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Tuesday, April 20, 2010

GDP: Who Needs It?

“For so it is, oh my Lord God, I measure it, but what it is that I measure I do not know.” –St. Augustine

Gross Domestic Product (GDP) gets a lot of attention these days. It’s fair game for bloggers, talking heads, perhaps your local barber.  While most agree that higher GDP is better than lower, there are problems, some better-known than others. Some theorists have considered the concept hopeless, such as Austrian economist Oskar Morgenstern, who called GNP (the predecessor to GDP) “primitive in the extreme and certainly useless.” Lamenting the idea that the whole of a nation’s economic activity could be captured in a single number, he said that “very few men, even few economists, or should I say regretfully, especially economists, have a real appreciation and understanding of the immense complexity of an economic system.”

Let’s get the formal definition out of the way. GDP is the market value of all final goods and services produced in a particular country in a given year. The federal Bureau of Economic Analysis computes this number and releases it quarterly. The level of GDP is used as a basis for evaluating other things, like the national debt, which currently stands at about 85 percent of one year’s GDP in the United States. GDP growth rates are closely followed. These are inflation-adjusted, seasonally adjusted, and annualized, and are of course supposed to tell us how well the economy is doing.

Simon Kuznets gets credit for the first serious attempt to calculate national income figures, publishing his first work on the subject in 1941. Following in his footsteps, calculation of GDP and other “national income accounts” has become a core area of the economics profession. The explosion of economic and financial news has thrust GDP into the limelight in recent years.

If high GDP growth is good, low is bad and negative is worse. A recession is informally defined as two consecutive quarters of declining real GDP. We had four quarters of declines during 2008 and 2009, the low point being negative 6.4 percent annualized in the first quarter of 2009. The third quarter figure was positive 2.2 percent and the revised fourth quarter figure was 5.9 percent, suggesting that the recession is ending. But as was widely reported, much of the third quarter figure was due to the Cash for Clunkers program, which has earned widespread scorn for its wastefulness. The fourth quarter figure was boosted by inventory replenishments.

Robert Kennedy had this to say about GNP in a 1968 speech: “The Gross National Product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile.”

Kennedy had a point, even if he overstated it. Indeed, GDP excludes household production, charitable services, bartered goods, and illegal production. If a mother stays at home to care for her children, her services don’t count. If she takes a job, both her production and the daycare services that she buys are counted. Production of marijuana, a good that many people value, is not counted–not in the United States, though it is in Canada. Economist Peter Bauer used to say that the birth of a cow increases per capita GDP, while the birth of a child lowers it.

Further problems arise in tracking GDP over time. One is inflation, which can be accounted for by using a price index to adjust the figures–though price indices are themselves problematic. Price indices are skewed by the introduction of new goods and services and by improvements in quality. For example, we get a lot more personal computer for our money than we did even five years ago. Statisticians use sophisticated techniques called “hedonic adjustments” to try to account for such developments, none of which can fully overcome the inherent subjectivity of things like quality.

Overblown adjustments of computer quality may have misled former Fed chairman Alan Greenspan into an exaggerated view of productivity gains during his tenure. In fact, the BEA quietly dropped hedonic adjustments for computers in 2003.

Comparisons of GDP per person between different countries raise different kinds of problems. Even in Guinea-Bissau, for example, can anyone really live on $461 per year, the per capita GDP figure reported by the International Monetary Fund? People in that impoverished West African country are much more likely to grow their own food and to barter among themselves, and because money is not involved, such production isn’t counted. If it could be counted, the $461 figure–about $1.25 per day–would likely be a lot higher, though still far short of the U.S. figure. Another problem is that the exchange rates that must be used in translating Guinean GDP from CFA francs into U.S. dollars may be unrealistic.

Government purchases are counted in GDP. The problem here is that because these are not market-tested transactions, their contribution to general welfare is dubious. Thus GDP soared during World War II due to production of war materiel. This production did not benefit citizens directly, though one might argue that it provided future welfare by helping to win the war. But because wartime GDP numbers shot up, almost everyone believes the war ended the Great Depression. In fact, as Robert Higgs showed in his book Depression, War, and Cold War, the war brought shortages, controls, rationing, prohibitions, conservation and limitation orders, and endless propaganda–hardships difficult to quantify but nonetheless real. Genuine recovery came only after the war, when the economy was substantially decontrolled.

In fact, reservations about GDP date back to Kuznets himself. “The welfare of a nation can scarcely be inferred from a measure of national income,” he once said. Although that’s exactly what people have tried to do, a backlash has been growing, more so since the recent economic crisis began.

Gross National Happiness?

Recognizing the shortcomings of GDP, many smart people are trying to invent better measures of human welfare. The Organization for Economic Co-operation and Development (OECD) is leading this effort. It is trying to devise measures that go beyond GDP to include health, knowledge, arts and leisure, and interpersonal relationships, among other good things. The OECD is expending a great deal of effort on this project, staging international conferences and producing many publications. It will be interesting to see how it proposes to attach numbers to some of these highly subjective matters and to do so in a way that will stand up to comparisons over time and across national boundaries.

The remote Himalayan kingdom of Bhutan has been attempting to define and apply “gross national happiness” for some years. “Happiness takes precedence over economic prosperity in our national development process,” the king declared in 1971. To this end, a bureaucracy has grown up and five-year plans have been produced. But it is not clear that this attempt to graft a form of socialist planning onto the Buddhist traditions of Bhutan will in fact bring smiles to the faces of the ordinary people of that country. The authorities did find one way to increase average national happiness: They simply expelled thousands of unhappy ethnic Nepalese who were said to be residing illegally in the Kingdom.

Consumption constitutes about 70 percent of GDP (the rest consists of investments, government purchases, and net exports). The predominance of consumption seems to have spawned the bizarre notion that if we can only get consumer spending up, GDP will rise and everything will be fine. Thus we have gimmicks like the $600 checks the Bush administration sent to most households. But consumption is an end in itself–it is the purpose of all economic activity, not a means to boost GDP. If people believe they need to save more, they will have to forgo some present consumption, and this may lower GDP temporarily. Savings, wisely invested, boost future consumption. But that future may not arrive until after the next election.

GDP has become a report card for the president. It’s his job, says conventional wisdom, to make the economy work. We must trust him, the Fed chairman, and all their expert advisers to manipulate the levers of fiscal and monetary policy so that things will come out just right. Never mind the stagflation of the 1970s that the experts said couldn’t happen. Never mind that unemployment remains high despite all the “stimulus” spending. Keynes is back from the dead.

Perhaps it’s time to quit trying to improve or replace GDP numbers and instead focus on the timeless principles that promote human welfare. “There is but one means to improve the material well-being of men, viz., to accelerate the increase in capital accumulated as against population,” Ludwig von Mises said. Capital accumulation requires saving, saving requires confidence, and confidence flourishes amid objective law, low taxes, and minimal regulation.

  • Warren Gibson teaches engineering at Santa Clara University and economics at San Jose State University.