GDP is a complicated concept that raises many issues. Understanding them requires a good grasp of the concept of GDP, its methodology, and the economic theory behind it. As an illustration of these treacherous grounds, the Irish GDP increased so much in 2005 because the “domestic” in “gross domestic products” refers to the residents (including corporate entities) of the territory over which it is measured. In 2005, several multinational corporations relocated to Ireland to avoid higher taxes elsewhere, giving the Emerald Isle an enormous one-year GDP boost.
There is much to learn in order to understand the use and misuse of GDP. Princeton University Press’s recent release of two books on GDP gives us an opportunity to do this. Let’s start with some basics, and then take a look at the books.
Oranges, apples and happiness / What is GDP? It is defined as the market value of final goods and services produced in a given country (or other area) during a given period of time. GDP is intended to measure an economy’s production. It incorporates only the production of final goods, which will not be further transformed during the period under consideration (usually one year). Intermediate goods—goods that are to be inputs for other goods—are excluded in order to avoid double-counting. For example, only the value of a finished loaf of bread is counted; adding the value of the flour that went into the bread would be double-counting since it is already accounted for in the price of the bread.
Soviet planners, who did not want to consider prices because they smacked of capitalism, aimed at measuring all production in physical volume. One drawback is that, with this method, they could not produce a single number that measured the production of their economy; they only had the amounts of apples, oranges, or tanks produced. They did not accept the concept of GDP. But then, without market prices, it is unclear how Soviet planners could have meaningfully calculated GDP.
Prices determined on free markets and used to calculate the value of GDP are not arbitrary. The free-market price of a good equals the marginal utility of that good—all consumers will buy additional units up to the point where the utility of the last unit is equal to its price. (Think of “utility” as satisfaction or happiness, although the technical concept is more complicated. See “John Hicks and the Beauty of Logic,” Winter 2014–2015.) GDP thus sums up production as valued by the consumers themselves in their quest to maximize their utility. GDP is a measure of economic efficiency.
One must tread very carefully here. Saying that the free-market prices used to compute GDP represent the value that consumers attach to the last units consumed of all goods does not mean that GDP measures the total utility of consumers, called “social welfare.” A person gets more utility from what he consumes than what he pays for it; economists call this “consumer surplus.” So GDP is worth more than its money value.
Another reason why GDP does not measure social welfare is that utility can be distributed differently among individuals and inter-individual comparisons of utility are scientifically impossible. In a 1950 paper, “Evaluation of Real National Income,” the future Nobel economics prizewinner Paul Samuelson provided definitive proof that GDP computed from prices and quantities cannot measure social welfare.
There are three equivalent ways to calculate GDP. On the expenditure side, it can be calculated as the sum of final expenditures by consumers, governments, businesses purchasing equipment, and foreign importers. Equivalently, it can be calculated as the sum of values added in all industries: this is the value-added side of the ledger. Finally, it can be calculated as the sum of incomes received—the income side. We thus have a triple-entry accounting system that makes it difficult to falsify GDP figures. Production must generate incomes that serve to purchase everything. (What is not purchased is held in inventories, which are defined as a sort of investment alongside machines, equipment, and buildings.)
AN AFFECTIONATE VIEW
GDP: A Brief but Affectionate History is a short book by Diane Coyle, an economist, professor at the University of Manchester (United Kingdom), and former adviser to the UK Treasury. The book explains the basic concepts and statistics behind GDP while reviewing its intellectual history. Three economists who worked on GDP-related concepts ultimately earned Nobel economics prizes: Richard Stone (1913–1991), Simon Kuznets (1901–1995), and Wassily Leontief (1906–1999), but there were many other precursors. Coyle’s book also broadly traces the history of economic growth, which is measured by GDP per capita. The book constitutes a defense of GDP, affectionate perhaps but very critical at times.
Coyle notes that “very few people … truly understand how the regularly published GDP figures are constructed.” She adds, “This excludes many of the economists who comment on GDP,” but I suspect this is a typo: she must have meant to include many economic commentators in her blame. Both conceptually and statistically, GDP relies on a vast set of assumptions. Coyle explains many issues in GDP accounting and data collection, from “chained” GDP to purchasing power parities and hedonic prices.
She also reviews many limitations of GDP. Because of data collection problems, GDP excludes the underground economy (drugs, prostitution, illegal labor, and such). This is beginning to change, however; European Union governments have recently started to incorporate estimates of their underground economy. Another limitation: GDP excludes non-market production such as household work (cooking, taking care of children, gardening, etc.).
Coyle notes that GDP does not measure welfare or happiness, but at times she seems to forget it. She does note that several other indexes that attempt to do this, such as the Human Development Index, are strongly correlated with GDP. Money does not bring happiness, but it seems to help.
Some of Coyle’s criticisms of GDP are not as convincing as others. For example, she claims that new digital services with zero price—think Google search—drive a growing “wedge between what GDP measures and aggregate economic welfare.” I am not sure this claim is correct, and not only because GDP does not measure welfare. Goods that are zero-priced for consumers do carry a positive price for others—advertisers in the case of Google. They generate new incomes and new value added. The advertisers make a profit and help Google make one. In the accounting logic of GDP, nothing seems to be lost.
Coyle criticizes the special and convoluted treatment of the financial sector in GDP. I am not totally sure she is right in her criticism of how the contribution of finance is calculated. She certainly is wrong when she questions “whether finance should be included in GDP at all.” If a market good or service is demanded by some consumers, it should be included in GDP. Except for extreme cases (like, say, murder contracts), GDP is not a moral concept. Or, at least, we try to keep it from becoming so.
Environment / Environmentalists have argued, and Coyle seems to agree, that depletion of natural resources or natural capital should be deducted from GDP, just as depreciation of physical capital is deducted to give Net Domestic Product (NDP). This environmentalist idea is not as useful as it may first appear. As suggested by Kuznets in 1973, the volume of resources available depends on human knowledge and technology, which influence efficiency in the use of those resources. Since the production of this sort of knowledge is not incorporated in GDP, why and how should natural capital and its depreciation be calculated?
We can go a bit further with a normative argument. The moral desirability of deducting depreciation of natural capital from GDP assumes that future generations—which, except for government follies, should be wealthier and healthier than we are—have a claim on today’s resources. Will they not be at least as altruistic as we are and wish we had enjoyed the best possible life? Or else, what monsters are we breeding?
From a positive (as opposed to normative) viewpoint, the pro-depreciation argument assumes that environmental and governmental apparatchiks are the best candidates to exercise the claims of future generations (who don’t often demonstrate or riot in favor of social justice and against globalization). Why shouldn’t decisions about the use of current natural resources be left to their private owners, who may have children or grandchildren to whom they would want to leave their resources?
Private property rights on natural resources partly solve the depletion and depreciation issue. The owner of an oil-rich piece of land decides whether the rent he would get is worth depleting his resource as opposed to leaving it to his children or, indirectly, to the children of a potential buyer bidding up the land price. This way, the optimal time path of depletion is, at least partly, reflected in GDP.
It is true that not all resources can be easily privatized and priced on markets—pure air or perhaps glaciers potentially affected by global warming are examples. But the first solution should be to try and better define and enforce private property rights. Shadow pricing of resources should only be resorted to when a Coasian solution does not work. (On Ronald Coase’s theory, see “The Power of Exchange,” Winter 2013–2014.)
Coyle explains how GDP and NIPA as we know them were offspring of the Great Depression and WWII. In both cases, governments needed to measure the economy in order to better control it. Keynesian macroeconomics soon provided a theoretical framework to justify government expenditures: “By design,” writes Coyle (the emphasis is hers), “GDP would increase when those policy levers were operated, at least in the short run.”
Government services / One major flaw of GDP relates to the treatment of government services. What is the value of these services, which are not priced on the market? In the early 1940s, it was decided to include in GDP all government expenditures on goods and services (including labor services, but excluding pure money transfers like, say, Social Security), as if government services were pure “profit” or value added. In other words, government services are valued at cost, contrary to ordinary services.
It is difficult to value something that is not sold on markets, but the main reason for overstating so blatantly government’s contribution to GDP was to valorize war expenditures and hide how they reduced consumption expenditures. Many economists involved in the development of GDP, including Kuznets himself, disagreed with this government decision. Coyle makes it clear that GDP and the NIPA as we know them were developed mainly as a tool for government.
I have other quibbles with Coyle’s book and I am not the only one (see the long and instructive review of the book by Moshe Syrquin in the Journal of Economic Literature). For example, I don’t know how she can blame deregulation and “the creation of toxic financial instruments that multiplied and focused risk” for the Great Recession without mentioning that mortgage-backed securities were created by a federal housing agency, Ginnie Mae. Coyle often seems to show as much affection for government as for GDP. Yet, her book remains a useful introduction to the meaning and limitations of GDP.
TOTALITARIAN GDP
Dirk Philipsen’s The Little Big Number is a very different animal. Despite lengthy endnotes, this book looks more like the work of a political pamphleteer. The author, an economic historian at Duke University, argues that GDP is a dangerous number that forces an inappropriate focus on economic growth, wasteful material goods, and unsustainable capitalism.
Against what he sees as a sort of GDP totalitarianism, the author longs for a new economy based on “belonging” and “tight-knit communities that integrate all aspects of life” and would lead to “rising access to fertile land for purposes of physical and social nourishment,” whatever that last bit means. Many of his pronouncements are more clichés or incantations than economic arguments: “people and nature are increasingly reduced to commodities” and we need to contribute “to a larger social whole,” etc.
Economics? / The reader may sometimes question Philipsen’s understanding of economics, let alone GDP. The author of The Little Big Number does not seem to grasp the nature of value and the function of prices. He argues that there is no relation between price and value. “Few people,” Philipsen writes, “would have to think long when faced with a choice between either $10 million in cash or, say, oxygen. Which would they value more?” He is puzzled by the low price of oxygen.
He seems unaware that Adam Smith raised this very problem in The Wealth of Nations, using water and diamonds instead of oxygen and cash. Economists have referred to this problem as the “water–diamond paradox,” and its solution was completed with the theory of marginal utility in the late 19th century. The solution is that, for a normal individual, the total utility of water is higher than the total utility of diamonds, but the marginal utility of diamonds, which are relatively scarce, is higher than the marginal utility of water, which is in large supply. An individual would prefer no diamond to no water but he would rather have another diamond than another glass of water.
The author of The Little Big Number apparently does not understand the function of property rights. He sees externalities everywhere and constantly calls on government, which is both a knight in shining armor and a black box, to legislate and regulate. He cites Coase twice in footnotes, apparently and strangely invoking him against GDP.
Under Philipsen’s pen, finance is a dirty word and a fuzzy concept. It is used as a synonym sometimes of money, sometimes of physical capital. Another time, “financialized” is identified with “given a price.” He does not seem to understand that financial assets are claims on physical capital and that it is normal that capital exceed annual GDP, just as a machine is worth more than the profits it generates in one year.
Philipsen argues that society and the economy must be reinvented according to “intelligent political design.” He does not explain how such constructivism works. He does not cite Friedrich Hayek even once.
Understanding GDP / It is not obvious that Philipsen understands what GDP is. For example, he claims that “modern governments … generate almost half of GDP.” This is not correct. Although public expenditures including transfers are often close to and sometimes above 50% of GDP, government production (strangely measured by its purchases, as we saw) is around 45% of public expenditures. In the United States, where total government expenditures represent about 40% of GDP, government thus “generates” slightly more than 20% of GDP.
Philipsen also falls prey to Frédéric Bastiat’s broken-window fallacy: he sees “robust GDP growth in the wake of disasters.” This makes sense only if there was Keynesian unemployment when the catastrophe hit; otherwise, resources for repairs and reconstruction are just diverted from what they would otherwise have produced. The accounting of GDP is consistent with this criticism of the broken window fallacy.
Some statistics reported in the book are questionable or unfindable. Some statements are at best metaphorical. For an example of the latter, we read in The Little Big Number that “humans are the only species that tolerates in its midst things like poverty and unemployment, despite an overabundance of wealth.” I am not sure that all chimpanzees have access to the best food (and all males to the best females) and are employed full-time at twice the primates’ minimum wage.
Petersen constantly attacks the “one percent”—the top percentile of income earners—and suggests that income equality is unacceptable both in the United States and in the world. But if inequality is unacceptable in the world, most Americans are on the wrong side of “social justice.” According to humanprogress.org (a project of the Cato Institute, publisher of Regulation), any American with a net income of more than $32,400 is among the top 1% of incomes in the world. Some back-of-envelope calculations with tax statistics suggest that four in 10 American taxpayers are among these. Similarly, a person receiving only the basic income entitlement that Philipsen proposes ($15,000 per year) would rank among the top 10% of income earners on the planet.
Anti-GDP elitism / What Philipsen fundamentally does not like about GDP is that the measure represents, however imperfectly, what consumers want. The preferences of most consumers do not correspond to his own preferences. He does not seem to like tobacco, fast food, guns, bottled water, “a sedentary life on stuffy couches,” Walmart, Facebook, or cars. He likes what the intelligentsia like, such as education, walks in the woods, beautiful bathrooms, tasty food, poetry, and “tight-knit communities” (although, as a practical matter of revealed preferences, intelligentsia denizens often live in cosmopolitan environments).
Philipsen proposes to redefine the economy around his own preferences, with the possible help of “several international leaders of either the caliber or political understanding of … Elizabeth Warren.” But “another scenario,” he tells us, could give the job to “enlightened bureaucrats and academic elites.” I suspect he is not opposed to his “reconstituted political and legal enforcement agencies” having guns to enforce his preferences.
Philipsen would protest that it is not what he likes that must be produced, but what “we, as a society” want. He does not understand that individual preferences cannot easily (if at all) be aggregated into social preferences and expressed as collective choices. He believes in methodological unicorns like the “satisfaction of the social body.”
He does not see that no “democratic dialogue” or “public conversation” can lead to unanimity, except perhaps at the level of an abstract constitutional contract à la James Buchanan. (Philipsen does not mention Buchanan’s work.) He does not understand Hayek’s point that each individual has his own goals and that a free society cannot impose a single goal on everyone.
A Glaring Misuse of GDP
Among the many forms of GDP misuse, one is obvious, frequent, and dazzling. It stems from an interpretation error that officials of national statistical bureaus readily recognize but apparently do not care to correct. (See “Are Imports a Drag on the Economy?” Fall 2015.)
One of the main accounting identities of NIPA states that GDP is equal to the sum of consumption, investment, government expenditures (excluding transfers), and exports. In other words, it is the sum of domestic production flows to domestic consumers, domestic purchasers of investment goods, domestic governments, and foreign importers. In still other words, the production side of GDP is equal to its expenditure side: everything that is produced is purchased.
This is an accounting identity, which means that it is true by definition and cannot be false. It is necessarily true because anything produced that is not purchased by domestic consumers, businesses, governments, and foreign importers will pile up in inventories, which is a form of (unintentional) business investment. Investment is defined as including (besides fixed capital) whatever remains after intentional purchases. This is how accounting identities are necessarily true in the real world: some residual adjusts as a matter of definition.
We could write our accounting identity as:
GDP = consumer expenditures + business investment + government expenditures + exports
provided that we took consumer expenditures, business investment, and government expenditures as including only goods and services produced domestically. As its name indicates, gross domestic product is made of domestic production only.
In the statistics that are actually collected, however, consumer expenditures (normally represented by C), business investment (I), and government expenditures (G) include some imported goods and services. The Chinese-made fishing rod you bought at Walmart was captured in C; the printing press a newspaper company bought from Germany was part of I; and the salary of the foreign consultant hired by the government was included in G. Consequently, it would not be correct to write our accounting identity as GDP = C + I + G + X (where X represent exports), because imports are captured in the right side of the equation and should not be included.
To solve this statistical problem, the accounting identity is written as:
GDP = C + I + G + X – M
The term – M cancels the imports that are hidden in C, I, and G, as any good macroeconomics textbook explains.
If one did not have a good textbook in his introductory macroeconomics class or never took such a class, being misled is easy. The problem is compounded by the fact that X – M is often grouped inside parentheses so that the accounting identity is remembered as:
GDP = C + I + G + (X – M)
For the non-expert, the last equation can easily suggest that (X – M) is the balance of trade. This interpretation error is further encouraged by experts who call (X – M) “net exports.” To repeat, it is only “net exports” if you forget that – M is used only to cancel the imports that, in the process of data collection, were included in C, I, and G. In other words, the term – M is a statistical trick.
Imports are not deducted from GDP. They cannot reduce the statistical measure of GDP because, by definition, they are not part it.
In its press releases, the BEA continues to write that imports “are a subtraction in the calculation of GDP” (see, for example, its release of August 26, 2016). This is not wrong when you know, as BEA economists do, that imports are subtracted after being added; but it is highly misleading. The typical journalist concludes that imports reduce GDP and transmits this impression to his readers, fueling protectionist sentiments.
Collective choices—“an economy that works for what we want”—imply that some will impose their views and lifestyles on others. To paraphrase H.L. Mencken, Philipsen’s proposed political system is one in which common people don’t know what they want and will get it good and hard.
If you do read this book, which will be released in paperback this spring, it may actually make you fall in love with GDP. It is an imperfect measure for sure, but one that is not based on the personal preferences of ivory-tower elitists. “ ‘No growth,’ ” notes Coyle in her book, “is for the rich.”
MIXED BAG
Technically, as Samuelson demonstrated, more GDP is neither a sufficient nor a necessary condition for increased welfare. Economist Robert Higgs counters that “if GDP is to make any sense at all, it must do so in relation to some concept of economic welfare” (emphasis in original). Otherwise, why would we be interested in such a figure? But, Higgs argues, it is an “exceedingly poor” measure of welfare. However, it seems to me, a poor measure is not always useless. GDP statistics can sometimes provide useful information. For example, observing a large increase in GDP per capita over a long period of time, or a much higher GDP per capita in one country than in another, helps document the likelihood that welfare is higher for most people.
A related criticism is that GDP is mainly, in practice, a tool for state dirigisme. It is bound to be misused (see sidebar). This is a serious problem, and our evaluation of GDP (and other NIPA statistics) must be mixed. GDP is not useless, but it must be used with caution.
With a view to the long term, we may ask if it should be government that produces these statistics. Why not leave them to academic research groups such as the National Bureau of Economic Research (which was a pioneer in the field)? The advance of Big Data could lead to competing estimates from various private institutes. Already, ADP Research Institute and Moody’s Analytics, two private organizations, jointly produce monthly employment statistics based on payroll data collected by ADP, a payroll services company. The problem with the Japanese GDP figures, which I mentioned in the introduction, appears to stem partly from fewer people answering government surveys and censuses (Financial Times, September 29, 2016), a problem that Big Data analysis could potentially solve.
In the shorter term, we should try to minimize the dangers of GDP in at least two ways. First, we should push for a methodological rethink of the contribution of government to GDP. Second, we should insist that official statistical agencies do not use GDP figures to mislead journalists and the general public.
Readings
- “A Review Essay on GDP: A Brief but Affectionate History by Diane Coyle,” by Moshe Syrquin. Journal of Economic Literature, Vol. 54, No. 2 (2016).
- “Evaluation of Real National Income,” by Paul A. Samuelson. Oxford Economic Papers, January 1950.
- “Gross Domestic Product: An Index of Economic Welfare or a Meaningless Metric?” by Robert Higgs. Independent Review, Vol 20, No. 1 (Summer 2015).
- Measuring the Economy: A Primer on GDP and the National Income and Product Accounts, published by the Bureau of Economic Analysis. September 2007.
- “U.S. National Income and Product Accounting: Basic Definitions and Concepts,” by Liegh Tesfatsion. Iowa State University, undated.
