Tuesday, August 17, 2010

The Trouble with GDP

In a recent interview, international investor, author, and Schlarbaum Prize winner, Jim Rogers, said he does not use Gross Domestic Product (GDP) in his investment analysis for four reasons:

  1. The numbers are backward looking;
  2. The numbers are always revised;
  3. Every government has different methodologies; and,
  4. Most governments have no clue, so they just make up the numbers. 
For many macroeconomists, GDP is their statistical bread and butter, GDP is a product of state intervention in the economy used to measure economic output. Keynesian attempts to manage the economy necessitated having something to target, so the government employed economists to develop national income accounting, of which GDP is a part. It is a convenient statistic because it seems that we can represent the state of the economy by using only one number.

However, as I explain in chapter 11 of my book, there are many practical and theoretical problems with GDP that should lead not just investors like Jim Rogers, but also professional economists, journalists, and policy makers to put away their GDP fetish. In the first place, too often people fall into the trap of believing that GDP measures human welfare. It does not, it merely sums up expenditures on all domestically produced final products for a specific period of time. That is why a hail storm that ruins your roof will lead to an increase in GDP. Getting a divorce or contracting a major disease will also work to increase GDP because these things require monetary expenditures. However, I don't see a ruined roof, major illness, or wrecked marriage as boons to human welfare. On the other hand, much work that does contribute to human welfare, such as productive work by a homemaker, is not included.

A problem hinted at by Rogers is that GDP numbers are often calculated using inaccurate data. There is a reason why GDP figures always need revising. Simon Kuznets, the economist who won a Nobel prize in economics for his work on national income statistics, estimated that GDP figures had a 10% margin for error. Another expert on GDP calculation, Oskar Morgenstern estimated the margin for error at 20%. This is so large that it is possible for GDP to be telling us the exact opposite of what is really happening in the economy. The problem gets even worse if we are trying to make international comparisons, because, as Rogers points out, each country has a different methodology and uses data of different quality. David Osterfeld has an excellent summary of these problems with GDP on pages 9-14 of his book, Prosperity Versus Planning: How Government Stifles Economic Growth.

Another major problem is that GDP is only partly gross. It leaves out investment expenditure on intermediate non-durable capital goods. This leaves out a large part of economic activity and leaves the impression that what drives the economy is consumption spending.

Finally, but not exhaustively, GDP includes large amounts of government spending. This is spending that does not reflect the subjective values of members of society. It is spending that is not funded by the voluntary purchases by the earners of the money spent, but by taxes forcibly taken from other people. In order to spend money, the government does not produce anything, but takes wealth out of the economy by either taxation, borrowing, or inflation. Government spending is much more consumptive than productive. Consequently, when GDP is increasing due to increases in government spending, this actually indicates more government consumption and less private production. It is a sign that the economy is getting worse, not better.

If economists must use GDP statistics, they should not kid themselves that the numbers present a scientific measurement of economic well-being. We should beware of equating GDP with the economy and increased GDP with prosperity.

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