The real meaning of GDP

This is my Perspective column from this week’s Fund Strategy magazine.

Although GDP is central to much economic and financial debate, it is remarkably poorly understood. Experts pore over every statistical release and every subsequent revision but rarely question the meaning of the measure itself.

This one-sidedness was clear in the recent preliminary estimate for the Britain’s GDP for the second quarter of 2013.

Even before the 0.6% increase was announced, a huge volume of words was expended discussing what the level was likely to be. Once the figure was released, the debate about the significance of the numbers was redoubled. Yet few considered what exactly the indicator meant.

On the other side of the Atlantic the recent revision of the GDP figures all the way back to 1929 also raises questions. Statisticians from the Bureau of Economic Analysis, part of the Commerce Department, are recalculating the data to give greater weight to intellectual property such as books, films, music and television shows. As a result of this exercise, America’s GDP will rise by about 3% at the press of a calculator button.

Of course there will be no real increase in the level of output. The statisticians will simply argue that the updated figures more accurately measure the real amount produced.

To understand the true significance of GDP it is necessary to go back to basics. Once some of the main features of GDP are understood it will be possible to see why many of the criticisms made of the measure are replaced. Although GDP is far from perfect, many of the critics simply fail to understand what it is meant to measure.

At its simplest GDP is the monetary value of all the goods and services produced in a country over a specified period, usually one year. It can be measured in three ways:

1. Value added: A measure of production calculated by adding the value added in all sectors of the economy less the costs of raw materials.

2. Income: The income from several sources including employment, self-employment, rent and company profits.

3. Expenditure: The value of all goods and services bought including, among other things, personal consumption, capital investment and government spending.

In theory all three measures should give the same amount. For example, national output should be equal to national income. That is because production is ultimately the source of all income in the economy.

But in practice there are often significant differences between the three measures.

The most common criticism of GDP is about what it leaves out. Environmentalists point out it does not take into account environmental damage, egalitarians that it fails to incorporate income distribution and feminists that it does not measure domestic work. It is also often argued that it does not measure happiness or human welfare.

Most critics naively assume such points are new. Although they often congratulate themselves on discovering what they assume are unrecognised flaws many were actually recognised decades ago.

If they cared to look further they would see that Simon Kuznets, the inventor of national income accounting, anticipated many of these criticisms at least as far back as the 1930s. In an official report published in 1934 he pointed out: “The welfare of a nation… can scarcely be inferred from a measurement of national income.”

One reason Kuznets gave for this gap is that national income measures do not take into account the distribution of income. For example, a given level of income could, at least in theory, go almost entirely to a tiny clique of individuals or could be dispersed widely. The wider distribution would almost certainly be better for social welfare than the former. He also pointed out that measures of national income did not take into account the “intensity and unpleasantness” of work.

He also considered domestic work, or what he called the “services of housewives and other members of the family”. Family members do an awful lot of work inside the home but it does not count towards GDP. Since such work is a form of production it at least has some scope for inclusion in the measure.

One practical reason for not counting it is that it is hard to measure its monetary value. For instance, it is relatively easy to measure the income of a professional child-minder. If, in contrast, a grandmother looks after a young child there is not generally any monetary transaction involved. There is therefore no clear-cut way of measuring what such work contributes to GDP.

Kuznets also pointed out that domestic work is different in character from paid work. As he put it: “The organisation of these services render them an integral part of family life at large, rather than of the specifically business life of the nation.”

For this reason it is questionable that domestic work should be included as part of GDP even given the social importance of raising families.

It is beyond reasonable doubt that the inventors of national income accounting anticipated many contemporary criticisms of GDP decades ago. But to properly rebut the critics it is necessary to go further.
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* Part two will run in the next issue of Fund Strategy