GDP, or Gross Domestic Product, has been a pillar of macroeconomic analysis ever since the Great Depression. It is the most commonly used method of estimating the health and productivity of an economy. GDP is the most common iteration of “national income statistics”, which are intended to estimate the entire income of a nation over a period of time. GDP is the most common of these, although there are others that use GDP and adjust it, such as Real GDP, which attempts to remove inflation from the equation.
Although many economists view GDP as an important, albeit imperfect, tool of economic theory, is this reputation well deserved? I contend that GDP does not deserve this reputation, and that GDP is much more limited in its usefulness than many economists give it credit for. GDP can be used as a tool, but these uses are restricted and must be recognized as such.
GDP is calculated by adding 4 different figures. The first is all consumer spending on all final goods over a period of time. Secondly, add to consumer spending all investment into final goods over a period of time. Next, add all government spending on final goods. Finally, subject all imports of final goods into the nation from all exports of final goods out of the nation. Once all four of these numbers are added, the result is GDP. The usual form of the equation is below:
I will draw attention to a few details in this calculation. First, note that the spending added is only new final goods and services. Any previously owned final goods are not included in the equation. A hat bought at a thrift store or a used suit jacket bought online do not add to GDP at all. However, if one went down to a local department store and bought a new hat and jacket, those purchases would contribute to GDP.
Similarly, purchases of non-final goods are not included in the equation either. Any purchases of raw materials that a businessman will use to manufacture consumer goods do not contribute to GDP. In practice, this means that all purchases and exchanges of non-finished goods in the process of production for a good are not part of GDP.
First we will examine what GDP is not, and then what GDP is.
GDP is not a measure of the overall utility or happiness of a group or nation of people. Utility or satisfaction gained from any particular goods or services is completely subjective. If a country’s GDP is higher than others, but does not produce goods and services that customers value, then it is obvious that the higher GDP is little consolation for the consumers.
As Walter Block has pointed out, if society became twice as productive, we could keep our current consumption levels steady, but only work half as long. Even though everyone would undoubtedly see a rise in their quality of life, GDP would not rise at all!
GDP only measures purchases. If goods are produced, but never purchased, they do not contribute to GDP at all. A businessman may produce 1,000,000 new widgets each day, but if they are never sold, they do not contribute to GDP. Inversely, if the goods are sold, but never used, it still contributes to GDP. A new car that is crashed driving off of the dealership contributes to GDP just as much as if the car was used regularly for the next 15 years. The productive capacity of a nation is wholly different than the overall sum of final goods sold.
GDP is not a method to measure material standards of living. As previously pointed out, any previously owned, or used, goods that one may buy do not contribute to GDP. However, these goods do contribute to one’s own standard of living. Hypothetically, one could buy everything second-hand and these purchases would never contribute to GDP! Never would one say that this lifestyle would be the lowest standard of living possible, however. GDP only counts final goods, and thus can only compute the new goods coming into the economy, and thus, cannot take into account goods already present.
GDP is not a method to measure the health of an economy looking forward or a forecaster of recession. Increases in GDP could be the result of an unsustainable boom. Inevitably, the bust will be right around the corner. This is often the case, and GDP usually does not forecast a recession until it has already hit and GDP starts to drop.
GDP is not a method of measuring increasing productivity in an economy. Increasing GDP is often seen as a sign that productivity is increasing and that standards of living are on the rise. This could certainly be the case, but not necessarily. GDP as such does not factor out inflation. Real GDP, a separate statistic, accounts for inflation by factoring out the inflation rate from the base year. For example, if one wanted to know how much GDP has grown in real terms since 1970, you would take the growth in GDP since 1970 as the numerator, and the value of a 1970 dollar today as the denominator.
On the surface, this seems to be a valid method for calculating how much GDP, and by extension, productivity, has risen over a period of time. The crucial flaw is with the inflation rate. Inflation itself cannot be calculated into a single rate, and thus, is not a method of cancelling out its effect on GDP.
The reasoning for this is as follows: Imagine over the course of a year we see an increase in price for Good A from $1 to $2, an increase in price for Good B from $4 to $10, and a decrease in price for Good C from $6 to $5. Let’s say that there is also an inflation in the money supply amounting to a 50%. In this hypothetical situation, what is the rate of inflation for the year?
This is more complicated than simply applying the rate of inflation to the price of each good. If the only influence on prices is inflation, we would expect a roughly 50% increase in prices for each good. However, the price of each good is also influenced by the everpresent factors of supply and demand. Increases in demand puts upward pressure on prices just as an increase in the supply of money would.Therefore, in order to determine the effect of inflation on prices, we would have to separate the effect on prices from changes in supply and demand versus effects from inflation. Inflation, while being an increase in the supply of money, must mean that someone is receiving the money to spend, and thus, their income is temporarily increased. The process of increases in prices from inflation starts with individuals with increases in their own incomes increasing their demand for certain goods. Thus, we can see that there is no qualitative difference between increase in demand coming from inflation as opposed to an organic increase in demand!
Because of the impossibility of isolating just the effects of inflation on prices, there is no way for us to put an exact number on the “rate of inflation”. This does not mean that we can have no idea whatsoever about inflation’s effect. No one would ever claim that we don’t really know if the hyperinflation in the Weimar Republic was caused by increases in the supply of money. Large increases in prices, seeing no large decreases in supply or increases in demand, would be largely attributed to inflation. However, a precise number cannot be determined, and thus, cannot be separated from GDP.
A very precise definition of GDP is necessary to avoid any confusion about its nature or its legitimate uses in economic theory. GDP is the total sum of all produced final goods or services sold over a period of time. At the expense of sounding redundant, I will carefully parse through the definition. GDP is the sum of only the final goods and services that have been produced, and have been sold on markets in a given period of time. Any definition that is more vague is likely to lead to error in application.
What Applications Exist for GDP?
Thus far, we have ruled out many different possible applications for GDP in economic theory and policy. This begs the question, what are the legitimate uses, if any, for GDP?
There are several useful applications of GDP, but these are significantly more restricted than the mainstream uses. GDP can be used to generally estimate the growth or shrinkage of an economy. However, this can only be done where we can estimate inflation and its effects on GDP growth. In a long-run scenario, this is much easier than in the short run. Discounting as best we can the effects of inflation, we can then estimate by how much GDP, and thus the economy overall has grown.
We can use GDP in the short-run in certain scenarios, but only where there are sudden and drastic changes to the economy. For instance, let us say that Ruritania declares war on Boldovia, but loses the war badly and Ruritania has been effectively destroyed over the course of a few years. In this instance, we could use GDP as a tool to roughly estimate by how much the Ruritanian economy has diminished, because inflation is likely much less than the discount in GDP, and can be estimated out of the result or ignored altogether.
Ever since its inception, GDP has been used as an economic crutch of sorts. Economists regularly point to it as an indication of the progress of standards of living and society as a whole. GDP is, fundamentally, an abstraction. Economics is a science of individuals, with only limited room for aggregate concepts. GDP is the king of these concepts, but should rightfully be demoted.
Originally published at https://www.thejwrich.com on February 19, 2020.
