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(Joe Raedle/2005 Getty Images)
(Joe Raedle/2005 Getty Images)

Taking Stock

Why the U.S. GDP number may be as bogus as a three-dollar bill Add to ...

In 10 days, Washington will release its revised estimate of first-quarter economic growth. This figure, based on more complete data than were available when the first assessment was issued toward the end of April, will undoubtedly grab headlines.

It could affect everything from the Federal Reserve's view on interest rates to corporate decisions about spending and the public's evaluation of how well the Obama administration is managing the economy. Economists will issue a variety of learned opinions about what it all means.

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What most of them will not be saying is that the GDP figure is essentially meaningless.

Many of us instinctively distrust some (okay, a lot) of what governments tell us. Anyone who buys food or fuel these days has a problem with the oft-repeated official line that inflation is tame, so don't worry about it. And we know unemployment just has to be worse than the official numbers show. But tell us GDP is growing at a faster clip than forecast, and we erupt into loud cheers.

Take Friday, when the Europeans revealed that first-quarter growth in the 17-country euro zone soared by more than 3 per cent on an annualized basis, led by much stronger-than-expected gains in Germany and France. The euro briefly jumped in value and analysts could barely contain their enthusiasm. "The data out of the euro zone … showed Germany and France's GDPs are absolutely on fire," one excited currency strategist told Bloomberg.

But what if the number turns out be fake? That's the provocative question posed by renowned U.S. money manager Rob Arnott, who makes a convincing argument that what passes for growth in the U.S. and a bunch of other deficit-ridden economies is less than it seems.

"It may be for real or it may be phony, based on increases in deficit spending," Mr. Arnott says of the latest European numbers. But while he's unsure of euro-zone growth in a new age of austerity, the chairman of California-based Research Affiliates is absolutely certain that next week's revised U.S. GDP number will be as bogus as a three-dollar bill. That's because it will not take into account how much of the American expansion stems from the government's deficit-spending binge.

"Gross domestic product is used to measure a country's economic growth and standard of living. It measures neither," Mr. Arnott says flatly. "GDP measures spending. It does not measure prosperity. Unfortunately, the finance community and global centres of power are wedded to a measure that bears little relation to reality."

The problem, he argues, is that the GDP figure fed to the public does not distinguish between consumption that is covered by current income and that which is financed by deficit spending. He likens it to a family with too many credit cards. The more credit they use, the higher the "family GDP" climbs. But that expansion is unsustainable. Once they are forced to slice up their cards, their GDP must plunge.

That, in essence, is happening now in Britain, where tough government austerity measures, including deep spending cuts, are biting into what Mr. Arnott would characterize as the phony portion of its GDP. Canada and other countries determined to straighten out their fiscal situation could also face somewhat slower growth.

"Let's not pretend that a drop in GDP by reducing our borrowing and spending is painless," Mr. Arnott says. "It hurts just as much. For the family that slices up their credit cards, that drop in spending is just as painful as if they earned less money. But their financial health is on the mend. And that's the difference."

People would have a truer gauge of the economy's performance if the government provided what he calls "structural" GDP, which does not include debt-financed consumption. Currently, per capita GDP in the U.S. is not far off an all-time high. But excluding deficit spending, the real number is 10 per cent below the peak reached in 2007. Indeed, it has fallen back to levels not seen since 1998.

"If structural GDP fails to grow as a consequence of our deficits, then deficit-spending has failed in its sole and singular purpose," he says. "What we find is that this recession is horrific."

He would also isolate private-sector GDP by subtracting government spending (excluding transfers). Lo and behold, this measure is also back at its 1998 level. What his calculations show is an economy "bottom bouncing and showing no signs of recovery. All we're doing is borrowing more and spending more. That's the only GDP growth we've got."

But surely, growth is growth, no? No, Mr. Arnott says, sipping a club soda during a brief respite from a hectic round of meetings with major pension funds and other institutional investors in Toronto. "Ultimately, the addiction to debt-financed consumption has got to come down."

What should an investor make of all this?

"As deficit-spending is reined in, either voluntarily or because the capital markets choke on new debt, that could have an effect on capital markets as quantitative easing winds down," Mr. Arnott says. "It's hard to identify uncertainties that could drive markets massively higher, but relatively easy to identify those that could drive them massively lower.

"Which means now is a wonderful time to have a very defensive investment posture."

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