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. 

U.S. GROWTH - WORSE THAN WE THOUGHT

Once a year the Bureau of Economic Analysis revises the Gross Domestic Product data series, from which the often-quoted GDP growth is derived. The revisions aim to improve the quality and accuracy of the data, and they are the result of a very extenuating evaluation of the source data used to calculate GDP.  The revisions typically show several major findings, however the media tends to focus on overall growth figure, such as the headlines following Friday's release of the second quarter, 2015 estimates:

"Economy bounces back: GDP grows 2.3% in second quarter (USAToday)"

"First reading on Q2 US GDP at 2.3% vs 2.6% expected (CNBC)"

this is all true. Reading further in those articles sometimes we may read commentary on the impact of those revisions, such as the latest one which resulted in a lowering of GDP for both 2012 and 2013. 

Although, as the bottom graph on the chart to the right shows, some quarters were revised upwards and others downwards, the net impact has been to reduce growth over the last few years. While previously average annual growth was pegged at 2.3% between 2011 and 2014, currently the estimate is for only 2.0%. These dismal figures reinforce the weak growth that the U.S. economy has had since the end of the recession, a full six years ago. 

Annual growth since the second quarter of 2009, when the recession was officially declared over, has averaged only 2.1%. This is close to European standards, the example that Krugman and other economists wish the U.S. should follow; that is, adopt policies like the European countries have favored for the last 30 years or so, and that have brought them continuous stagnation, high unemployment, and unbearable debt loads.

Failed Government Policies

But the sad truth is that all the "GDP boosting" policies of both the Federal government and the Federal Reserve Bank have failed. The Federal government debt has nearly doubled since the third quarter 2007, at the onset of the recession. At that time, debt amounted to $10.2 trillion, and it has jumped to $18.2 trillion today for a total increase of $8.1 trillion- this is an 81% increase in just seven years. To put it in a dramatic perspective, in seven years we've acquired debt equal to that incurred in the 226 years between the time the U.S. became a country, in 1789, and 2005- a remarkable feat. 

At the same time, the Federal Reserve Bank has increased what is misleadingly called its balance sheet, by well over $3.8 trillion. Just out of thin air, the Fed has purchased $3.75 trillion worth of U.S. securities since August 2008. That is, in the earlier period it held securities worth $479.6 billion, and today it is the proud owner of $4,231 billion of U.S. securities. It is interesting to note that nearly half of the U.S. government debt issued since the recession has been acquired by the Fed; that is, it has been monetized. 

But all of this spending and money pumping has not produced anything other than creating a stock market bubble. The impact on the economy has been minimal, at best. Actual GDP has risen by only 9% in total since the recession onset. Real GDP in the fourth quarter of 2007 was running at an annual rate of just under $15.0 trillion; it has risen to only $16.3 trillion since then. This translates into a 1.1% annual rate over the 30 quarters in this time. This is very poor performance indeed; both by itself and compared to our experience in prior recoveries. The bottom graph on the chart to the right shows the U.S. performance in all recoveries since the end of the Second World War, beginning with the 1949 recession. Since it's been 24 months since the end of the Great Recession (that should be called the "Lingering Recession" perhaps), we calculate average GDP growth, at annual rates, for the same period after each recession ends. The lowest average growth for all post-recessions is the latest one, at only 2.1% - clearly this is the worst by far of all other periods.

How Accurate are the Data?

One issue that is usually ignored in all the discussions on GDP growth is the accuracy of the statistics. Aside from the fact that they try to measure perhaps the wrong things, the revisions suggest that the data can not be reliably used as a guide for business. Take the first quarter of this year. The initial data release suggested that the economy had actually slowed significantly, in fact it had gone backwards since GDP shrank two-tenths of a percent (-0.2%) (what many economists state nonsensically as "negative growth," an oxymoronic word if I ever heard one.) But contrary to the initial release that the economy had shrunk in the first quarter, the revised figure tells us that in fact the economy grew modestly by slightly over half a percent. And these revisions are a common occurrence. I am not suggesting that I would want them not to revise the data, but that we should look at these figures with some degree of skepticism.
A few years ago, well actually many years ago, the economist Oskar Morgestern (see the brief biographical note below) wrote a book aptly titled On the Accuracy of Economic Observations. There he deplored the practice of government agencies issuing data that typically give the impression of being very accurate and precise, while they have a high degree of uncertainty. In all fairness, I should admit that the agencies usually footnote the sampling errors in the data, but they are not strongly highlighted. Analysis of the revisions to historical GDP data and their revisions, reveals that the growth rate for a specific period may be revised in the future by an average of 1.6 percentage points. For example, this means that a 2.5% GDP growth rate could end up being either as high as 4.1% or as low as 0.9%- which is a wide variation in fact.

EconLives
My plan for this blog was to provide brief biographies of economists from time to time. Let me start with Oskar Morgerstern.

He was an economist born in Germany  in 1902, grew up in Austria and studied at the University of Vienna, where he obtained a PhD in Political Science in 1925. After this he attained a scholarship from Rockefeller Foundation to study in the U.S., where he stayed until 1929. Subsequently he moved back to Vienna and taught at the University of Vienna for a few years until an invitation to visit Princeton University came in 1938. He was in the U.S. just about the time that Hitler took over Austria in the infamous Anschcluss, so Oskar decided it was wiser to remain here. He was a faculty member in Economics at Princeton until his retirement in 1970, when he took a position in New York University until his death in 1977 (like many people today he continued to work past retirement age!)
Besides the book on economic measurement mentioned above, he wrote jointly with the mathematician John Von Neumann the first book on game theory, titled Theory of Games and Economic Behavior, the book for which he is best known. Morgenstern was one of the economists in the "Austrian Schoool" of economics- a group known for voicing an economic theory radically different and opposed to the Keynesian paradigm. He worked with Ludwig von Mises, Friedrich von Hayek and others while in Vienna, although his work on economic theory tended to be more technocratic, and emphasized a mathematical approach that is anathema to the Austrian school. But at heart he was a strong believer in free markets and free association.

Game theory has been famously brought to prominence recently by Yanis Varoufakis, who was touted and feared as an expert in game theory when he was appointed as Finance Minister in the Greek government. Underlying all the media statements and opinions when Varoufakis was appointed, was the implication that the Greeks had now the upper hand in all discussions with the European Union, and the Euro group primarily, regarding the huge Greek debt load. Yanos had in game theory the silver bullet that would solve the problem. We all know now how it all ended up. The Euro group, dominated and led by the Germans, particularly by the influence of Wolfgang Schauble the German Finance Minister, crushed the Greek government's claims and forced them to surrender their position. Game theory met its match, German might.