GDP – what does it measure and is it still useful?

Gross Domestic Product, which measures the total market value of goods and services produced in an economy in a period of time, is regarded by economists as the single best measure of economic activity. It provides a measure of how well a country is doing relative to other countries and, if adjusted for inflation, i.e. measured in constant prices or real terms, it shows progress over time. When converted into a common currency such as the US dollar, its size reflects a country’s economic power in the world while its PPP (purchasing power parity) value is used to compare living standards between countries. Equally importantly, it provides information which the government can use to manage the economy.

It is measured in three ways – output, income or expenditure in an economy – and, in theory, these should be the same since expenditure on a product determines its monetary value and also generates the incomes of the factors of production involved in its production. The output method involves looking directly at the value of the output of goods and services produced less the inputs used to produce them, plus indirect taxes minus subsidies. The income method considers the income earned by households and businesses in the production of goods and services and the expenditure approach measures spending by households, businesses (investment in capital and stocks of goods) and the government, plus net exports (exports less imports) of goods and services. Government services, such as healthcare or education, which are not paid for directly, are particularly difficult to measure. In the past, the Office for National Statistics has looked at the cost of providing these services; more recently it supplements this by looking directly at outputs such as the number of patients seen.

It is accepted that GDP does not measure the value of activities which are not traded, such as volunteering or services undertaken at home by parents such as childcare or cleaning; it does not directly measure  welfare, takes no account of inequality and most recently, concern has been expressed that it does not take into account the depletion of natural resources. Thus, if Brazil increases its logging in the Amazon, its GDP increases through the production of timber, without any corresponding reduction to take account of resources used up. Similarly, ironically, a disaster is good for GDP since it will require  re-building of houses, factories, roads, etc, which is counted, while the initial damage is not subtracted. GDP does not adequately take account of improvements in quality, particularly with electrical goods – computers are estimated to be 1,000 times more powerful than 30 years but in real terms are cheaper.  It also does not accurately reflect the hidden economy, although since 2014, UK GDP data has included an estimate of the value of  illegal drugs and prostitution (£10bn in 2014) in the GDP data.

There has been concern over the accuracy of GDP estimates, which are frequently revised following initial publication as more data becomes available. The UK is similar to other countries in this respect but where the problem becomes important is when the country might be entering a recession, with all the political and economic significance attached to it. The definition itself (two successive quarters of negative growth) is questionable since it suggests an economy shrinking by 0.1% in two successive quarters is in recession and therefore doing badly, while one growing by 0.1% in one quarter and then shrinking by 2% in the next quarter is okay.

15 years ago, only half the adult population had access to the internet. By 2015 only 10% of adults did not have internet access. Today two thirds of adults own a smartphone, a percentage which has more than doubled in nine years. This increase in on-line activities has been one factor behind the increasing discussion of the usefulness of GDP as an economic indicator and the government commissioned Professor Sir Charles Bean to produce a review of government statistics. He noted that, when an economy mainly produced tangible products, measuring GDP was relatively simple. As services became more significant, GDP calculations became more difficult and, in recent years, with the rise of on-line services, such as Spotify and Google, the validity of GDP statistics has become even more doubtful. Previously, for example, if I wanted to go on holiday to Paris, I might buy a map. Today, I will use google maps instead. Although the physical quantity of goods produced has dropped, I receive the same “product” in a different form, but it will not be recorded in GDP data. As Professor Bean writes, “Digital products delivered at a zero price ……  are entirely excluded from GDP. …….  The issue is analogous to that posed by public goods provided free of charge at the point of delivery. But, unlike that example, there is not even a protocol that dictates their value is related to the value of inputs used in their creation.”  (Page 76, Independent Review of UK Economic Statistics – Professor Sir Charles Bean)

He considers what has been omitted and also looks at the way the digital revolution has made us more productive saving time ( or less productive if you get bored reading this and go off and email friends or buy something on-line) and estimates that the digital economy currently adds approximately 0.5% p.a. to our GDP growth which we are not adequately measuring. Given the current low levels of UK GDP growth, this is a significant adjustment.

Purchasing Power Parity and the Big Mac

According to the Purchasing Power Parity (PPP) Theory of exchange rates, currencies should adjust so that the prices of a similar basket of goods costs the same in different countries and is used to examine whether a currency is currently over or under-valued. If the current exchange rate between sterling and the US dollar is £1 = $1.50, we would expect that if a  basket of goods  cost £100 in the UK  it should cost $150 in the USA .  However, if the basket only cost $100, travellers from the UK to the USA would find that their pounds, when converted into dollars, were buying more in New York than they could purchase in London and sterling was overvalued.

The PPP exchange rate is also used when comparing living standards in different countries. GDP per capita is the most common method but there is a problem with the exchange rate. The UK GDP is measured in sterling while the US uses dollars. If the exchange were stable AND reflected the prices of goods in the two countries, there would not be a problem. However this is not the case. As an illustration, consider that the £:$ exchange rate has fluctuated between £1 = $1.49 in 2016 and £1 = $1.25 in 2019. Depending on when one made the comparison, it might look as if the UK standard of living had fallen significantly over the three-year period. Therefore, using a PPP exchange rate, which uses the cost of similar baskets of goods, avoids the problem of a fluctuating exchange rate.

The use of PPP exchange rates can have a significant impact when looking at a country’s income. In India, the predicted GDP per head for 2020 rose from $2,500 per person to $8,900 when a PPP measure was used, indicating that goods and services there were cheap and the Indian rupee was significantly more valuable than indicated by the exchange rate  while in Norway predicted GDP per head fell from $79,000 to $69,000, showing that goods are services in Norway were relatively expensive.

However  PPP’s use brings different problems. Calculating the cost of a comparable basket of goods is a complex process  – think what you might have for breakfast at home compared to what you would eat in France. Since 1986 The Economist has published its own, non-scientific, PPP measure based on the price of a Big Mac in different countries. (An alternative to the Big Mac particularly in countries where the eating of beef is not common is the Starbucks Grande Latte Index). The Big Mac Index is useful as a quick guide to whether or not a currency is over or under-valued. Last year a Big Mac cost $5.58 in the USA but SFr6.50 or $6.62 indicating that the Swiss franc was overvalued by almost 20%. However if you wanted to fill up on Big Macs, the best place would have been Russia where it cost 110 roubles or $1.65, showing that the rouble was significantly under-valued.

The PPP is not an accurate predictor of short-term changes in exchange rates since speculation and interest rate changes can move currencies quickly. However, over a long period, the concept is valid. According to The Economist, currencies which, according to the Big Mac Index, were undervalued, appreciated over a 10 year period and vice versa.

Why bother with GDP?

Modern GDP statistics (“the value of goods and services produced in a given period”) have their origin in the USA around the 1930s with the work of Kuznets, who produced the first national income data in order to see the impact of the Great Depression on the US economy. They became more important during the Second World War when the UK government, prompted by Keynes, and the US government needed to be able to manage the war effort to maximum effect while still providing enough resources for consumption.

A major criticism of GDP is that it takes no account of what is produced, merely its value. As a result,  disasters can be good for GDP if they involve countries reconstructing roads or buildings damaged in the disaster. War is also a good way of boosting GDP since it will involve producing more tanks, weapons and aircraft! Similarly, two forks are, in GDP terms, as useful as a knife and fork, but less useful in reality when trying to spread butter. GDP and GDP per capita also take no account of how the income is shared among the population. A rich oil producing country might have a high GDP per head but, if the income is concentrated in the hands of a few, the standard of living of the majority might be below that of a country with a lower average of GDP.

Measurement of GDP is difficult since it is impossible to measure every transaction and therefore relies on surveys e.g. the Living Costs and Food Survey for about 5,000 households and monthly surveys of approximately 45,000 businesses. The development of technology has made the measurement of GDP more difficult. The UK Government set up an inquiry under Charlie Bean – OB and former Deputy Governor of the Bank of England – who identified activities which are now much harder to measure and value such as using Google Maps rather than buying a paper OS map or streaming films rather than buying or renting DVDs. Another problem is that many things have become cheaper and better – my new DVD recorder is easier to use and records more than a previous model but, in GDP terms, it is less valuable because it is cheaper.

There have been many debates over what should be included in GDP and although these might seem largely irrelevant, they matter when trying to compare countries’ GDP. In the past certain things, such as the sale of cannabis in cafes in Holland were legal and therefore recorded while a similar purchase in Romford would not be counted. However Eurostat wanted consistency among its members and decided that all transactions for goods or services involving money were to be recorded, whether they are legal, illegal, good or bad. Therefore, in a purely numerical way, those who argue in favour of increasing GDP as being a key government objective, could argue that encouraging the sale of drugs or prostitution is as valid as increased spending on education or health – something even an economist would find hard to justify! More relevantly sales of guns in the UK are part of the shadow economy but in the US they are legal, widespread and contribute to GDP.

GDP data is particularly suspect in developing countries where a significant percentage of production takes place in the hidden economy; for example, in Zimbabwe only 6% of the labour force is formally employed. Similarly, my purchase of bottled water from Sainsbury’s is counted in the UK’s GDP, but the effort of an African villager who spends hours walking to and from a stream to collect “free” water has no value according to GDP statistics. There are also basic measurement difficulties in LDCs, such as obtaining accurate population figures, accurately measuring inflation and valuing the hidden economy, e.g. only half the maize produced in Nigeria is sold in a shop or market.

There is now a consensus that we are trying to measure too many things in our single GDP number and, although we can improve it by using GDP per head or median GDP or NNP, it is still deficient.

Economists have therefore started both to consider other possible methods of estimating economic activity and to develop alternative measures which go beyond simply the output of goods and services. One way of tackling the former is to look at light intensity to indicate economic activity in different areas with increases in intensity over time indicating growth. Such methods indicate that the proportion of economic activity occurring in villages, and not always measured, is more significant than thought and therefore the GDP of many developing countries is, similarly, larger than previously calculated. It also provides a fascinating snapshot of the difference between the North and South Korean economies.

However a major concern is how we measure the damage which our focus on output is doing to the environment. China’s focus on growth has resulted in 40% of its river water being undrinkable and one cannot always see the stars at night because of pollution. GDP does not take into account depreciation of natural resources lost to build houses and factories and damage to the environment but this is not easy to do. How does one put a monetary value on a rainforest, beautiful view or footpath by a river? One way is to make an estimate based on how much people pay to see them and, for things which benefit the environment, how much it would cost to replicate them. The UK government in 2012 formed the “Natural Capital Committee” to advise the government on things such as ‘forests, rivers, minerals and oceans’ and by 2020 the ONS must include a measure of natural capital in the UK’s national accounts. The aim is to move towards sustainable growth. Along the same lines, a US think tank has invented Earth Overshoot Day – the date when the earth used up its regenerative capacity for the year. In 2018 this occurred on 1st August.

Other measures include the Genuine Progress Index – a measure of economic welfare which is currently in use in Maryland. GDP is the base but invisible “goods” e.g. leisure time, volunteering, & housework are added while “regrettables” e.g. crime prevention spending such as burglar alarms, pollution and commuting time are subtracted. The Happy Planet Index tries to measure what matters – namely sustainable wellbeing for all and tells us how well nations are doing at achieving long, happy, sustainable lives.  Some countries have followed Bhutan which developed a Gross National Happiness index which sets out priorities such as psychological well-being, health, education, living standards, good governance and ecological resilience. Before adoption, all new projects must undergo a GNH impact review. We carry out an annual happiness survey as does the OECD and many of its members. These focus on six key variables which determine happiness – GDP/head, healthy years of life expectancy, having people to turn to, trust in others, freedom to make decisions and donations to charity.

Olen niin iloinen

For those of you who do not speak Finnish, a clue to the meaning of the words above might be found in the following questions.

What happens on 20th March 2018?

Answer – UN has declared it to be World Happiness Day

What do Norway and Burundi have in common?

Answer – they both dropped in the UN World Happiness Report. Burundi dropped to bottom place while Norway dropped out of the top slot to be replaced by Finland – hence the Finnish comment “I am so happy”.

The Report ranks 156 countries by their happiness levels, and, this year, it also looked at 117 countries by the happiness of their immigrants, with Finland coming top in both rankings.

The top and bottom 10 are recorded below. A sample in each country are asked to score their happiness on a scale of 10 (most happy) to 1 (least happy) with Finland scoring 7.6 and Burundi 2.9. In order to identify the reasoning behind the score, the report also looks at economic strength (measured in GDP per capita), social support, life expectancy, freedom of choice, generosity, and perceived corruption. The biggest loser was Venezuela, dropping 2.2 on the scale, which is little surprise considering the state of their economy. This year the study also looked at the happiness of migrants,

It is worth a warning note about the numbers – the difference between the top 6 countries is only 0.191 on the 1 – 10 scale.

The world’s happiest – and least happy – countries 2018 World Happiness Report
Happiest Least happy
1. Finland 147. Malawi
2. Norway 148. Haiti
3. Denmark 149. Liberia
4. Iceland 150. Syria
5. Switzerland 151. Rwanda
6. Netherlands 152. Yemen
7. Canada 153. Tanzania
8. New Zealand 154. South Sudan
9. Sweden 155. Central African Republic
10. Australia 156. Burundi

New insights into GDP

A new book “The Growth Delusion” by David Pilling, a Financial Times journalist, provides interesting insights into our obsession with economic growth and how we measure it. This blog highlights only some of his key points which are relevant to A’level and IB economics. The book is definitely worth a read. Modern GDP statistics (“the value of goods and services produced in a given period”)  have their origin in the USA around the 1930s with the work of Kuznets, who produced the first national income data to see the impact of the Great Depression on the US economy. They became more important during the Second World War when the UK government, prompted by Keynes, and the US government needed to be able to manage the war effort to maximum effect while still providing enough resources for consumption.

Pilling points out the many failings of GDP as an economic indicator such as the way it takes no account of what is produced, merely its value. Thus he points out that  wars can be good for GDP if they involve countries producing more tanks, weapons and aircraft. Similarly, two forks are, in GDP terms, as useful as a knife and fork, but less useful in reality when trying to spread jam on toast or cut one’s steak.  He is also scathing about the use of averages and points out that while a rich country might have a high average GDP, and therefore, according to economists, a high standard of living, if this is held by a very small number of people, the standard of living of the majority might be below that of a country with a lower average of GDP.

Measurement of GDP is difficult since it is impossible to measure every transaction and therefore relies on surveys e.g. the Living Costs and Food Survey for about 5,000 households and monthly surveys of approximately 45,000 businesses. The development of technology has made the measurement of GDP more difficult. The UK Government set up an inquiry under Charlie Bean – OB and former Deputy Governor of the Bank of England – who made comments similar to those expressed by David Pilling in terms of activities which are now much harder to measure and value such as using Google Maps rather than buying a paper OS map or streaming films rather than buying or renting DVDs. Another problem is that many things have become cheaper and better – my new recorder is easier to use and records more than a previous DVD recorder  but, in GDP terms, it is less valuable because it is cheaper.

There have been many debates over what should be included in GDP and although these might seem largely irrelevant, they matter when trying to compare countries’ GDP. In the past certain things, such as the sale of cannabis in cafes in Holland were legal and therefore recorded while a similar purchase in Romford would not be counted. However Eurostat wanted consistency among its members and decided that all transactions for goods or services involving money were to be recorded, whether they legal, illegal, good or bad. Therefore, in a purely numerical way, those who argue in favour of increasing GDP as being a key government objective, could argue that encouraging the sale of drugs or prostitution is as valid as increased spending on education or health – something even an economist would find hard to justify! More relevantly sales of guns in the UK  are part of the shadow economy but in the US they are legal, widespread and contribute to their GDP.

Pilling also considers the problems of measuring GDP in developing countries where a significant percentage of production takes place in the shadow economy; for example in Zimbabwe only 6% of the is formally employed. Similarly, my purchase of bottled water from Waitrose  is counted in the UK’s GDP, but the effort of a African villager who spends hours walking to and from a stream or well to collect “free” water has no value according to GDP statistics. He describes the way lights at night are used to indicate economic activity in different areas with increases in intensity over time indicating growth. Such methods indicate that the proportion of economic activity occurring in villages, and not always measured, is more significant than thought and therefore the GDP of many developing countries is, similarly, larger than previously calculated.