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S1:E01 Cow Tongue Sandwich

When you think of an economics professor, what comes to mind? For me, heading into my graduate program’s economics class, I envisioned the old stereotypical banker – with glasses and a wet cloth of a personality. Before class I read that our professor, Tony Frost, received his Ph.D. from MIT’s Sloan School of Management where his thesis “The Geographic Sources of Innovation in the Multinational Enterprise” received the inaugural Gunnar Hedlund Award for the best doctoral dissertation in international business. Which in my mind confirmed my suspicion. So it came as a surprise when someone with a full set of hair walked into the classroom blasting heavy metal over the speaker system and putting up a picture of a triple layer cow tongue sandwich. He was no ordinary professor. 

Each class started with the same routine. Lights dimmed, heavy metal music blaring and the cow tongue sandwich picture projected on the board. You see, in his opinion  – my mother has a very different opinion – the cow tongue sandwich is not meant to be enjoyed. So when you are faced with one, you just have to work your way through it.  It was his way of acknowledging that Econ can be bland and not a lot of fun. However, it turned out to be one of my most favorite classes – aren’t you in luck. Prof. Tony made it fun and relevant for me. He didn’t just give us the formulas, he made them applicable to what was going on in the economy. His stated goal for the class was, “When you leave here, I want you to have a framework to contextualize what you hear on the news or read in the media.”

I learned a lot from him and many of the things I will be covering in this episode I learned from his class and our conversations. I might take some creative license with the concepts here and they are to communicate the broad points, but the essence will remain the same. And just like he left me with a framework, I want you to have a framework you can apply to economic and news events around you. I hope you will find it more enjoyable than a cow tongue sandwich. Let’s jump right in. 

What is GDP (Gross Domestic Product) after all?

I think at a high level we all have a sense of what GDP is, but not many of us understand how it is measured or why – or if it is even necessary. In essence, GDP is the total value of all the finished goods and services produced within a country. For our purposes it is calculated by this simple formula:  C + I + G + ( X – M ).

It is really a simple formula.  C = total spending by consumers. I = total investment by businesses. G = total spending by government (federal, provincial, and local). X = the total exports and M = the total imports (X-M = Net Exports). So that is to say, you add up all consumer spending on goods and services, together with the total investment/spending of businesses and the government, and you add in the net exports (trade deficit or surplus) to derive the GDP for the economy. 

Okay, I think that is the only math equation you need to know to become a great backseat economist. Write on a napkin the next time you are at a party to impress those around you – I wouldn’t lead with that though. 

Which part of that equation do you believe is the most important? 

While government spending and business investments are important, consumers (you and I) play the biggest part in today’s economy. In Canada, consumer spending has averaged around 56% of the total GDP since the sixties. Our neighbors to our south averaged over 63% over the same time period. When consumers stop or increase spending it has a large effect on the overall growth/output of the economy. Yeah us.

Why should we measure GDP? Well, GDP is one of the best measures we have to show (1) the size of an economy and (2) how the economy is performing – is it growing or contracting – over different time periods. A growing economy, when it is grown in a healthy sustainable way, is a good thing as it improves the standard of living, health and wellbeing for those living in that economy. It can also produce positive effects for other trading and economic partners.  At the same time, it also helps us know when an economy is shrinking – a recession is when an economy has two negative quarters of GDP growth – more on recessions in a later episode. 

Where does Canada rank in GDP compared to the rest of the world? Below is a snapshot of the top 15 countries by GDP in 2020 by the World bank. We rank #9 just below Italy and above Korea.  You might also notice that the top two economies combined are about 92 trillion larger than the next thirteen economies below it.

Starting to feel like a cow tongue sandwich? Stick with me as we look at how we can use this in our daily lives.

When I listen to the news or read an article in the paper or the economist pertaining to the economy, I always ask myself: how does this impact the consumer (C)? How does this impact business (I) or government (G) spending? What effect might this have on imports or exports (X-M)? By answering these questions, I get a sense of how it might impact the economy and GDP. Now I never personally go through the painstaking task of trying to calculate GDP – we have enough well-paid economists doing that – but it helps to know the model to understand how different things, like interest rates, affect the economy. Always remember this little formula C + I + G + ( Net exports) when listening to the news and remember that the customer plays the leading role. 

Click on the image below for a quick snapshot of the global GDP.

Or how Canada’s GDP has changed over the years and its future forecast. (GDP in US$)

That is economic output in a nutshell. Now we move into an area that I am not quite sure how to address in this format without making it too technical or irrelevant. Let’s see how I do.

From GDP we can create  larger economic theory, or principles, to explain what you and I experience as boom and bust cycles. The four tenets that I always come back to are:

  1. In most economies, real output (GDP) follows a rising trend determined by the supply side of the economy.
  2. In the short run, fluctuations around the trend growth rate of GDP are dominated by demand side forces.
  3. Fluctuations around trend growth may be substantial (and costly) because economies, by themselves, don’t return to full speed quickly.  
  4. Fiscal and monetary policy can, in theory, be used as discretionary instruments to adjust and stabilize fluctuations so the economy returns to its trend growth path.

It might sound like greek as you read through those – it did to me the first time I heard it – but I think it will all make sense as we look at each one. I also think that we will end this first episode in the series after these as I know this is getting a bit long.

#1. In most economies, real output (GDP) follows a rising trend determined by the supply side of the economy.

Simply stated, economies grow over time with the growth determined largely by the supply side of goods and services. Why does the supply side affect the economy so much when earlier we said that it is the consumer demand that makes up the majority of GDP?  There is actually a raging debate amongst economists regarding which side of the economy is more important – supply or the demand side. I always picture these debates taking the same form as avid DC comic fans debating which superhero is the strongest in the cafeteria. In the end, it doesn’t overly matter. What matters is that without supply of goods and services, consumers will not have anything to buy and they will drive up the price on the little goods there is – case in point, COVID19 supply chain disruption (Cue Law & Order sound effect). And also, without someone to buy the goods and services, there is no need for the supply. In the end both sides are important but it has been shown that the more you can increase your economic supply, the faster your economy grows. However, as we will see, demand creates short-term fluctuations and is equally as important. 

 Below is Canada’s GDP output since that 70’s show.

As we can see, GDP has grown in the long run. I.e. real output (GDP) follows a rising trend.

#2. In the short run, fluctuations around the trend growth rate of GDP are dominated by demand side forces.

Okay, so we know GDP goes up in the long run but we also know, from our own experiences, that economies sometimes go into recessions i.e. contracts. These fluctuations are dominated by the demand side. Think back to the economic collapse of 2008. People were overspending by borrowing from the equity in their houses which caused GDP to rise and accelerate. Once house prices started to come down, consumers did not have any cash to spend anymore. Result? A demand shock that sent the economy into a tailspin.

Below are the changes in GDP on a quarterly basis over the same timeline as the graph above.   

We can clearly see when GDP fell below the 0 line (horizontal black line) – which indicates negative growth – and also how lumpy real growth is (it is not like you can lay your mattress down on those peaks and get a good night’s rest). It is also easy to see the big economic shocks in GDP in 2008 and again in 2020 when the economy was brought to a standstill. It is these changes in GDP that sometimes makes us nervous as investors as it is not clear from one quarter to the next what the future growth will be.  I think you can attest to it from your own experience. When has it ever felt like “the good old days’ ‘ while you were going through them? It is only when we look back that we see the growth and recognize how good things were/are.  

We will look at the forces that drive demand and how it impacts the economy more directly in the next episode. I know it is ill advised to end the first episode on a cliffhanger but my production manager (i.e. me) told me to keep the episodes as short as possible.   

Only two more statements to go. 

#3. Fluctuations around trend growth may be substantial (and costly) because economies, by themselves, don’t return to full speed quickly.

While very few alive today lived through the great depressions, we all know the stories of breadlines and mass unemployment. The economy came to a halt and had four years of negative GDP growth. Can you imagine experiencing 2008 for four years in a row? Ouch. Recessions can be very costly and can last a very long time when left to recover by itself, and it almost never recovers to the same growth as before. Western Economies have not reached the GDP growth of the 90’s since, well, the 90’s. Growth has slowed as most of the technological advancements have been incorporated into the economy and globalization moved the industrial complex predominantly offshore. Time will tell if this trend can be reversed by some of the more recent technological advancements and after corporations and governments adjust from the learnings from COVID. One area I can see changing is inventory management. Where the world has mostly shifted to “just in time” manufacturing, I think we will see a shift to “just in case” inventory management. This will require more warehousing and other economic outputs. 

#4. Fiscal and monetary policy can, in theory, be used as discretionary instruments to adjust and stabilize fluctuations so the economy returns to its trend growth path.

Another way of saying this is, the government can use interest rates and other mechanisms (like buying bonds) to stimulate the economy and provide the fertile ground for growth to resume. When the government does not step in, things like the great depression happens. During that time the governments generally wanted to balance the budget (i.e. cut spending and increase taxes). It is widely believed that those measures deepend and prolonged the economic recovery and those measures (or the lack of)  turned it into the great depression. The fallout was severe and the cost far exceeded just the economic collapse. On the other hand, government interventions have been proven especially effective during the great recession of 2008 and of course when Covid19 hit. However, it comes at a cost – government debt. After 2008 we saw a big increase in economic activity and growth that lasted more than a decade. It is still too early to know how the economy will fare over the next decade, but I think it is safe to assume that interest rates will stop rising, and possibly come down again, inflation will come down and the war will end at some point. All these factors should act as a tailwind to help GDP return to more stable growth. 

Wow, that is a lot of information. Let’s pause there for now after a brief recap of the main points.

  1. GDP is the measure of economic output and is measured through C+I+G+(Net Exports) 
  2. GDP, or economic growth, rises over time and this growth is determined by the supply side of the economy.
  3. GDP growth fluctuates from quarter to quarter, sometimes to a large degree, because of the changes in demand. 
  4. These fluctuations lead to recessions that can be costly to the economy and
  5. Does not correct itself quickly without the help of government interventions.

Okay, maybe that wasn’t so bad after all. I hope that was informative and helpful and you feel better equipped already to understand what is happening in the economy.

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