## Sunday, July 28, 2013

### It's cheating, but nobody seems to notice.

From yesterday's post, Employee Compensation relative to GDP:

 Graph #1: Employee Compensation as a Share of GDP

If Employee Compensation is falling, how can Unit Labor Costs be rising?

 Graph #2: Comparing Employee Compensation as a Share of GDP (blue) to Unit Labor Cost (red)

It's because Unit Labor Cost is Employee Comp multiplied by the price level:

 Graph #3:  Multiply "Employee Compensation as a Share of GDP" by the GDP Deflator and it starts to look just like Unit Labor Cost

Oh, they're not so blatant about it, of course.

The calculation for Graph #3 is crude. You can see that the GDP deflator is multiplied in. The deflator is a measure of prices, so you can see that prices are multiplied in. That's crude. But you can rearrange the formula and still get the same graph:

 Graph #4: Divide "Compensation of Employees" by "GDP divided by the GDP Deflator" and we get the same picture as in Graph #3

In this version, we don't multiply prices into the "Employee Compensation/GDP" ratio. Instead we divide prices out of GDP, and divide Employee Compensation by the result.

But the calculations are equivalent, so Graph #4 looks just like Graph #3.

But once we have the formula arranged this way, you might notice that the denominator, the Nominal GDP divided by GDP deflator part, is the calculation that gives what economists call "Real GDP". So you can use that instead:

It's shorter and cleaner, and it has the word "real" in it so everybody likes it. When you make the graph using Real GDP, it still looks just like Graph #3 and Graph #4:

 Graph #5: Divide "Compensation of Employees" by "Real GDP" and we get the same picture again because Real GDP is equal to "nominal" (actual price) GDP divided by the GDP Deflator

It's still the same picture. It's still the same calculation. It still has prices factored in, but now not even an economist can see it.

They'll tell you they are dividing by real GDP you know, but there is no such thing. Oh, the cars are real, and the houses, and the cups of coffee in the morning, those are very real, and the apples, and the oranges. All of it, all the pieces are real. But it's all apples and oranges. You can't add the values of all those things together, na, na, na, you can't figure the values of all those things in prices that never go up without doing complex calculations based on actual GDP, the so-called "nominal" GDP I mean, and the changes in prices.

There is no real GDP. There is only nominal GDP, actual GDP at actual prices. After that, it's all calculation. When they tell you they are dividing by real GDP, they are really dividing by estimates of actual GDP with price changes stripped away. Oh, they may have a series of numbers that's called "Real Gross Domestic Product" all right. And they may have incomprehensible stories about how real GDP is calculated. But if you factor price changes into their numbers you get "nominal" GDP. And if you take actual GDP and factor price changes out of it, you get their so-called "real" numbers.

No matter how you slice it, if you are dividing by "real GDP", you will get exactly the same result if you divide by actual GDP and factor price changes into the result. And the thing is, actual GDP is the actual one. "Real" GDP isn't.

They take numbers like Employee Compensation going down relative to GDP. They times it by prices to make the numbers go up. They say Look, look! Labor costs are going up! And they claim that rising labor costs are pushing prices up.

It's cheating, but nobody seems to notice.

The Arthurian said...

Two corrections to the text.
1. I want to insert the word "instead" in the third paragraph from the end. Here is the revision:

No matter how you slice it, if you are dividing by "real GDP", you will get exactly the same result if you divide instead by actual GDP and factor price changes into the result. And the thing is, actual GDP is the actual one. "Real" GDP isn't.

2. I want to revise the fifth paragraph from the end. Here is the revision, now two paragraphs:

They'll tell you they are dividing by real GDP you know, but there is no such thing. Oh, the cars are real, and the houses, and the cups of coffee in the morning, those are very real, and the apples, and the oranges. All of it, all the pieces are real. But it's all apples and oranges. You can't add those things together. You can only add their money values.

And you can't figure the values of all those things in prices that never go up without doing complex calculations based on actual GDP, the so-called "nominal" GDP I mean, and the changes in prices.

Greg said...

Excellent excellent post Art. I've never liked the terms nominal and real. When using a money system and a numeraire its ALL nominal!

I wasn't aware til recently (and you said it again here) that what they mean by real is "in prices that never go up" . I'd never seen it explained that way til last week and now you again.

But think about that, how is it useful at all to examine things from a standpoint where prices never rise ( I assume fall either). It would be like a doctor examining you from the standpoint of a body that never ages. Change is inevitable, desirable, a little scary sometimes and the only thing that is constant. Economics is way worse off than I thought if they really think an analysis of things in prices that never go up is something useful.

The Arthurian said...

Haha: "worse off than I thought"

Hey, I can see taking inflation (and deflation) out of the numbers in order to compare GDP over different years. Otherwise you get a false comparison.

But it's a problem when they strip the inflation out of GDP and then use those smaller numbers in the in another calculation like labor cost or the quantity of money. It makes the other numbers look bigger than they really are. This is a false comparison just like the other. But economists do it all the time.