Friday, February 21, 2014

The GDP at 80: Should We Retire It As a Measure of Progress?

When performing economic or public policy analysis, it's always nice to have sound metrics. Since its inception back in 1934, the gross domestic product (GDP) has been considered the "gold standard" of determining a country's standard of living. Given the change of political economy over the past eighty years and the roles that governments have played since 1934, I was wondering if the GDP is still an outstanding metric, whether it should be accompanied by other metrics, or whether it should be scrapped all together.

First, it would help to know what the GDP actually measures. The GDP is the sum of private consumption (C), gross investment (I), government spending (G), and the trade balance (exports minus imports; X-M) within a given time period, or to put it in equation form:

GDP = C + I + G + (X-M)

Using economic output as an indicator of success certainly has its advantages. The GDP measures a nation's buying power, which takes market activity and economic growth into account. The GDP is an indicator that is objective, widely used, consistently calculated across borders, and has readily available data, which makes it easy to measure GDP. Also, there is the matter that countries that have a higher GDP is roughly correlated with having a higher standard of living.

However, the GDP has its flaws. Just to name a few:
  • GDP only measures quantifiable, monetary economic output. The GDP has nothing to say about the quality of said output. A country could be producing short-lived, cheap, low-quality products. Having to replace cheap goods often versus buying a high-quality item once can artificially increase the GDP. It also does not differentiate between good spending (e.g., education) and bad spending (e.g., cigarettes). 
  • Disasters and externalities inaccurately increase the GDP. War requires soldiers and ammunition, natural disasters require relief, oil spills and pollution require clean-up, and rampant crime requires more government expenditures towards crime reduction. If these externalities did not have to be cleaned up, our scarce resources could have been applied elsewhere in a more efficient manner, which leads to my next point….
  • "Government is inherently good,  free trade is inherently bad." What makes the public sector different from the private sector is that the public sector cannot accurately value its output. The private sector at least can use a willingness to pay [reflected in supply and demand] to determine such a value. What is the value of domestic intelligence, the worth of government's subpar operating of preschool, or the benefits of carbon reduction? If the government produces something of little or no value whatsoever, the GDP framework would count this squandering of resources as economic growth (The same works if such waste happens in the private sector and gross investment). Under this framework, even financing of debt with the central bank printing money en masse followed by increased amounts of government spending is considered a plus in the GDP formula! A framework that says that government spending is always good is problematic in my book. Furthermore, it makes the erroneous assumption that net imports (read: free trade) are harmful. 
  • Omission of non-market activities. Transactions that are not counted in the GDP are volunteer work, household services provided by [stay-at-home] parents, production solely for one's consumption, barter, or the underground economy. 
  • Other measurements matter. There is more to success than economic output, and that includes happiness, the value of leisure time, literacy, quality of health care, social cohesion, child welfare, maternal mortality, quality of labor, and environmental impact.
  • Does not account for distribution of wealth. The GDP is a macroeconomic indicator that looks at the economic wealth of a country as a whole. It does not break down the distribution to determine poverty levels or income inequality. Although GDP per capita does a more-than-decent job of capturing the average individual's wealth, in the even that a country has an absurdly high Gini coefficient, the average wealth and well-being measured in per capita terms becomes misrepresented. 
In spite of the GDP's apparent flaws, it is still the best measure of economic activity we have, and we thusly should still use it to measure economic progress. The GDP measures what it measures relatively well, but to have it be the primary or sole factor for determining fiscal policy is faulty. Narrow focus on quantitative economic output doesn't seem to cut it anymore. One could try such alterations as measuring national wealth in lieu of GDP, construct a GDP-GDI Index or GDPplus Index, or subtract depreciation from market value, but I still believe that the GDP is still the most comprehensive economic indicator. Even so, we should ask ourselves what other factors contribute to progress, which is where such indicators as the Gross National Happiness, the UN's Human Development Index, the Genuine Progress Indicator (GPI), and the OECD Better Life Index can play a role. In spite of the ideological tilt that these more subjective indexes can exude, we should still have the discussion what indicators best measure societal success.

1 comment:

  1. "GDP only measures quantifiable, monetary economic output."
    I'm not sure about the first point. At least over time the savings due to quality should mean more money for other goods.

    Disasters and externalities inaccurately increase the GDP
    If resources would have been applied elsewhere, then the GDP figure would be unchanged, at least over any long run. Of course we might see a temporary jump, but that should be offset by a corresponding depression of GDP in future years as debts are paid off. Or in an imaginary world, depressed spending in previous years as people save up for disasters.

    Government is inherently good, free trade is inherently bad
    The import/export thing is one indicator that quality of life and production are related, but not the same thing. Surely imports raise quality of life, yet that consumption is not a reflection of local production.

    Overall, the trouble comes when we run with the basic "higher GDP is good" mindset. Any indicator, particularly one that aggregates a lot of measures, will cause trouble. For example, we could dramatically increase per-capita GDP by killing poor people or everyone giving $100 to someone else. Or this comic: