Gross Domestic Delusion?

It’s the most ubiquitous of economic metrics, gross domestic product, or GDP.  In one handy, easily accessible number lies revealed the health of the American economy.  And woe to any administration that doesn’t oversee a steady growth in the number.

But what does the number mean exactly, and where does it come from?  While probably not thinking about it too much, you might have felt a twinge of skepticism that a single, simple, number can accurately and thoroughly express the well being of a nation of 300 million people.  Turns out the organization responsible for calculating GDP pretty much shares that skepticism.

BEA

The GDP number is calculated and released by the Bureau of Economic Analysis, a part of the Department of Commerce.  Helpfully, the BEA has a list of methodology papers you can view that discuss what the BEA does and how they do it.

Simply put, GDP measures the value of finished goods and services produced in the United States within a certain time period.  “Finished goods” being those goods that aren’t used as input to produce another good (such as flour that’s made into bread), but those that are consumed by end users (the bread that was made form the flour).  These measurements were first developed by Simon Kuznets in the 1930’s, in the midst of the Great Depression, the goal being to give the government a better idea of how the economy was doing and thus give some indication of the impact their policies were having.

The BEA refers to the economic reports it puts out as the national income and product accounts (NIPAs).  Account 1 is the Domestic Income and and Product account, which is where you’ll find the GDP number.  There are 6 other accounts, which basically break the numbers down further, such as into the major economic sectors of businesses, individuals, and governments.

For the basic GDP measure from Account 1, the BEA uses the “expenditure method”.  The idea being to determine the value of all the finished goods produced by finding the total amount of money spent.  But not everything that is produced gets bought does it?  BEAs NIPA primer briefly addresses this:

GDP is a measure of current production, not sales.

In the NIPAs, output measures when a good or service is produced, not when that good or service is sold. For example, an automaker may produce a car in one period and sell it in a later period. In the first period, the production of the car is recorded in GDP as an addition to inventories, a component of investment. In the later period, the sale of the car is recorded as a consumer expenditure and is offset by the withdrawal of the car from inventories.

It’s not clear to me if this concept extends to more perishable goods, such as bread, but I presume in that case, if the bread isn’t sold, gets moldy and is thrown out, that it does not count towards GDP.  And even though the claim is that production is being measured and not sales, there is plenty of production that is not sold on the open market and thus not counted towards GDP, particularly services that people consume themselves, such as car repairs, cooking, or child rearing.  If these services were being paid for, they would be counted towards GDP.

Since market transactions have two sides, a buyer and a seller, GDP can also be calculated as a sum of incomes.  So Account 1 also contains a section calculating GDP using the income approach, the resulting number is sometimes referred to as the gross domestic income or GDI.  In theory it should equal GDP, but there is usually a small discrepancy due to the different data sources used.

Lastly, for the sake of comparison between years, GDP is deflated to account for inflation using a price index, so apples aren’t being compared to oranges.  GDP that is inflation adjusted to a baseline year is referred to as real GDP (as opposed to nominal GDP which hasn’t been adjusted for inflation).

Revision

Most of the data the BEA uses in its calculations come from Census Bureau surveys.  But a comprehensive economic census is only performed once every five years.  In between these less comprehensive surveys are done.  When recent data isn’t available the BEA engages in extrapolation and estimation.  Because of this, the quarterly and annual GDP numbers the BEA puts out are continually revised as more information comes in.  The process is described this way in the paper “Taking the Pulse of the Economy: Measuring GDP”

The initial monthly estimates of quarterly GDP based on these extrapolations are revised as more complete data become available— early tabulations of monthly data are replaced by more complete tabulations in subsequent months and later by comprehensive annual surveys that have larger sample frames and provide more detailed information. The successive revisions can be significant, but the initial estimates provide a snapshot of economic activity much like the first few seconds of a Polaroid photograph in which an image is fuzzy, but as the developing process continues, the details become clearer.

So the initial numbers that are put out are “fuzzy”, and as time goes by, as more data comes in, the numbers are revised to their ostensibly more accurate versions.  How long does this revision go on?  From the same paper:

During the summer of each year, the Bureau of Economic Analysis revisits the estimates for the most recent calendar year and the two preceding years, when annual data from the Census Bureau, Internal Revenue Service, and other sources become available. These data are based either on more complete survey —Census Bureau annual data collections are mandatory and the sample frames are much larger than those for the monthly surveys, which are not mandatory—or on comprehensive administrative data, which provide more detailed information by industry, by type of product, or by type of income

So the GDP number is open to revision three years after it is released.  While the same paper discussed accuracy and called the advanced GDP estimates “fairly reliable”, this fact is something important to keep in mind when GDP numbers are released and subsequently used as political weapons.

Revisions and incomplete data to the side, can GDP be used to determine the well being of a society?  The BEA thinks not, as it expresses early on in the GDP Primer:

While GDP is used as an indicator of economic progress, it is not a measure of well-being (for example, it does not account for rates of poverty, crime, or literacy).

Incidentally this is a view shared by Simon Kuznets, GDPs initial developer.  In 1959 economist Moses Abramovitz cautioned:

we must be highly skeptical of the view that long-term changes in the rate of growth of welfare can be gauged even roughly from changes in the rate of growth of output.

So, given the methodological and philosophical hedging being done, it’s a bit incongruous that the BEA brags about the influence of GDP on their Misson, Vision, and Values page:

The GDP was recognized by the Department of Commerce as its greatest achievement of the 20th century and has been ranked as one of the three most influential measures that affect U.S. financial markets.

Questions

If GDP isn’t a measure of well being, why is so much attention paid to it, why does it have so much power?  It’s not as if the problems with GDP are unknown.  French president Sarkozy in 2008 created a commission, headed by Columbia University economist Joseph Stiglitz.to discuss and address the inadequacies of current GDP based economic measurement.  The commission generated a report that is worth perusing and can be found here.

A significant portion of the report discusses “sustainable development”.  A common baseline for yearly GDP growth for a healthy economy is considered to be around 3%.  GDP growth below that is considered anemic.  But a constant growth rate represents exponential growth.  An economy growing at 3% a year will double in about 24 years.  Is that growth rate reasonable?  If so, is it even desirable?

I don’t have the answers.  So while the folks at the BEA undoubtedly work hard to provide numbers that are as accurate as possible, it seems to me we should approach the venerable number as we should approach most things, with healthy skepticism and a sense of proportion.  And always keep in mind these wise words from Stiglitz:

Our economy is supposed to increase our well-being; it is not an end in itself.

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