Over time, an increasing percentage of what we spend on government is spent on optional rather than core services because the core services tend to have been around longer. Another way of putting it is to say that the marginal value of added government, even if positive, falls as government grows larger.  This statement is not antigovernment; it’s just common sense.

Thus, usually, when we spend another dollar through government, it is worth a bit less- on average- than the last dollar we spent on government.  Government, at the margin, is becoming less productive.  Yet, when measuring GDP, we treat each dollar of government spending as if it is equal in value to the previous dollars that were spent.  We’re valuing dollars spent on highway extensions as if they were worth as much as the dollars we spent on building the core roads that link major cities.

Compare that to how we measure what we spend on apples.  Like government spending, it’s also true that the extra apples are (again, on average) less valuable to us than the initial apples we buy.  The first batch of apples satisfies a craving or helps us bake an important pie, but at some point, extra apples are much less important.  Here is the difference.  As the economy produces more apples, those apples fall in price. The lower value of apples is reflected by a lower price for apples, and so our measurements do not lead us to over value the crop of apple production.  We are valuing at price- not cost-and so we don’t have to assume that all apples are worth the same amount.  If a glut of apples makes the marginal apple worth less, market prices will reflect that change in value.

Yet we are still valuing government expenditures at cost rather than being able to measure prices set in a competitive market.

To better understand how well we are doing as a nation, remember this about productivity:

The larger the role of government in the economy, the more the published figures for GDP are overstating improvements in our living standard.

from  The Great Stagnation – How American Ate All the Low-Hanging Fruit of Modern History, Got Sick and Will (Eventually) Feel Better by Tyler Cowen.

Tyler is a professor at George Mason University and blogs at www.marginalrevolution.com

HKO comment:

This is an exceptionally astute observation.  Tyler also notes in this brief volume (89 pages- a $3.99 Kindle download) that the short explanation of the cause of the crash is that we were not as wealthy as we thought we were.  Easy money from the fed may have been one cause but analyzing the way the GDP is measured revealed another cause.  The more we rely on government spending and solutions the more we are likely to be overstating our wealth.

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