-1928 period is famously known as the “warlord era.” Multiple generals enjoyed regional authority over counties, provinces, and in some cases multiple provinces. Most craved expansion of their fiefdoms, some signed fragile alliances with one another, and others went to war.

The one constant under all warlords was general suffering of the common people. Warlords raised funds for their mini-empires by imposing direct taxation—often precocious and excessive—on the peasants. To the common Chinese villager it seemed that things hadn’t changed much from the Qing dynasty. Instead of corrupt regional Qing officials it was now regional warlords who squeezed them.

The many warlords also made for a colorful cast of characters, some whose nicknames found their way into the western press. For example there was Zhang Xun, known as the “Pigtail General” for his Qing loyalties. Zhang wished to restore the Qing monarchy and ordered his troops to retain their queues.

Then there was the “Christian General” Feng Yuxian, who converted his troops to Christianity and baptized them with a fire hose.

One of the worst warlords was Zhang Zongchang, dubbed the “Dogmeat General” because of his taste for a Chinese tonic named “dogmeat” and penchant for playing the Chinese gambling game known as “eating dogmeat.” Time Magazine called Zhang Zongchang “the basest warlord” for his brutality, eccentric personality, and lavish lifestyle—financed by the peasants he crushed under repressive taxation.

Given that the warlords enjoyed de facto control over their regions, business interests—both domestic and foreign—were forced to deal with them which usually meant paying regular bribes to retain their investments and run their operations.

The most consequential warlord-foreign investment relationship was between Japan and perhaps the most famous and powerful of all the warlords: Zhang Zuolin, who enjoyed control over all three provinces of Manchuria while engaging in power-sharing agreements with Beijing.

During the 1920’s Japan made significant investments in Manchuria, the offshoot of expelling Russia during the Russo-Japanese War of 1905. Zhang's army received financial backing from the Japanese in exchange for allowing the construction of Japanese railroads and factories.

Japan, which history now records had its eye all along on the outright conquest of Manchuria, felt Zhang was too formidable an obstacle to their plans and arranged his assassination by exploding a bomb under his railcar the evening of June 4, 1928. From there the Japanese attempted to install his more malleable, opium-addicted son Zhang Xueliang to replace him. However, the Japanese were soon surprised at the son’s resolve when he shook off his opium habit, assumed his father’s place with authority, and put up a great deal more resistance than they had anticipated.

A decade later Zhang Xueliang, serving as a general in Chiang Kai-Shek’s Nationalist army, would kidnap his own boss in an incident with huge implications for China’s future, a subject we’ll get to during World War II.

In the next installment on the Republican Era we’ll look at foreign interference during China’s early road to modernization.

Inflation Has Repudiated $5 Trillion of U.S. Government Debt Since Biden's Inauguration

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3 MIN READ - A national debt update from the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff.

Cautious Optimism regular Keith Shapiro (aka. K-Shap) commented a few weeks ago that “governments love inflation.”

He’s absolutely right and here’s a prime example of why.

This November the federal government will have repudiated $5 trillion of its debt since Joe Biden took office, but without paying the debt down by even a penny. It will all be through the magic of inflation.

Here’s the fairly simple math.

1) Starting with the arbitrary baseline of January 2021, the national debt was $27.75 trillion at the time.

Since January 2021 the CPI index has risen 19.9%—diminishing the dollar by 16.6% of its value. Hence, $4.61 trillion of the $27.75 trillion debt has been wiped out due to the watered down value of our money.

(We are using official government CPI here for what it’s worth, so apply your own numbers which will certainly mean higher inflation and ultimately far more than $5 trillion of debt erased)

2) In 2021 the federal government added another $1.87 trillion of debt and the dollar has lost 10.3% of its value since then.

Another $193 billion of debt erased.

3) In 2022 the federal government added another $1.80 trillion of debt and the dollar has lost 4.6% of its value since then.

Another $83 billion of debt erased.

4) In 2023 the federal government added another $2.58 trillion of debt and the dollar has lost 1.6% of its value since then.

Another $42 billion of debt erased.

We’ll skip what debt has been added so far in 2024.

So add $4.61 trillion + $193 billion + $83 billion + $42 billion and inflation has helped the Treasury renege on $4.93 trillion of debt.

These numbers are as of September 2024. Unless the government borrows nothing in the next two months and inflation reaches zero as well, the amount of debt relief the government has granted itself will exceed $5 trillion by November.

As a reminder, $5 trillion is roughly how much George W. Bush increased the national debt during his eight years in office—a figure liberals screamed bloody murder about at the time. But with less than four years of inflation the Federal Reserve has just “coincidentally helped” absolve Bush’s entire eight-year debt tab just by cranking up the printing presses.

It’s an old trick that goes back to (the oldest version the Correspondent can find) ancient Greece around 380 BC. Cautious Rockers who missed that story can go to…

https://www.cautiouseconomics.com/2024/02/economic-history-05.html

The same story repeated itself in ancient Rome…

https://www.cautiouseconomics.com/2023/07/inflation-currencies33.html

And in medieval England…

https://www.cautiouseconomics.com/2022/10/inflation-currencies25.html

And today across the entire world with modern central banks.

Governments borrow $1,000 and promise to pay it back 10 years later. But in between the economy grows 2% a year and the central bank raises prices by 2.5% a year, so 10 years later nominal GDP is 56% greater.

Assuming the government taxes roughly the same percentage of GDP in 10 years that it does today, its nominal revenues are 56% higher, making it easier to repay the $1,000.

Of course the economy really only grew 21.9% in those ten years (1.02^10). The other 34.1% of that nominal GDP growth is simply inflation and higher prices.

It’s a sweet deal for the government that finds it much easier to repay debt with considerably less valuable dollars that are more abundant when the bill comes due.

But there’s no such thing as a free lunch. So who really pays for this sweet deal? 

Savers—basically anyone holding dollars who watches their wealth debased 22.4% by the printing press.

In a longer 30 years their dollars are debased by 53.2%. Yep, cut by more than half.

This is what the Fed calls “price stability,” and what Democratic politicians pin on “corporate greed.”

And these numbers all assume a scenario of 2.5% inflation. We saw official inflation peak at 9.1% in late 2021.

The 1970’s were even worse. From 1971, when Richard Nixon broke the last link between the dollar and gold, to 1983 the dollar became 38 cents wiping out savers and retirees in particular. If the national debt ever starts to get unmanageable the Fed can come to the Treasury’s rescue in such a manner again (imagine our $35 trillion debt becoming only $13.3 trillion in twelve years), then officially announce “Sorry, it was just a small mistake on our part. We have inflation back down to about 2% so everyone should be happy now.”

And anyone who complains that “Hey, this fiat money monopoly run by the Fed is ripping us all off. We need money tied to a finite commodity like gold again” will be mocked and ridiculed by the liberal media and government economists as a pedantic neanderthal. 

Because everybody knows the only way an economy can possibly function is with a state-sanctioned monopoly that creates money at zero cost without limit, gets its power from the same government that is heavily in debt and which uses police and guns to shut down any alternative form of money while forcing its citizens to use only its crummy, depreciating currency.

Another coincidence: the government and its economists say the state monopoly issuing their constantly devaluing money is just the only version of money that will ever possibly work. We can't even think about alternatives.

GDP Part 4: Is the Consumer Really Two-Thirds of the Economy?

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6 MIN READ - The Cautious Optimism Correspondent for Economics Affairs and Other Egghead Stuff concludes his miniseries on what goes into GDP.

Gross business receipts vs. consumer spending

We’ve all heard it over and over from politicians and media: “the consumer is two-thirds of the economy,” or sometimes “consumer spending is two-thirds of the economy.” And the statistic is accepted as an article of faith by the business press while used by certain politicians and academics to minimize the importance of the business sector.

Why exactly do they run around saying this? And is it true?

As you might guess, the answer is a little complicated.

GDP MATH

First let’s cover where the “two-thirds” number comes from. You may recall reading in an earlier installment of this GDP series that Gross Domestic Product is calculated as consumption spending + business investment spending + government purchases + net exports, or:

Y = C + I + G + Nx

If we go to the Bureau of Economic Analysis webpage and break down these elements for the full year 2023 we get the following:

(C)onsumption spending = $18.8 trillion
Business (I)nvestment spending = $5.0 trillion
(G)overnment purchases = $4.7 trillion
(Nx)et exports =  -$800 billion
GDP = $27.7 trillion

Based on these figures, consumption spending is indeed 67.8% of GDP. And business investment is a surprisingly small 18.1% of GDP.

And there it is (according to politicians and the business press): proof positive that the consumer is “two-thirds of the economy.”

But is it really that simple?

PROBLEMS WITH GDP

A vocal minority of economists argue that official GDP numbers are misleading and understate the size of business investment activity. For one, salaries aren’t counted but instead only spending on capital investment for things like factories, buildings, machines, etc…

Incidentally, excluding salaries is part of the more popular “expenditure approach” to GDP, but the less-used “income approach” to GDP includes employee compensation. However we’re not going in depth into the accounting of “expenditure” versus “income” GDP in this article.

Another controversy that the Economics Correspondent would like to address in more detail is the intermediate “value added” math used in GDP.

That sounds like a mouthful, but in plain English it means this: GDP calculates business investment spending by counting only the total investment that goes into the final stage product. It doesn’t include investment spending on all the intermediate goods that work their way up the supply chain to the finished good.

A simple example might be a car. General Motors might make a steel chassis and produce its own engine and transmission for a car it intends to sell. Additionally GM will have investment costs for factories and machines that help workers produce these components and assemble the car. 

GDP includes all these costs in investment spending.

However before GM bought the steel for the chassis, raw iron first had to be extracted from the earth. The raw materials company had business investment expenses of its own.

Guess what, the raw materials company’s investment expense is not included in GDP (will explain why in a moment).

The same is true for the refining company that purified it into productive metal. Its purchase of the ore and all investment expenses for its plant are not included in GDP.

Then the steel mill that combined the iron and coke incurred expense to purchase those precursors plus investment expense for the mill and furnaces. None of this spending is included in GDP either.

In economics terms, only investment spending on the final product is counted, but investment in goods produced during the intermediate stages of production which ultimately find their way into the final product are not counted.

Hence the controversy. How can business investment be only 18% of GDP when only investment spending at the final goods level (General Motors’ inputs, plant and equipment) is counted, but spending for the steel mill, the refiner, the raw ore extractor, and countless other firms that produce the myriad of precursors for wheels, tires, seating, windows, electronics, fluids, glass, etc… is not?

OFFICIALLY THE ANSWER IS…

Well the mainstream economics community has a good answer. They want to avoid double counting.

If the refiner pays $250 for a block of ore, then adds its own investment to turn it into refined iron and sells it to a steel mill for $500 which in turn combines it with other inputs and sells the steel for $750, economists don’t want to add $250 + $500 + $750 = $1,500.

To count $1,500 in business investment expense would count the $250 paid for the block of ore three different times as it's sold once to the refiner, a second time to the steel mill, and a third time to GM.

The same for the refined iron. Economists don’t want to count its $500 twice: once when sold to the steel mill and a second time when the steel is passed on to GM.

On and on, they say, down the production chain… double and triple and quadruple counting could inflate the numbers. By the time the chassis is produced for, say, $1,000 (the Correspondent is guessing, he doesn’t really know how much a chassis costs to produce), the chain of businesses could have “invested in” the $250 block of iron ore three or four times. 

In economics terms the logic is this: all the investments by intermediate stage companies will ultimately be reflected in GM’s final product: the car. GM paid, say, $20,000 for all inputs (there’s your single counting for intermediate stage investments), added $10,000 more of its own investment spending and, after a few transfer costs like interest on debt and taxes, sold the final product for a profit at $35,000.

With traditional GDP only the investment inputs added by GM—plus all the inputs from intermediate firms which are reflected solely in the prices GM, and only GM, paid suppliers for those inputs at the last stage—are counted using this math. There is no double counting of investment.

VERDICT?

As mentioned before, the mainstream economics community accepts the “don’t double count” logic pretty much unquestioningly.

The Economics Correspondent agrees with the logic too, but believes that leaves us with a not fully satisfying number that can still be misleading in other ways.

In the affirmative, yes, the investment dollars for a block of iron shouldn’t be multiplied two, three, four, or five times just because it passes through the hands of several firms.

Where the math gets misleading is it completely understates the total amount of business activity and gross investment spending that goes on in the economy. The math looks as if GM is the only company spending any money when in fact there are countless firms “behind” GM that are collectively spending even more and also employing a lot more people.

It also understates the impact on the economy of disruption in the business sector. If investment spending fell by 5% then according to the standard formula just 5% of 18% is a 0.9% fall in GDP: a blip on the radar.

But a 5% reduction in all (gross) business spending is a much larger number. In the real world the scope of business losses, bankruptcies, and idling of workers would be enormous, far outstripping the suggested 0.9% slump (see attached chart during 2008 and 2020 recessions).

Why? Because there are a whole lot more dollars flowing through the business sector overall than the GDP model portrays.

(Also see comparative size of recessions in attached chart from economist Mark Skousen’s column: “Business—Not Consumers—Drives the Economy.”)

And let’s not even get started on how the salaries and compensation of all those employees isn’t even counted. We even noted in an earlier article that government spending on employees and contractors is considered a “purchased service” and counted in GDP, yet all those private sector salaries and other compensation are not. This makes government worker salaries look “productive” for the economy while private sector salaries are mathematically excluded.

What, private sector employee's aren't productive but government workers are?

Imagine how much larger business investment would look as a share of the economy if private payrolls were included.

There is an alternative measure of economic output that attempts to right some of these wrongs called Gross Output or GO, and in 2014 the Bureau of Economic Analysis even began including crude statistics on GO although they’re buried deep in the website and basically require a search to locate. However the BEA is tacitly admitting GO has certain advantages by putting it on their site.

Conclusion: In the first article on GDP the Correspondent said the formula is pretty good, but not perfect. Understating business activity and excluding expense on salaries are the two biggest reasons why.

In the end, traditional GDP is correct not to double, triple, and quadruple count investment expenditures as intermediate goods flow through the various stages of production, but the press should be a lot more careful when concluding from the simplified math that “the consumer is two-thirds of the economy.” 

Of course in a world where people only want to have to digest a single headline, good luck explaining the nuances of where GDP math falls short. And don’t hold your breath waiting for the media, in its present wretched form, to grasp the math either let alone not censor it even if they did understand.

GDP Part 3: Annualized GDP and GDP Across Different Countries

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5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues his mini-series on understanding GDP.

Nominal and PPP GDP yield different results

ANNUALIZED GDP

As we continue our examination of GDP as a measurement tool, a quick word about quarterly and annualized GDP figures.

When the Bureau of Economic Analysis releases a quarterly GDP report with headlines like “Economy Grew at 3% Pace in Second Quarter,” the 3% number is annualized. That is, the economy only grew about one-quarter as fast as 3% but the BEA reports an annualized number that assumes the same quarterly rate of growth continues for three more quarters. This makes the final number easier to understand for readers.

Most people would prefer a headline that reads “grows at 3% annualized pace” than “grows at 0.75% quarterly pace.”

Incidentally the assumed growth over four quarters is compounded so technically 3% annualized isn’t quite 0.75% per quarter. If one compounds 0.75% growth over four quarters the annualized result is actually slightly higher than 3% (1.0075 * 1.0075 * 1.0075 * 1.0075 = 1.030339), or +3.03%.

Such a tiny difference may not mean much, but when dealing with larger numbers the differences can stack up, namely during the recent Covid crisis.

When the state governments shut down economies across the country in the second quarter of 2020, the BEA reported that GDP contracted by 34.3%.

We now know that’s an annualized number so one might assume the real rate of contraction for the quarter itself was 34.3 divided by 4 or -8.575%.

In fact, the quarterly contraction has to be compounded four times, so although the math is a little weird the formula is actually

(1-.343)^(1/4) = .9003

...or a quarterly contraction of -9.97%, not -8.575%.

Likewise when the economy reopened in the third quarter, the much less widely reported headlines read that GDP rose by 33.4%.

Once again, 33.4% is annualized, assuming the quarterly rate of growth compounds over four quarters total. So using our compounded math the economy really grew 1.334^(1/4) = 1.0747 or 7.47% that quarter.

Down 9.97% in Q2, up 7.47% in Q3. In one quarter the economy clawed back most of what it had lost, but not all.

OTHER COUNTRIES: NOMINAL GDP

Occasionally the Economics Correspondent will read a headline that “China has the world’s largest economy measured by purchasing power parity.”

As you might guess, this headline is pretty misleading. China does not have the world’s largest economy (although it is safely #2).

The source of confusion is that economists use two different measures of GDP, especially when comparing different countries: nominal versus purchasing power parity or PPP.

The easiest way to think of these two is:

“Nominal” is the best measure of the actual value of all products and services produced by an economy. On that measure the United States remains #1 at $28.78 trillion versus China at $18.53 trillion (IMF).

"PPP" takes nominal GDP and adjusts it for cost-of-living in each country. So while the USA might produce more stuff and more valuable stuff than China, it still costs Chinese less to live in China than it costs Americans to live in the USA.

But when comparing U.S. output to Chinese output the Economics Correspondent thinks it’s useless to work with PPP and divide by U.S. or Chinese cost-of-living. Nominal is what matters which indicates the USA still outproduces China.

To see the difference in U.S./Chinese nominal vs PPP GDP, see the following links:

https://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)

https://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)

So why use PPP at all?

PPP GDP

Because PPP does still play an important role in measuring "per-capita" GDP.

On a nominal basis U.S. per-capita GDP, or output per citizen, ranks #6 in the world at $85,373 (IMF) and is easily the highest of any country with any meaningful population (Monaco, the Caymans, Singapore, and even Ireland, all of which rank higher than the USA, are small countries with at most 5.9 million people).

China, which has far more people than the USA, falls to #69 at $13,136 on a per-capita basis (IMF). This is where the phrase “American workers are among the most productive in the world” comes from: the United States still produces a lot more valuable stuff per worker, and per citizen, than China and most other countries.

However, it still costs a lot less to live in China, so adjusting with PPP gives us a clearer picture of the material standard of living for a nation’s citizens. By nominal measure Americans produce 6.5 times more stuff per person than Chinese, but PPP tells us Americans don’t enjoy a 6.5 times higher living standard.

Using PPP, U.S. per-capita remains $85,373 but Chinese per-capita GDP rises to $25,015. So a more accurate picture of living standards tells us Americans are about 3.4 times richer than Chinese. Still a lot better, but not 6.5 times richer.

To see the difference in U.S./Chinese nominal vs PPP per-capita GDP, see the linked photos:

Per-capita GDP nominal

https://image.cnbcfm.com/api/v1/image/106859827-1616735644553-US-China_GDP_per_capita.png

Per-capita GDP PPP

https://mgmresearch.com/2018/12/China-vs-US-GDP-PPP-per-capita-comparison.png

Bottom line? When comparing how much one country produces against another, use nominal GDP.

When comparing how high a living standard one country’s citizens reap from economic production against another country’s citizens, use PPP per-capita GDP.

And ignore articles and charts that compare U.S. GDP to Chinese GDP using PPP metrics. They are meaningless when stacking two entire countries' economies next to one another.

One final complication about comparing countries. Nominal GDP is the best metric to use, but it’s not perfect.

U.S. GDP is measured in dollar spending on consumption, business investment, government purchases, and net exports. But, say… Japanese GDP is measured in yen spending on those same variables.

So we are now comparing a dollar-based metric with a yen-based metric, aka. apples and oranges.

To convert to an apples-to-apples comparison economists simply adjust by the going currency exchange rate. This is not a bad thing since, although the exchange rate fluctuates, currency markets adjust largely based on the perceived economic output of each country.

So if Japan were to go into a depression and produce 50% less stuff while leaving the money supply constant (leading to a doubling in prices) the Japanese nominal spending numbers might look like U.S. vs Japanese GDP hasn't changed much when in fact Japan’s real GDP is half what it was.

But currency markets would notice the Japanese inflation and the U.S. dollar would strengthen—by somewhere around double—against the yen. Hence Japan's dollar-denominated GDP would be halved (adjusted by a far more favorable exchange rate for the dollar) and in nominal terms U.S. GDP would accordingly look a whole lot bigger than Japan’s, and far bigger than it was a year prior.

Where this can lead to complications is central bank exchange rate manipulation. If a government is intervening in currency markets and manipulatively undervaluing its currency—something China did a great deal of 15-20 years ago and still does occasionally today—Chinese GDP would appear slightly smaller than it really is. This is why 15-20 years ago economists argued Chinese GDP was probably somewhat higher than the nominal numbers indicated.

Likewise if a country is overvaluing its currency, as Venezuela has for decades and Argentina did up to Javier Milei’s election victory, the currency adjustment will make Venezuelan or Argentinian GDP look stronger than they really are.

Yes, all along Venezuela's nominal GDP has been even worse than it appears, and that's before the socialist government starts lying.

In extreme cases like Venezuela and Argentina the resulting nominal GDP numbers were way off, but economists took into account the overvaluation and adjusted their GDP estimates to be more realistic. But in cases of modest undervaluation, such as China or Japan today, the GDP adjustment is pretty small.

GDP Part 2: How Much Does Government Spending Distort GDP Reports?

Click here to read the original Cautious Optimism Facebook post with comments

5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff discusses government spending’s effect on GDP.

In Part 1 we defined GDP as total spending in the economy, or consumer spending plus business investment spending plus government purchases—purchases, not transfers—plus net exports.

In mathematical terms GDP, or Y = C + I + G + Nx.

Many people notice that government spending (G) contributes to GDP and understandably wonder if GDP reports, particularly those that reflect strong economic growth, are inflated by it.

The short answer is: "Usually not by much, but there are some notable exceptions."

There are two major factors the public might not always take into account when formulating perceptions about government spending's role in GDP.

1) The first is that only government purchases are factored into GDP, not all government spending.

Which immediately excludes any spending that is simply direct transfers.

For example, Social Security is not included in GDP because the government isn’t really buying anything (although some might say votes) but instead taking money out of workers’ paychecks and transferring it into disability and retiree pension checks.

The same is true for welfare payments, unemployment checks, federal transfers to state and local governments, direct subsidies, and most notably interest on federal debt. None of it is factored into GDP.

In the end, only purchases are factored in.

Examples of government GDP purchase activity would include military procurement of weapons, maintenance parts and services, payments to contractors for building infrastructure and public works, or medical claims payments to purchase healthcare services and medicines for Medicare or Medicaid patients.

And government payrolls, which are considered “purchased services," are also included in GDP.

But once transfers are excluded the face of government spending changes significantly. For example, it may surprise some to learn that state and local government spending is actually a larger contributor to GDP than federal spending. The federal Departments of Transportation and Education may spend a lot of money, but much of it is simply transfers to state and local governments who in turn are the real purchasers of highway construction contracts, teacher salaries and schoolbooks, and even a great deal of medical spending.

State and local governments are also large spenders on salaries of state/city law enforcement, municipal transportation workers, social workers, etc… In 2023 there were over 19 million people employed by local and state governments versus just under 5 million by the federal government (including military).

In fact, even though defense spending is only about 15% of all federal spending, military purchases and payrolls represent 56% of all GDP purchases by the federal government. Which shows you just how much of federal purchases are defense-related and, more importantly, how so much more federal government spending above and beyond defense is simply redistributing money from taxpayers to someone else’s pocket.

And state and local government purchases are 68% higher than federal purchases.

2) The second factor is government’s contribution not to GDP, but to GDP growth.

In the most recent quarter (2Q24) government purchases constituted only 17.5% of GDP (as opposed to all government spending which is closer to 37% of GDP).

But even if one day the government ballooned to the point that purchases regularly became 50% of GDP, a government of that size  still wouldn’t necessarily inflate GDP growth.

The reason is in order to inflate GDP growth figures, the purchases themselves would have to grow much faster, beyond a big number like 50%.

To keep numbers simple, let’s say a $10 trillion GDP is comprised of $5 trillion in government purchases or 50%.

The following year GDP grows 3% to $10.3 trillion but let’s say government purchases remain $5 trillion which is still a huge share.

But since government purchases haven’t grown at all, none of the $300 billion or 3% in GDP growth can be attributed to government spending. In other words a huge government budget alone isn’t enough to push GDP growth up. Rather government purchases need to grow very rapidly.

This is why when a good GDP report comes out—say the recent Q2 revision to 3% annualized growth—one has to be careful about saying “Well all the growth is just government spending.” One first has to determine how much of the 3% growth was due to growth in government purchases.

And we have it for the last quarter. According to the BEA the economy grew at an annualized rate of 3% in Q2. Contributing to that figure was a 2.9% annualized increase in the largest component—consumer spending—a 7.5% annualized increase in business investment spending, and a 2.7% annualized increase in government purchases.

So at least in the case of Q2, government purchases grew slower than the private economy—both consumer and investment spending—and therefore can’t be argued to have artificially propped up GDP growth.

However during 2023 government purchases rose at a faster rate than overall GDP in four out of four quarters. So for the entire year, yes, government purchases can be blamed for propping up GDP growth although it would take more calculations to determine by how much.

And without question there are episodes in our history when government purchases have spiked so sharply that they have completely distorted GDP growth, making it look far stronger than it really is.

These episodes would be wars and, to a lesser degree, government stimulus packages.

The most extreme example is World War II when the federal government spent nearly half of GDP on purchases, mostly for war materiel and to pay for a near tenfold increase in federal employees (mostly military).

From 1941 to 1945 real GDP technically increased by an incredible 48.7%, seemingly an economic miracle after the Great Depression of the 1930’s.

But in fact the standard of living for Americans fell during the war with shortages of basic goods and draconian rationing.

This is reflected more accurately in GDP numbers when backing government purchases out—effectively looking at only private sector GDP.

From 1941 to 1945 GDP excluding government purchases actually contracted by 12.1%, and this from a baseline of the Great Depression. To put 12.1% in perspective, at the nadir of the 2008-09 Great Recession GDP is believed to have fallen about 4%.

The contraction in WWII private sector GDP is even worse when one considers U.S. population grew by 3.7% over the same period.

In a reverse extreme example there’s the single year period of 1945-46. In the year after the war GDP fell by 11.6%, a stunning contraction that dwarfed any single year in American history except for 1932.

So 1946 must have been the year of Great Depression 2.0, right?

No, it was the diametric opposite. GDP only contracted on paper because government cut back so sharply on war spending. In fact, the private sector absolutely boomed, reflected by a 42% upsurge in private GDP (a record) including a mindboggling 140% expansion in private business investment spending (another record).

This is how much government spending during a giant war can distort GDP growth. A major slump with low living standards can look like an unprecedented economic boom while a truly unprecedented boom can look like a terrible depression.

(All calculations are based on BEA historical statistics. Links to core data available upon request.)

A similar pattern, albeit on a smaller scale, holds true in the 1950-53 period during the Korean War.

And the Obama administration’s 2009 stimulus act also inflated GDP, albeit with even smaller effects than the Korean War. And even with higher government purchases GDP was still negative/recessionary—only less negative than it would have been without all of Obama’s deficit spending.

From Q1 of 2008 to Q1 of 2010 real GDP fell by about 1.6%, the recession bottoming out in Q2 or 2009. However in that same period federal government purchases rose by 12.6%.

To which liberal Keynesian economists argue “See, if the government hadn’t spent all that extra money GDP would have fallen more, meaning a deeper recession.”

Free market economists would counter that “Government spending and blowing money on cash for clunkers and other wasteful ‘shovel-ready’ projects doesn’t mean a stronger economy just because the dollar numbers can be added to a GDP ledger.”

But that’s another debate entirely.

In upcoming columns we’ll talk about annualized GDP, comparing GDP between countries, and a small GDP consumption vs. investment controversy.

What Exactly Goes Into GDP Reports? (Part 1)

Click here to read the original Cautious Optimism Facebook post with comments

5 MIN READ - The first of a few articles on GDP from the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff.

Annualized GDP growth rates by quarter

In late August we saw a revision of second quarter GDP to 3.0% annualized growth, and in late October we should get preliminary estimates for third quarter GDP.

But just what does this GDP number mean? And is it accurate or reliable?

Gross Domestic Product (GDP) is the economist’s attempt to measure the output/production of all goods and services in any economy.

More importantly to those reading the news, the change in GDP—sometimes reported as “GDP grew by 2.5%”—is an attempt to measure whether economic output is growing or contracting and by how much.

But just how reliable a measure is GDP?

Well in the Economics Correspondent’s opinion GDP isn't perfect, but it's still a pretty good measure considering the immense size and complexity of an economy like the US.

Let’s start with one of the far from perfect things which, to the Correspondent’s knowledge, no one has been able to improve on: mathematically measuring “output.”

If the U.S. economy were simple and only produced one thing—say, pencils of a uniform size and quality—then measuring economic growth without GDP would be easy. If the economy produces 100 pencils in 2023 and 105 pencils in 2024, and nothing else, then we could easily argue "economic output grew by 5%."

But of course a national economy, especially the size of the U.S. economy, is hardly that simple. In fact a mindboggling number and variety of goods and services are produced in the U.S. every year, and of varying quality. The buyer’s subjective assessment of the relative value of those products, whether the buyer is a consumer, a business, or the government, is impossible to nail down. Even something as ridiculously simple as a single consumer may value the same item—say, a Big Mac—more on Saturday night than when he doesn't feel like McDonalds on Tuesday afternoon.

So enlarging our economy from one to two products (unlike 105 pencils being 5% greater than 100 pencils), how much larger is the economy overall if it produces 5% more bottles of wine and 10% more symphony concert show tickets? The Correspondent might value a bottle of wine over a ticket to the symphony, but I can guarantee you his mother would value the concert ticket over the wine.

With the subjective values of just two types of products—never mind the brand, year, and grape varietal of wines and the various calendar shows for multiple symphony orchestras—being so difficult to assess you can imagine how hard it would be to calculate for the countless products and services made by the U.S. economy every year.

Hence by far the best method economists have of measuring the value of those countless products and services, and their subjective value to consumers, is dollar spending.

Which brings us to how GDP is measured. The buyer’s valuation of bananas versus oranges versus hiking boots versus bicycle tires is best defined by how much money they’re willing to and actually spend on those things.

While this is not a perfect method, the Economics Correspondent so far hasn’t heard of a measurement process that’s better.

SIMPLE GDP MATH

Which brings us to the spending components in GDP’s fairly simple calculation. For a very long time GDP has been defined as the sum of four types of spending.

1. Consumer spending, or C 2. Business investment spending, or I 3. Government purchases, or G 4. Net exports, meaning dollar value of exports minus imports, or Nx

In mathematical terms, the economist’s formula for GDP is:

Y = C + I + G + Nx

Some critics might challenge this formula and argue “Well just because a shirtmaker charges $200 for his shirts doesn’t make them worth that much. Therefore economic output is being inflated."

To which the Correspondent counters “Well if a consumer pays $200 then it must be worth $200 to him. Otherwise he wouldn't have bought it.”

And “If not enough consumers are willing to buy all the shirts at $200 each, we know businesses tend to lower prices until demand is adequately stimulated to clear the market. If consumers buy up all the remaining shirts at $100, the lower price of those shirts will be reflected in (C)onsumer spending. If no one is willing to buy any of the shirts, then they don’t sell and are not included in GDP that year.”

That’s a pretty fair system.

Incidentally, if you want to see the components of C, I, G, and Nx measured in practice, the Bureau of Economic Analysis or BEA keeps a database of GDP going back to 1929 with measurements of the various components and even breaks down spending activity within each one. For example, Business (I)nvestment spending might be broken down into "structures" and "equipment" while (C)onsumption spending might be broken down into "durable" and "nondurable" goods.

There’s a link to the BEA GDP database at the end of the article.

WHAT ABOUT INFLATION’S EFFECT ON SPENDING?

One more thing about GDP that comes up a lot in discussion: Is it artificially boosted by inflation? The simple answer is no... usually.

The headline reported number we read in the news every quarter is technically "real GDP,” or total dollar spending adjusted downward by the official inflation rate.

What’s less commonly reported is the actual dollar figure, inflated by rising prices and all, known as “nominal GDP.” So when you read a news story that says “The U.S. has a $28 trillion economy,” they’re using the nominal number.

If you read a story a year ago that “The U.S. has a $26.4 trillion economy” and you get out your calculator, you might think that meant GDP grew by 6% in one year ($26.4T x 1.06 = $28T).

Well nominal GDP did grow by 6%, but that’s because prices rose 3.5% due to inflation. The growth in actual output (real GDP) was only 2.5% which is the real “GDP report” growth number that makes bigger headlines.

This is also why if you hear “The U.S. had a $7.15 trillion economy in early 1994” you definitely shouldn’t think to yourself “Wow, the U.S. economy is on a tear. Output has quadruped in the last thirty years!”

A gain of $7.15 trillion to $28.6 trillion is comparing nominal GDP numbers, which means it’s been inflated by, well…. inflation again.

To measure how much the output of goods and services has grown in real terms since early 1994 you should compare real GDP from one period to real GDP from the other. Granted, the measure in prices will have to use the same price index standard for both periods (for example, “both measured in 2017 dollars”) but the percentage gain will be a lot more accurate.

And just how much has U.S. real GDP grown since early 1994? Has it quadrupled?

No, adjusting for inflation real output has really grown by 109% in thirty years. Not bad, but slightly more than double in real terms versus quadruple in nominal terms. That's how much impact inflation has on the growth in nominal GDP over decades.

Incidentally on a compounded annualized basis 109% in thirty years works out to +2.49% real GDP growth per year on average.

In short, when reading about or calculating how much the U.S. economy has grown or contracted over time you always want to use real GDP.

For those interested in seeing the official nominal and official real GDP numbers here are links from 1994 to 2024 from the St. Louis Fed for both. You can also change the dates to see GDP growth over different time periods.

Nominal GDP

https://fred.stlouisfed.org/graph/?g=1tvfv Real GDP

https://fred.stlouisfed.org/graph/?g=1tvfy

We’ll cover some more criticisms, fair and unfair, of GDP measurement in the next column.

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Correspondent's note: Link to BEA tables breaking down (C)onsumption spending, Business (I)nvestment spending, (G)overnment spending, and Net Exports (Nx) by year.

https://apps.bea.gov/iTable/?reqid=19&step=2&isuri=1&categories=survey&_gl=1%2A1y3yh57%2A_ga%2AMTE3MjQ5MzM2OS4xNzE5MjAyOTEz%2A_ga_J4698JNNFT%2AMTcyNTc0MTc3My41LjAuMTcyNTc0MTc3My42MC4wLjA.&fbclid=IwY2xjawFtRGFleHRuA2FlbQIxMAABHTDC_QcHLaiN9Z24p1tOM8czCQlMiY1hqrXbV-dH2kyO0QZHfI5ugldOvQ_aem_mf-XjQKGVhuJYsO0z3PWKw#eyJhcHBpZCI6MTksInN0ZXBzIjpbMSwyLDNdLCJkYXRhIjpbWyJjYXRlZ29yaWVzIiwiU3VydmV5Il0sWyJOSVBBX1RhYmxlX0xpc3QiLCI1Il1dfQ==