Written by Brandon Croarkin, GEI Associate
GDP: The market value of all final goods and services produced in a nation in a given year.
This definition of GDP is one that is seen and memorized by every student who takes an economics course. It's a metric that is held above all others in economics. Economists, investors, politicians - all look at our GDP to look at the state of our economy. Simply put, it tells us how well our economy is doing. Or does it?
Bobby Kennedy did a great job summarizing the downfalls of GDP:
"It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country. It measures everything in short, except that which makes life worthwhile."
Invented after the Great Depression by Simon Kuznets in 1934, GDP helped tell us how much stuff (like bombs, tanks, etc.) we were making. But, even he warned about it
"the welfare of a nation can scarcely be inferred from a measurement of national income."
What is GDP Lacking?
- The free time that is pivotal to an enjoyable human life is not included in GDP. According to GDP, any volunteer work is a waste of time.
- Our GDP is actually hurt when we buy goods that are not produced in the United States.
- GDP does not include nature into its formula. In fact, our GDP is actually increased by oil spills and other harmful disasters. The cost of cleaning up the spill more than offsets any losses in oil output.
- It does not account for how efficiently income is distributed.
- GDP tells us little about the overall quality of living.
What it Includes
While there are many flaws in what GDP does not account for, some of its largest shortcomings come from what it DOES include. Examples:
1. There is no distinction between activities with differing beneficial and harmful effects. Examples:
- It counts the destruction (harvesting) of our forests as much as it does a new ambulance.
- It counts the building of nuclear warheads as much as it does the new high school.
2. It counts as a positive the repair of damage equally with the creation of something new, without subtracting the value of that which was destroyed. This fallacy was related in the 'Parable of the Broken Window' by the 19th century economist, Frederic Bastiat.
Problems With This
By basing our economy solely on GDP the goal of the economy becomes solely on producing more goods and services. You get what you measure. But shouldn't the economy be more than just producing more? The economy should be more focused on increasing the welfare of society.
The result of this view of the economy has "hidden" a shift from the manufacturing sector to financial sector. Activities that generate profits from purely financial transactions (unrelated to the creation of anything of "real" value) count as additions to GDP, so while this may appear to make us richer as a nation, it has actually occurred with a reduction in our capacity to produce real things.
Let's consider that last statement further. While the financial sector does provide necessary resources to the goods and services producing economy, it also profits from pure speculation which have no other purpose than to make money just for the sake of making money. These latter profits have very little or no relationship to the production of goods and services for the larger society.
Andrew Haldane, Chief Economist at the Bank of England and Executive Director, Monetary Analysis and Statistics, has said the following about speculation for the sake of speculation:
If risk-making were a value-adding activity, Russian roulette players would contribute disproportionately to global welfare.
I believe it is significant that he chose the term "risk-making" rather than "risk-taking". It is because of this distinction that Haldane has criticized GDP accounting as causing the "very misconceptions which caused the measured contribution of the financial sector to be over-estimated ahead of the crisis."
Haldane has summarized his thoughts (in 2011) with a distinction that isolates risk management as a needed function for economic activity in general, but with a caveat relating to the mis-measurement of the value of "risk-making":
Risk-management is a legitimately value-added activity. It lies at the heart of the services banks provide. Today's debate around banking and bankers has usefully rediscovered that key fact, amid the rubble of broken balance sheets and wasted financial and human capital. Investors, regulators and statisticians now need to adjust their measuring rods to ensure they are not blind to risk when next evaluating the return to banking.
Leaving one elephant in the room to move to another: The World Bank was praised for shifting subsistence farming communities to urban centers because of the increases it made to GDP. While in the subsistence farming communities the people there had no need for money, but now in the urban slums they add to GDP. However, this is often done with subsistence incomes (or even less) and a day to day struggle by those in the urban slums. Is this really a better outcome? According to the GDP, it is.
The GDP is a very useful statistic that can tell us valuable information about our economy, but it alone should not be used to base the performance of our economy. There should be various social and economic measures used to gauge our economic performance, not just one.