Quantifying all the money being moved around the economy is difficult. It requires understanding the will of households, firms, governments, and foreign markets. To pull off such a trick, we’d need near perfect knowledge.

Such omniscience is impossible. So, our solution is to provide a macroeconomic model for all the money being earned or spent on all final domestic goods and services.

Measuring a Nation’s Income

Gross Domestic Product (GDP) serves as the measurement of the income or expenditures of a nation, the calculation of money transferring hands, and a comparison of national efficiency and wealth. As an economic indicator, it gives us an idea of a nation’s welfare by giving it an income, and comparing it’s earning and spending powers to previous fiscal calendar quarters. Investors and economists looking to interpret the data can find releases from the Bureau of Economic Analysis.

Stocks and Flows

Thinking about GDP means categorizing all things in the national economy as either stocks or flows. Stocks are a quantity we measure at a specific point in time. Flows are that same quantity measured over a specific period of time. These numbers give us two distinct ways of measuring GDP:

1. Looking at the prices of goods with inflation (nominal GDP); and,
2. Looking at the prices of goods without inflation (real GDP).

When nominal GDP is higher than real GDP (it usually is), there is a rate of inflation within the economy. We measure this with the Consumer-Price Index (which finds how prices have changed over a specific quantity or flow variable) and the GDP Deflator (which finds how quantities have changed over a specific price or stock variable). Then we take the best of both worlds and average the two together. This is known as the Fisher Index.

(Note: all numbers are presented with seasonally-adjusted averages.)

The Income Approach and the Expenditure Approach

A nation’s total income is added up in two different forms:

1. the income approach; and,
2. the expenditure approach.

The income approach measures a nation’s income by the amount of money made within the country. The expenditure approach measures by the amount of money spent within the country. Either approach should theoretically yield the same amount.

The Income Approach Breakdown: W+P+R+I+T

The income approach is found through all money earned by firms and households. This includes:

Wages – Monies earned by households through business payrolls.

Profit – Monies earned by firms through businesses. This also includes money earned by the self-employed.

Rent – Monies earned by landlords for use of land and properties by consumer households and firms.

Interest – Monies earned through banking interest.

Taxes – Monies collected by the government.

The income approach is a valid method for collecting GDP data, yet is less popular and not used officially on government economic releases.

The Expenditure Approach Breakdown – C+I+G+(X-M)

The expenditure approach is used more frequently than the income approach, and its components are accessible through Federal Reserve Economic Data.

Consumption – Consumption, which accounts for around two-thirds of GDP, is the expenditure of all households within a nation. It is divided into three subcategories: durable goods, nondurable goods, and services. Durable goods make up items that are held for long-term purposes such as TV’s or cars. Nondurable goods serve short-term purposes and include food and clothing. Services are work done for consumers by individuals and firms.

Investment – Investment is made up of goods bought for future use. Investment is also divided into three subcategories: business fixed investment, residential fixed investment, and inventory investment. Business fixed investment is the purchase of new plant and equipment for firms. Residential fixed investment is the purchase of housing by households and landlords. Inventory investment is the increase in a firm’s inventory. For example, an unsold 2010 Corolla would be added to Toyota’s (TM) investment spending.

Government Spending – Government spending makes up all goods and services bought by federal, state, and local governments. This includes military spending, highways and infrastructure, and funding for government services. However, it is important to note that government spending does not include transfer payments to individuals such as Social Security and welfare. Transfer payments reallocate existing income. Since they are not made in exchange for goods and services, they are not included in GDP.

Net Exports – The last category, net exports, is the total value of the exports a nation provides the rest of the world minus the value of the imports a nation receives from foreign countries. Starting in 1976 our country has experienced a trade deficit because the amount of goods imported were more than the number exported. In 1985 the US began its infamous trading deficit with China.

Is Gross Domestic Product Accurate?

The flaws with GDP data are that some use these numbers to determine the welfare and quality of life in a country. Unfortunately, GDP can only be used to calculate the amount of domestic production. GDP fails to tell us how large the gap is between the rich and the poor, the wealth of the average citizen, and is also underestimated because it does not include money being pumped through underground economies.

Another criticism is that GDP fails to categorize unpaid house work such as that performed by stay-at-home parents. The value of this labor not being included diminishes overall GDP. Similarly, this draws criticism because a sandwich eaten at a restaurant contributes to GDP, where a sandwich prepared at home does not. The sale of used goods is not included either. Anyone who has been to a yard sale or heard of eBay (EBAY) knows this is a major flaw with GDP data.

Lastly, GDP data is backward looking, always revised later, and subject to government manipulation. For this reason, some famous investors such as Jim Rogers don’t even pay attention to GDP numbers.

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This post was contributed by our friends at Minyanville.

“Everyone” is upset with the level of fiscal deficits being run by nearly every developed country — and with much justification. The levels of fiscal deficits are unsustainable and threaten to bring many countries to the desperate situation that Greece now finds itself in. “We must balance the budget” is the cry of fiscal conservatives. But there are unseen consequences in moving too fast or too slow in the effort to get the deficits under control. Today we look at them as we explore the fine mess we’ve gotten ourselves into.

GDP = C + I + G + (X-M)

We’ve discussed the above equation before, but let’s look at it again from a different angle. Basically, the equation is another accounting identity. GDP (Gross Domestic Product) for a given country is the total of Consumption (personal and business) plus Investments plus Government spending plus exports minus imports.

The Keynesians argue that when there’s a drop in C due to a recession that G must rise to offset the drop. That was at the heart of the argument for stimulus packages in so many countries. And there’s no doubt that stimulus did help keep a very deep recession from turning into an even deeper depression. One can legitimately argue about the size of the stimulus, or about the nature of the spending, but it’s difficult to argue that it didn’t have an effect.

Now, of course, the hope is that a recovery will allow C to begin to rise so that there’s no more need for government deficits. Keynes argued that governments should run surpluses in good times, which is conveniently forgotten by most government-spending types. The problem is that we’re still running massive deficits. Tax receipts are way down (10% unemployment will do that to you!) and show no sign of turning back up soon all over the developed world.

If you reduce government spending, that also has a negative effect on GDP in the short run. But in past recoveries the growth of the private sector has overcome that negative effect. Normally at this time in a recovery growth is in the 7% range. This is a very tepid recovery in the US and the developed world.

There are loud calls in the US and elsewhere for more fiscal constraints. I’m part of that call. Fiscal deficits of 10% of GDP is a prescription for disaster. As I’v discussed in previous article, the book by Rogoff and Reinhart (This Time Is Different) clearly shows that at some point, bond investors start to ask for higher rates and then the interest rate becomes a spiral. Think of Greece. So, not dealing with the deficit is simply creating a future crisis even worse than the one we just had.

But cutting the deficit too fast could also throw the country back in a recession. There has to be a balance.

Greece has promised to cut its deficit by around 4% a year for three years. Spain is also making deep cuts. But the danger is that you could create a nasty spiral.

That deficit reduction will also reduce GDP. That means you collect less taxes, which makes the deficits worse, which means you have to make more cuts than planned, which means lower tax receipts, which means… etc. Ireland is working hard to reduce its deficits, but its GDP has dropped by almost 20%! Latvia and Estonia have seen their nominal GDP drop by almost 30%! That can only be characterized as a depression for them.

If you’re in a country that cannot print its own currency as Greece or Ireland, the only way you can get back to competitiveness is to increase your competitiveness by decreasing your costs of production. And that’s not just goods. It’s a lot of labor cost. But if you reduce labor costs, you get less tax receipts. It’s a very painful path, but once you get to the end game, the only choices you have are painful.Britain is now running about 5% inflation. Let’s say real (after inflation) growth could be 3% for a total of nominal growth of 8%. If Britain can get its deficit to GDP down to 6%, then it would actually be seeing the relative size of its debt being reduced. Debt isn’t adjusted for inflation (what that does to bond investors is another story), and so a country can run a deficit that’s less than nominal GDP essentially forever. That may not be wise, but it’s not a course for disaster.

But countries like Greece that cannot print their own currency don’t have the inflation option. They’re stuck with the low inflation of Europe. So if their economy is shrinking by 3%, that means their debt-to-GDP level is rising even if they weren’t borrowing any more money. And trying to reduce “G” by large amounts ensures that their GDP will shrink even more. Essentially they have to deflate their economy to make themselves more competitive. It’s not going to be easy.

Those calling for countries to quickly cut their deficits are essentially telling them they must enter into a serious recession for some time in order to get the ECB to buy their bonds. And what choice do they have? If they don’t make the cuts, the bond market will simply dry up and their interest rates will skyrocket, which will force more cuts that will be deeper and sooner. There are no good options, only painful ones.

By the way, as countries go into recession, they’ll buy fewer goods. That cannot be good for exporting countries like Germany and China.

Be Careful for What You Wish

In the US, we must start to get our fiscal house in order. But if we cut the deficit by 2% of GDP a year, that’s going to be a drag on growth in what I think is going to be a slow growth environment to begin with. If you raise taxes by 1% combined with 1% cuts (of GDP), that will have a minimum effect of reducing GDP by around 2% initially. And when you combine those cuts at the national level with tax increases and spending cuts of more than 1% of GDP at state and local levels, you have even further drags on growth.

We need to cut our fiscal deficits. We need to reduce the size of governments. But make no mistake — it won’t be painless. It’s necessary that we begin as soon as possible so that we can do it at a reasonable pace before the bond markets force us to move at a pace that will be even more painful. Be careful what you wish for.

I still maintain that we have better than a 50% chance of a recession in 2011. I wish it were otherwise.

The View From Europe

A few observations from my European trip (I’m now in Paris).

There seems to be a sense that Europe will fall into a recession later this year from those I talk with and read. That will be a drag on growth everywhere, and only make their situation worse.

No one seems too worried about the recent fall in the euro. Calls for the euro to go to parity with the dollar are everywhere. That echoes Martin Wolf’s call a few weeks ago that Britain should allow the pound to fall further.

One of our guides in Italy, a very educated and sophisticated young lady of 40, said she plans to work and save for another 10 years then move to Brazil or Chile and open a gelateria. “The government will never be able to pay my pension or health care. I must take care of myself.”

Everyone wants to run a trade surplus, but everyone can’t. Someone has to buy.

The feeling seems to be that the euro will survive. As one bond trader told me, the euro isn’t an economic currency. It’s a political currency, and there’s political will for it to survive.

When the euro was created, the Germans got a Mediterranean currency and the Mediterranean countries got German interest rates.

Have a great week.

For more interesting stories, check out Minyanville >

In other words, is this all there is? That was the question I had to ask myself today after reviewing weeks of economic reports that moved the needle slightly up or down, or reversed a trend ever so slightly, or gave multiple data points that danced around the same reading.

Looking for solid news of a rebounding recovery has been as elusive as the proverbial needle in a haystack. So the question remains, are we looking at it…. is the haystack the recovery? Is this as good as it gets?

Let’s take a look at the personal income and consumption report today from the Department of Commerce. The good news is if you are looking to buy a car, this might be a good time to do it ─ consumer spending remains soft, particularly in durable goods (up only 0.1 percent) but only if you have the money to spend, as personal income rose a lower-than-expected 0.1 percent for the month of January. Savings also dropped and spending on services was weak, up a modest 0.2 percent. Prices, however, remain tame with an increase of 0.0 percent for the month and a year-to-year increase of only 1.4 percent.

Recently, the construction industry became the focus of economic optimism. The larger-than-expected 2.8 percent January increase boosted hopes that the housing recovery was beginning to take root. But was the concentration of new apartment housing a sign that the “American Dream” (no, not beating Canada for the gold) of owning a home would again be out of range for most folks?

According to today’s construction spending report from the Department of Commerce, construction spending dipped by another 0.6 percent in January following a revised 1.2 percent dip in December. The biggest takeaway from the report: the fact that total construction is down by 9.3 percent for the year. Enough to start thinking about what kind of a boost construction could get following a small earthquake.

And then there’s the ISM Manufacturing Index for Feb, which came in at 56.5. The good news is manufacturing continues to hum along, boosting employment by 3 points to 56.1 and replenishing inventories. New orders, however, moderated their previously accelerating pace, dropping below 60 for the first time in several month. Backlog orders were up 5 points to 61, which bodes well for the sustainability factor.

So, again, is this the recovery we’ve all been hoping for? According to the famous lyrics of that existential lament “Is that all there is?” if that’s all there is my friends, then let’s keep dancing.

An increase in energy as well as new and used motor vehicles contributed to gains in the consumer price index for October, the Labor Department reported today.  The department reported a one-month rise of 0.30 percent for October and a 0.20 percent increase for all items less food and energy, the same increase as September.

Price increases for used and new vehicles account for 90% of the increase in the all-items index. Prices for airline transportation and medical care also increased. The food index showed a slight increase of 0.10 percent, with dairy-related products showing the biggest increase in the food group.

Analysts expected a rise of 0.30 percent for the one-month all-items index, but expected a rise of only 0.10 percent for the one-month index excluding food and energy.

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At the beginning of George W. Bush’s presidency, political rhetoric regarding China took the form of old-school Cold War mantras. At the time, US consumption and Chinese production were as dependent on one another as heroin addicts on Afghan poppies. Thus, the “threats” were nonsensical political scapegoats.

As President Obama makes his way through China, we are witnessing more silly talk. Part of the President’s agenda is to convince the Chinese that importing US goods will “create even more jobs on both sides of the Pacific.” Um, no.

If China steps up US imports, they will cannibalize their own production (i.e., jobs). While this would be partially offset by their need to have the US make money to pay off our insane debts to them, as each moment passes China’s economy is growing less dependent on US consumption.

With one of the largest populations on Earth, China’s internal consumption will ultimately offset historic dependence on foreign consumption of their goods. Like the mafia, eventually China will not care how we pay them their interest so long as we pay. Global politics is a fierce Machiavellian game. As Warren Buffett eloquently explained in I.O.U.S.A.: One Nation. Under Stress. In Debt,Thriftville owns Squanderville in the endgame:

Aren’t we tired of this BS? The cold hard truth for US citizens is we must work to create a sustainable economy. We must set our sights on explosive industries such as alternative energy and health technology. The longer we sit home and imagine the Chinese buying our shitty cars or exotic financial securities, the shorter the road to serfdom for more generations of US citizens who will be stuck paying off the reckless debts of our elders.

As with the previous administration, our government is wasting time giving empty speeches for the US media to pump at home. If you believe in the coming wave of jobs based on Chinese consumption of current US goods, I have some strongly defended US Dollars to sell you …

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