TCS Daily

Can Taiwan Do Better?

By Christopher Lingle - February 9, 2005 12:00 AM

Taiwan's economic growth rate of about 5.9 percent for 2004 was the best performance in seven years. At the same time, the unemployment rate improved to just over 4 percent, its lowest level since May 2001.

Despite these improvements, policy makers insist that they have the means to make it better. It is expected that they will use public spending on the "10 New Major Construction Projects" plan to raise Taiwan's economic growth rate to 5 percent.

However, there are several flaws of logic in their reasoning on the policy responses to economic downturns. In general, the aim is to manipulate overall demand. The methods used to achieve this goal are increased public-sector spending, most often relying upon budget deficits, and/or monetary expansions to cut interest rates.

In the first instance, government spending is not the driver behind economic growth. As such, public-sector deficits cannot bring a permanent improvement in economic trends.

Sustained economic growth requires more investment from the private sector NOT more spending by the public sector. The false expectations of higher growth from more government spending are supported by the notion of demand-led growth that has very deep roots in the calculations of GDP.

Calculations of GDP focus upon the demand for final goods and services that implies that goods emerge simply because people desire them. If all that matters is the demand for goods, then the supply of goods can be taken for granted.

Thus, the various stages of production preceding the provision of final goods would be irrelevant. However, intermediate goods must be produced and used to produce tools and machinery until the final stage of production is reached.

These stages of production must involve capital formation that depends upon the real stock of savings in an economy. Contrary to the GDP-mindset, it is savings and NOT consumption that drives an economy. And the best way to encourage private investment is to lower the tax and regulatory burdens imposed by government policies.

So, the first step in abandoning the assumption that the demand for final goods and services is at the heart of economic growth requires rethinking about GDP.

The exclusive focus upon final goods and services of GDP estimations implies that the availability of goods arises out of the desires of consumers. Yet these desires can only be accommodated if they are preceded by an act of production that provides their supply and income to labor as the means to satisfy demand.

By taking the supply of goods for granted, the GDP framework ignores the various stages of production that lead to the arrival of a final good. For example, intermediate goods required in the production of final goods are not readily available and must precede the demand for the eventual output.

Ignoring these crucial aspects of commercial activity contributes to a misunderstanding of how an economy works. In particular, developments in the earlier stages of production are important determinants of business cycles since they are especially responsive to changes in interest rates and technological innovations.

In the first instance, focusing upon final output leads to the mistaken belief that consumer spending is more important than capital investment in an economy. This false conclusion is drawn from the fact that consumption expenditures account for around two-thirds of measured GDP.

But such a conclusion reverses the direct of causation. It is private business investment that drives economic growth while consumer spending is a consequence, rather than a cause, of economic growth. And so it is that entrepreneurs that innovate and use accumulated capital along with technological change that create new jobs and wealth.

The most essential flaw with GDP data is that it suggests that government spending can provide an autonomous addition to national output. Under this misleading conclusion, new government spending can stimulate economic growth, even if deficits are the source of the funds.

Despite so many problems, there is a continued reliance upon GDP measures as an indicator of economic strength. This view supports the conventional economic wisdom that recessions result from sudden declines in household consumption. Unfortunately, it also provides governments and central bank officials with justifications for interfering in the economy through active monetary and fiscal policy.

Tampering with monetary and fiscal policies induces wealth producers to redirect their activities towards unsustainable activities once the so-called stimulus inevitably disappears. In fact, these expenditures on current consumption spending do not reflect a change in household's long-term real earnings patterns and cannot support sustained growth. Therefore, it is not surprising that even ultra-loose monetary policy has failed to end Japan's economic drought.

Changing our thinking about GDP can have important consequences. In the first instance, it might lead to abandonment by governments of their dependence upon deficit spending. Similarly, central banks might not pursue their ruinous policies of credit expansions in response to economic downturns.

The author is chief strategist for eConolytics.



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