GDP - THE MEASURE THAT ISN'T

In a recent post I discussed the issue of accuracy of economic data, focusing particularly on Gross Domestic Product or GDP (http://econlives.blogspot.com/2015/08/us-growth-worse-than-we-thought.html). Here I want to address misconceptions commonly held about the definition and content of GDP itself, that lead to misunderstandings and incorrect policy prescriptions. It is commonly held by many people, including journalists and economists, that GDP is a measure of an economy's size, and sometimes even a measure of an economy's health and the wellbeing of the population. These misconceptions lead people to think that an increasing GDP, commonly referred as GDP Growth, is the end-all purpose of an economic system. Positive GDP growth is automatically taken to be a good thing, that unquestionably it is a sign of progress. Moreover, a high GDP growth rate is automatically seen as better and more desirable than a low one. This high growth is interpreted as a signal that the economy and the well being of the population are improving. But in reality such is not always the case, these interpretations are often incorrect.

GDP is not the same as Production
The most commonly made mistake is to confuse GDP with production within a region, the U.S. in our case. Typical is the view of Sho Chandra, for instance, a reporter at Bloomberg who recently referred to Gross Domestic Product as "the value of all goods and services produced." Also, the common error of equating GDP with "total" production can be found not only in Wikipedia, as one would perhaps expect, but also in statements by such venerable institutions as the OECD, that defines GDP as

"an aggregate measure of production equal to the sum of the gross values added of all resident, institutional units engaged in production"

Which is not an improvement over the commonly held understanding of Bloomberg and others.

Also, the U.S. agency that comes up with the GDP data, the Bureau of Economic Analysis, defines GDP slightly different by adding the phrase

"less the value of the goods and services used up in production..."

This statement brings to the forth a key point to understand what GDP measures. It does not include any goods or services that were used in the production of other goods. For instance, a chair that is purchased by a consumer in a given quarter will show up under Consumption in the GDP accounting. But the materials used to make that chair, such as the wood, glue, nails, paint, etc. are not counted on GDP because they want to avoid the so-called "double-counting." All those things (wood, nails, etc.) were produced but are not counted, thus GDP is not a measure of production as such. A true measure of production would include all those "intermediate" goods that are used to make the final goods that consumers purchase.

A more subtle misconception is the implicit assumption that GDP represents the value of things or services produced in the period in question, whether it's a quarter or year. The first term in the equation making up GDP, "consumption," attempts to capture the purchases of goods and services made by consumers in the quarter in question. But those purchases may be of goods that could have been produced in a previous quarter or year. Naturally perishable goods such as food items, were very likely produced within the same quarter; but this may not be the case with more durable items that last longer than a quarter, such as cell phones, appliances or canned food, that were very likely produced in previous quarters once we take account of the time lapsed between their production, inventorying and shipment to the final destination where a consumer may purchase it. That is, consumption of goods in a specific quarter is not equal to production of goods in that quarter.

Thus, the largest component of GDP, consumption, does not truly reflect production but rather consumer purchases of goods that may have been produced at different times.

GDP is not Demand
Another common mistake is to equate GDP with demand, such as the statement coming from none other than the chief economist at JPMorgan Chase, who said that this is a "pretty broad-based pickup in domestic demand." This also is not entirely true when we see that one of the components of the arithmetic definition of GDP as

GDP = Consumption + Investment + Government Spending + Exports - Imports

Includes the element "Government Spending" which reflects the amount of money that the various governmental entities spend on providing "services." Now, only a confused mind would equate the services of government, many if not all of which are foisted unto the public whether or not such public wanted them. So, in a strict sense, government services can not be equated with demand and therefore defining GDP as national or domestic demand is incorrect.

GDP does not represent the health of an economy
But the most troublesome, and perhaps misleading, interpretation is to take Gross Domestic Product as an indicator of the health of an economy. This is a common misunderstanding. Investopedia, a website that is presumably designed to give advice to investors, defines that GDP is one of the primary indicators used to gauge the health of a nation's economy. But, why is it wrong to equate GDP with an economy's health?

After hurricane Sandy hit the Northeast back in 2012, Forbes published an article pointing out that the devastation caused by the hurricane could reach $50 billion but "at the end of the day, Sandy may end up being beneficial to the U.S. economy." (Forbes, Nov 6, 2012). In addition to other comments touting how despite Sandy leaving "many casualties in its path...it could have a positive economic impact in the near-term." The conclusion one draws is that disasters are good for the economy since we should expect the post-disaster reconstruction and rebuilding to boost GDP. Somehow they just see the cost of reconstruction as a good thing but ignore the huge losses of wealth caused by the disaster. The economy is not healthier because of the post-disaster spending- it is poorer because what is lost can never be recovered.

The economists at Forbes, Goldman and similar outfits who focus on the growth resulting from a disaster, fall prey to the broken window fallacy. They only see the spending that occurs after a disaster but ignore two important things. One is the loss of wealth that occurs in a disaster that is much greater than the spending after the disaster. The other is the fact that the funds used in the post-disaster reconstruction have been diverted from other uses. The broken-window fallacy was cleverly discussed by the French economist Frederick Bastiat more than a century and a half ago (here is an article explaining the fallacy in a more recent context https://mises.org/library/broken-window-fallacy)

GDP does not reflect how an economic system works
Another misinterpretation is to take this definition of GDP as a true representation of how an economic system works. Thus, the equation becomes a tool that can be used to finesse the economy's performance. If GDP is falling, or even GDP growth slowing down, the usual prescription is to try to change one of the components, such as increasing government expenditures, and by definition the problem is solved. Such was the case after the 2008 recession when the Federal government engaged in extraordinary spending to boost GDP. But all this spending did not improve economic performance- GDP growth has remained anemic since then.

Unfortunately they do not realize that the economic system is not like a machine whose performance can be improved by moving some levers.

What is the alternative?
In reality there is not a single alternative to GDP. Not even the silly concept of Gross National Happiness that was introduced about 50 years ago in Bhutan, a country that ironically at that time was an absolute monarchy. The solution lies in taking a broader view and inspecting a number of economic statistics, such as employment indicators, production statistics, price information, etc. Only such a holistic view can give a true assessment of the health status of an economic system and whether the economy is prospering or not.

In a future post I will discuss Gross Domestic Output, an alternative measure that the Bureau of Economic Analysis has been releasing periodically and that can serve as a better measure of the nation's production output.