Free Free Lunch by David Smith Page B

the government hands over to other people to spend. This is not true, by the way, of the salaries of public sector workers such as teachers or nurses. When the government pays them, it is buying the services of these professionals, just as your purchase of the services of a plumber counts as part of consumer spending.
    The other missing bit of government spending comes in our next GDP category, investment. When a business buys a computer, that is investment. When a household does so, it is consumer spending. Most investment in Britain is done by the private sector, on plant, machinery, vehicles and so on. But government, often now in partnership with the private sector, also carries out investment. New hospitals, roads, government computers, for instance, count as part of investment, or ‘gross fixed capital formation’, as statisticians usually describe it. Investment in productive capacity, as every businessman knows, is vital for long-run economic growth. For many years it was thought that Japan’s economic success was due to high levels of investment, averaging 30 percent of GDP. More recently, Japan’s economic problems, together with those in other Asian economies, have raised the question about whether, as far as investment is concerned, it is possible to have too much of a good thing. In Britain in the year 2000 investment totalled £165 billion, or just over 17 percent of GDP.
    Adding up spending by consumers, spending by government and investment gives us, for the year 2000, 63 plus 19 plus 17 percent, or 99 percent in total. Give or take the 1 percent for rounding, it appears we have got to GDP. Well, we would have, but only if we lived in a ‘closed’ economy with no overseas trade. What we are measuring, albeit via different categories of spending, is gross domestic product , in other words the value of spending on goods and services produced in Britain. That Japanese DVD player or German car included in consumer spending – quite a lot of them actually – should not be part of Britain’s GDP (although the proportion of the selling price that reflects distribution costs within Britain and the retailer’s profit should be). At the same time, there are plenty of products and services produced in Britain but consumed in other countries. GDP therefore also has to reflect exports and imports. Exports are goods and services made here but consumed elsewhere. Imports are made elsewhere but consumed here.
    In 2000 exports totalled £265 billion, equivalent to 28 percent of GDP. We add this £265 billion to the totals for consumer spending, government outlays and investment. Imports, on the other hand, were £281 billion, 30 percent of GDP. We take this away from our GDP total. The fact that both exports and imports were roughly 30 percent of GDP shows that Britain is an open economy, as it has been for centuries. Both America and Japan, the world’s two biggest economies at the time of writing (Britain has sneaked back up to fourth place), have much smaller export–import shares. The fact that imports exceeded exports shows that Britain was running a trade deficit.
    This book is intended to be an equation-free zone, but GDP = C + G + I + X - M is a way of setting down simply what has been spelt out above. Strictly speaking it is not an equation at all but an ‘identity’. C is consumer spending, G government spending, I investment, X exports and M imports. Sometimes you will see instead of GDP the letter Y (for reasons that have never been entirely clear to me), for national income, but the meaning is the same.
    Why is this so useful? First, it provides a simple way to understand explanation of the various types of spending that drive the economy. Second, anybody trying to forecast what will happen to the economy will first need to predict what is likely to happen to these expenditure components of GDP. All the main models of the economy are based around this simple identity. It also provides, with the