Economics 101 teaches you that you that growth in the economy is measured by gross domestic product (GDP), but factors included in calculating GDP are masking an important trend in the economy that investors should be mindful of.
GDP is the sum total of consumer spending, investment made by the private-sector, net exports, and government spending. The formula econ teachers have always taught students is GDP = C + I + G + Net Exports. But changes in attitudes toward government spending over the last three decades belie the reliability of the old formula for economic growth. The notion that government spending should be part of a measure of economic output is questionable, and including government spending in the GDP growth figure masks the strength of the private sector in the current recovery.
Government spending accounts for 18% of U.S. GDP. In recent years, however, government spending has been cut sharply, with the deepest cuts sustained by state and local government agencies. The chart below showing state, local and federal government spending’s contribution to the rate of growth in GDP illustrates the sharp cuts by government following the global financial crisis of 2008-2009.
Many economists would argue that reducing government spending will increase economic growth in the long run by leaving more resources available for reinvestment by the more productive private sector. However, in the recent short-run it’s clear that cuts in government spending have reduced GDP. To be clear, while reducing government spending is thought to be good for economic growth, it reduced GDP growth in recent years. Government spending cuts, which many economists would argue are a positive factor, show up as a negative in the GDP formula.
Moreover, removing government spending from the calculation of GDP conveys a very different story about recent U.S. economic growth. Excluding government spending from the GDP formula, according to data compiled by Fritz Meyer Economic Research, an independent research firm, puts the rate of growth of the current economic recovery in line with the long-term economic growth rate since 1980
From 1980 through 2008 the GDP grew at approximately 3.0%. However, the GDP growth rate over the three-year period ended September 30, 2013 has only been 2.1% — weak by comparison to the long-term trend. However, if you exclude government spending from the GDP calculation, the growth rate of 3.2% over the 33-year period is equaled by the growth rate in consumer spending and investment shown over the period since the economy recovery began three years earlier.
GDP is intended as a measure of economic output. Since measuring economic output is more difficult than measuring consumption, however, government consumption is used as a proxy for output. Consumption and output are thought to be interchangeable because they are so intertwined. That’s arguably flawed because the government does not produce anything and sell it.
While debate over the merits of government spending is politically charged, the practical implication of including government consumption in GDP is that it has masked the underlying strength in the other components of GDP. Maybe this explains why stocks rose so sharply after the financial crisis despite what appeared to be a lackluster economic recovery.