But there are those who argue that GDP is fundamentally flawed and should be replaced. Sadly, some of them show a lamentable lack of understanding of accounting and the methods used to calculate GDP. For example, here is Steve Forbes:
GDP represents the value of all final products and services. It ignores all the steps that go into the making of these things. It’s sort of like looking at a carton of milk and paying no heed to everything that goes into creating that milk and getting the carton onto the store shelf.
GDP thus gives a distorted picture of the economy. How many times do we read that consumption represents 70% of the economy and therefore it’s important to “stimulate demand” by increasing government spending?And he goes on to recommend using gross output (GO) instead of GDP, arguing that it "measures the economy in a far more comprehensive and accurate manner".
To show why this is seriously flawed, I need to explain a bit about how GDP is calculated. Experts on this will no doubt call me out on being far too simplistic - GDP is an incredibly complex measure and its calculation is close to being a black art. But this post is not aimed at experts. It's aimed at ordinary people whose opinions are swayed by the likes of Steve Forbes.
GDP can be calculated in three different ways - the expenditure approach, the income approach and the production approach. The first of these adds up all the forms of expenditure in the economy, giving us the familiar formula:
GDP = C + I + G + (X-M)
where C is consumption spending, I is investment spending, G is government spending and (X-M) is net exports(imports).
Steve Forbes complains that imports are treated as negative for GDP. But this is a no-brainer. If you buy imports, money leaves the country. If you sell exports, money comes into the country. Purchases of imports are therefore correctly a negative for GDP. (But profits from sales of products made with imported goods are positive.)
The second way of calculating GDP adds up all the sources of income in the economy:
GDP = W + P + R + I + D+ (T-S)
where W = wages & salaries, P = corporate profits (or operating surplus), R = rents, I = interest, D = depreciation and (T-S) = net taxes after subsidies.
As total spending = total income, the first and second methods should give approximately the same result, though measurement errors do create some difference.
But it is the third way of calculating GDP - the production approach - that Steve Forbes is complaining about. It takes gross output (yes, THAT gross output) and eliminates intermediate outputs to give the gross value-added output for the economy. Like many, Steve Forbes does not seem to understand why intermediate outputs are eliminated. But it is because intermediate outputs are used to create final output. To show this, I'm going to use Steve Forbes' own example of milk production. (Please note the figures are entirely fictitious. I have absolutely no idea how much it actually costs to produce, package and market a litre of milk.)
- Farmer X has a herd of dairy cows. The cost of maintaining his dairy herd is $1,000. They produce 1,000 litres of milk which he sells to a supermarket for $1.10 per litre. Gross sales are $1,100 and profit is $100.
- Manufacturer Y produces the cartons for milk. Production cost is $200 for 1,000 cartons and he sells the cartons to the supermarket for 25 cents per carton. Gross sales are $250 and his profit is $50.
- The supermarket puts the milk into one-litre cartons and sells it to customers at £1.80 per litre. The supermarket's unit costs are $1.10 + $0.25 = $1.35 per litre and they have staff costs and overheads amounting to a further 15 cents per litre. So if they sell all the milk, the gross sales revenue is $1800 and profit is $300.
So GDP does not recognise the value of intermediate outputs. But that doesn't make GDP wrong, any more than a set of consolidated group accounts is wrong because it has eliminated intra-group transfers. What Steve Forbes is proposing is replacement of consolidated business output with grossed-up business output to make the contribution of business to the national economy look bigger. I think they call this "cooking the books".
Currently, the US's National Income and Product Accounts only show gross output by sector. It is now planning to produce overall gross output figures as well, in parallel with GDP figures (this is the change that Steve Forbes is crowing about). This is a good addition to the national accounts: we do need to understand the contribution of intermediate producers, and sector analysis isn't always adequate since final products may be made from intermediate sources in several sectors. Also, in these days of global supply chains, intermediate sources may not be in the same country as the final output, in which case the intermediates arguably should be regarded as imports and their cost deducted from gross output (no wonder Steve Forbes wants imports to be treated as positive!). So gross output will be a useful measure. But it is not by any stretch of the imagination a replacement for GDP.
But it is the conclusion that Steve Forbes draws from this that worries me. Returning to the familiar expenditure equation GDP = C+ I+ G+ (X-M), Steve Forbes in effect argues that grossing-up business output would considerably inflate the importance of I in relation to C and G, since all those intermediate outputs would have to be included in investment spending. This would, in his words, "put business and investment in their rightfully large place". But this is bizarre. In what way is milk bought daily from a farmer "investment spending"? It is simply a cost of production and therefore belongs in C, not I. If you are grossing up, then businesses consume too.
Of course, it suits businessmen like Steve Forbes to claim that the driver of the economy is business output and consumption is an optional extra. But the sole purpose of business output is consumption. Businesses don't produce products unless there are people willing and able to consume them. Without C, there would be no I.
And this brings me to Steve Forbes' view that government spending is a negative. In days gone by, when governments mainly raised money to finance wars, this was a reasonable view: money spent on wanton destruction leaves the country never to return. But that's not what the majority of government spending is used for these days. Most government spending goes into the economy: whether or not it is effectively spent entirely misses the point. Businesses sell to government just as they sell to households. Government spending should therefore correctly be seen as positive in the GDP expenditure calculation, just as household consumption and business investment are.
So Steve Forbes's criticism of GDP is ill-informed and irrational. But GDP is certainly not without its problems. Its extreme complexity makes constant revision inevitable, and even with all that complexity it is still at best only a rough indicator of economic growth. If the inputs to the GDP calculation change significantly, the result can be large swings in apparent economic standing that have nothing to do with reality - for example, Nigeria has just reported an 89% increase in GDP that is entirely due to rebasing the components of GDP. And it leaves out all sorts of things - such as unpaid "home work" - for no particularly good reason other than that they are difficult to measure. Critics of GDP complain that it doesn't measure wellbeing (true), it doesn't adequately account for intangibles (also true), it gives greater importance to "making stuff" than providing services (true, but not surprising given when it was invented), and it ignores depletion of natural resources. All of these are valid criticisms.
Coyle gives a good summary of these criticisms in her book. But she then dismisses most of them. Replacing GDP, or changing it to include other factors, is not the point. The real problem is that we are expecting far too much of GDP. There cannot be "one measure to rule them all". The fact that GDP focuses narrowly on measures of expenditure, income and output is not a bug, it's a feature. We need other measures as well. Coyle suggests a "dashboard" of economic indicators for policymakers to enable them to judge the health and prospects of the economy and set policy accordingly. GDP (nominal and real) would be included in this dashboard but would not be the sole driver of monetary or fiscal policy.
As I am no fan of single targets such as CPI or NGDP, I like Coyle's idea. I am encouraged by the fact that both the Bank of England and the Fed are now using a "basket" of indicators, though they have not yet ended the primacy of the inflation target, because we still have not exorcised the 1970s inflation demons. But I am hopeful that we will gradually move towards a more balanced approach and start to include other indicators such as wellbeing and sustainable resource use in our measures of economic health.