GDP and Economic Policy

Construction towers loom above the skyline in Miami, Florida. Bryan Woolston/Reuters

Economists who want to compare the living standards of countries often use GDP, but the calculation and usefulness of the measurement remains controversial.

August 7, 2013

Construction towers loom above the skyline in Miami, Florida. Bryan Woolston/Reuters
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Current political and economic issues succinctly explained.

Introduction

Economists who want to compare the living standards of one country to another or the wealth of one country over time often use gross domestic product (GDP). Designed to measure the value of a country's production of goods and services, the metric has for decades provided a critical framework to guide policy decisions that affect people's living standards. But as issues such as the environment and wealth inequality gain political prominence, some economists argue GDP fails to account for important factors of societal wellbeing that are not directly tied to economic production, such as air and water quality, health, education, and leisure.

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According to this view, measuring only the goods and services produced by a country also does not reflect an economy's productivity, or how much society gains from each input of capital and labor. Others say there is no broader social measurement tool for policymakers to gauge improvements in living standards. But they add that policymakers should not rely on GDP as the only factor in measuring economic prosperity or societal wellbeing.

The History of GDP

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Gross Domestic Product

In the United States, GDP is measured by the Bureau of Economic Analysis within the U.S. Commerce DepartmentIt is similarly measured by international economic institutions, such as the World Bank and International Monetary Fund, and by other governments around the world. As the broadest measure of economic activity, GDP represents the total monetary value of all goods and services produced over a specific time period. Usually GDP is expressed as a comparison to the previous quarter or year by adding up spending by households, businesses, and the government. The metric is one of the most comprehensive and closely watched economic statistics [PDF], since it is used by the White House and Congress to prepare the federal budget, by the Federal Reserve to formulate monetary policy, by Wall Street as an indicator of economic activity, and by businesses to prepare forecasts of economic performance and make decisions on production, investment, and employment planning.

The measure was developed by Nobel Prize-winning U.S. economist Simon Kuznets in the 1930s as Presidents Herbert Hoover and Franklin D. Roosevelt sought to design policies to combat the Great Depression. Until then, policymakers had relied on less exhaustive data such as stock indices, freight car loading, and industrial production indices to gauge overall national economic health. But the growing role of government in the economy prompted increased demand for a comprehensive set of data to account for national economic activity.

Since its creation, GDP has been credited with improving the ability of policymakers to analyze the economy.

Since its creation, GDP has been credited by economists with improving the ability of policymakers, economists, and businesses to analyze the impact of various tax and spending policies and the impact of monetary policy on the economy. It is also credited with reducing the severity of business cycles and the era of strong economic growth that followed World War II. The average downturn between 1854 and 1945 was twenty-one months and occurred on average once every four years. In the postwar era, the length of the average downturn has been halved to eleven months, occurring once every five years, according to the Bureau of Economic Analysis. Bank runs, financial panics, and depressions that recurred after World War II were curbed, in part due to timely, comprehensive, and accurate data on the economy.

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Use of GDP spread globally after the Bretton Woods Conference in 1944, which led to the creation of the World Bank and International Monetary Fund. Those institutions adopted GDP methodologies from the United States and Great Britain to guide policymaking on international monetary exchanges and determine which global development projects merited funding. Today, GDP is also used to compare economic progress between countries. Although it is not a direct indicator of a country's living standard, it is often used as such, since in theory a country's increased economic production is assumed to benefit its citizens.

GDP's Flaws

Kuznets did not approve of using GDP to assess overall national wellbeing, since by his estimation the metric failed to distinguish "between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what." Other economists have also cited drawbacks to the way GDP is used. GDP's focus on quantity rather than quality of output often leads to policies promoting excess production and unforeseen negative consequences for society, these critics contend. Financial products that increase household debt, for instance, may increase an economy's output levels, but they do not necessarily translate into real wealth increases. Many economists contend that loose monetary policy aimed at boosting growth in the first half of the decade led to excessive risk-taking in the U.S. housing market, which eventually brought on the financial crisis.

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Gross Domestic Product

Similarly, increased economic output due to rising health-care spending may not reflect the cost effectiveness or quality of care in a country's health-care system. According to data from the Organization for Economic Cooperation and Development (OECD), for instance, the United States spends two-and-a-half times more than the OECD average [PDF] on health care, but many analysts say more U.S. businesses are less competitive globally because of ballooning health-care costs. The quality of U.S. health care also ranks lower than countries that spend less per capita on care. In China, GDP has been used both as a benchmark for judging local officials' policy decisions and a criteria in determining promotions within the Communist Party, despite the environmental repercussions.

GDP is an incremental measure, calculated annually or quarterly, which does not account for longer-term factors [PDF] such as environmental and food sustainability. For example, the goal of increasing GDP might encourage depleting forests for lumber, since cutting a forest has more value in GDP terms than the benefits to the ecosystem of leaving the forest uncut. These benefits include fostering eco-diversity, improving water quality in lakes and rivers, and manufacturing oxygen, which are not part of the market economy and thus not captured by GDP. According to the UN Food and Agriculture Organization, forestry accounts for more than 3 percent of global trade and directly employs more than thirteen million people globally. However, dependence on sustaining growth through wood exports in countries like Cote d'Ivoire and Mexico has led to large areas of deforestation, animal and rainforest extinction, and increased risk of flooding.

Another drawback, according to some economists, is GDP's inability to account for income disparity.

Another drawback, according to some economists, is GDP's inability to account for income disparity. Since GDP is measured as an average of per capita output, it reflects increases or decreases in overall economic production but not changes in specific segments of a population. Poorer populations within a single economy can be getting poorer, even though GDP is increasing. In turn, increasing wealth inequality, as noted in this 2006 New York Times article, can negatively impact an economy, since research has linked income disparity to decreased worker productivity and increased social unrest.

Some researchers argue unequal growth—concentrated in the highest income brackets—is less productive, because the social benefits of consumption by the wealthy are less beneficial to society than spending increases at lower income levels. This line of thinking is supported by a growing body of research termed "happiness economics," which stems from a concept authored by University of Southern California economist Richard Easterlin called the "Easterlin Paradox." Easterlin's research found that, on the whole, rich countries do not get happier as they become richer. To some critics of GDP, this finding suggests that economic growth does not do much to increase wellbeing, which has vast implications for the goals of economic policymaking. Other economists have refuted this line of thinking, arguing that more recent research shows GDP and feelings of "happiness" tend to move together. This research also refutes the idea that there exists a satiation point, or the belief that increases in national wealth only raise national happiness up to a certain point.

Alternatives and Improvements

Most economists agree that the way economic progress is measured should evolve over time. And in recent years, a number of improvements to measuring national-level progress have been proposed globally, including the Index of Sustainable Economic Welfare, the Genuine Progress Indicator, Green GDPs, and Genuine Wealth. But economists remain divided about whether GDP should be improved upon, replaced by other approaches, or supplemented by other indicators.

Those who wish to improve GDP itself advocate for directly incorporating the negative impact of some expenditures in the economy, such as logging and oil consumption (rather than only including positive contributors to GDP), since these additions would be relatively easy to implement. Many of these economists are hesitant to attempt creating new economic measures for concepts that are "hard to define and quantify such as wellbeing and happiness," says Director of the Bureau of Economic Research Steve Landefeld. More political issues, he says, "must be left to those responsible for guiding social movement and legislative policy. Economists' contributions must continue to focus on what economists can uniquely provide: the objective impacts of such programs."

The citizens of the rich nations find it difficult to grasp that higher GDP will not make society happier.
Andrew Oswald, University of Warwick

Other economists argue that GDP should be replaced, since it is not a measure of welfare and was not meant to serve that function. These advocates say merely tweaking GDP is insufficient since policymakers and their constituents incorrectly focus on the measure as a proxy for wellbeing. "The citizens of the rich nations find it difficult to grasp that higher gross domestic product from this point onwards will not make society happier," says the University of Warwick's Andrew Oswald in this April 2010 Economist debate. Much of the economic data used would also be the same as GDP and so would still have limitations in valuing items not regularly reported in monetary terms (such as volunteer work and resource depletion).

Yet another group of economists argues that GDP should not be eliminated but instead enhanced by additional key indicators that give policymakers a fuller picture of the impact of their economic decisions. Columbia University economist Joseph Stiglitz stresses the need for incorporating additional measures into economic decision-making to prevent most governments from making "a fetish out of [GDP]," he said in a 2009 Bloomberg interview. Adding additional measures of economic prosperity are "important because it affects how you make decisions," Stiglitz says. French environmental economist Claude Henry says longer-term environmental indicators, such as water acidity and carbon emissions, are especially well-suited to being [PDF] attached to GDP, since their delayed effects cannot be accurately translated into present-day quarterly or annual figures and wrapped into a single indicator.

Tinkering With the Formula

It's common for government agencies to revise GDP data in the weeks and months after they are calculated as more information trickles in, but it's rare for the changes to alter the overall view of economic output and growth. That changed in July 2013, when the Bureau of Economic Analysis decided to count spending on research, development, and copyrights as investment, as well as factor for pension deficits, a shift that added 3.6 percent, roughly $560 billion, to U.S. GDP in 2012.

Economists in advanced economies were previously ignoring the significant allocation of resources for research and development, and had no way to account for income-generating intangible assets such as copyrights for a hit TV show that could spinoff revenue decades after its initial run. The new formula, which was applied retroactively to 1929, didn't have a great effect on growth rates, but there were some subtle implications. The 2007 recession, for example, looked shallower than previously thought, the savings rate was higher between 2005 and 2012, and the debt-to-GDP ratio was smaller, providing a cushion for policymakers grappling with a surge in public borrowing. Economists will likely uncover more lessons as they crunch the new data, and might also differ on what intellectual property qualifies as investments or expenses, illustrating how seemingly minor tweaks to the GDP formula can have major consequences.

Prospects for Adopting GDP Alternatives

In 1990, the UN Development Program adopted the Human Development Index to show how well efforts toward economic growth and development are improving countries' wellbeing. In November 2007, the European Commission, European Parliament, Club of Rome, OECD, and World Wildlife Fund hosted a conference aimed at looking beyond GDP to create consensus on which indicators are most appropriate to measure progress and how to organize their adoption globally. Some Chinese provinces have eliminated GDP growth as an official indicator of government accomplishments to focus more on environmental concerns. And in the United States, the Bureau of Economic Analysis has proposed [PDF] supplementing GDP with alternative measures of economic activity that better reflect growth disparities across households, sectors, and regions of the country.

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