Why gdp is a bad measure?

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When it is growing, especially if inflation is not a problem, workers and businesses are generally better off than when it is not

Many professions commonly use abbreviations. To doctors, accountants, and baseball players, the letters MRI (magnetic resonance imaging), GAAP (generally accepted accounting principles), and ERA (earned run average), respectively, need no explanation. To someone unfamiliar with these fields, however, without an explanation these initialisms are a stumbling block to a better understanding of the subject at hand.

Economics is no different. Economists use many abbreviations. One of the most common is GDP, which stands for gross domestic product. It is often cited in newspapers, on the television news, and in reports by governments, central banks, and the business community. It has become widely used as a reference point for the health of national and global economies. When GDP is growing, especially if inflation is not a problem, workers and businesses are generally better off than when it is not.

GDP measures the monetary value of final goods and services—that is, those that are bought by the final user—produced in a country in a given period of time (say a quarter or a year). It counts all of the output generated within the borders of a country. GDP is composed of goods and services produced for sale in the market and also includes some nonmarket production, such as defense or education services provided by the government. An alternative concept, gross national product, or GNP, counts all the output of the residents of a country. So if a German-owned company has a factory in the United States, the output of this factory would be included in U.S. GDP, but in German GNP.

Not all productive activity is included in GDP. For example, unpaid work (such as that performed in the home or by volunteers) and black-market activities are not included because they are difficult to measure and value accurately. That means, for example, that a baker who produces a loaf of bread for a customer would contribute to GDP, but would not contribute to GDP if he baked the same loaf for his family (although the ingredients he purchased would be counted).

Moreover, “gross” domestic product takes no account of the “wear and tear” on the machinery, buildings, and so on (the so-called capital stock) that are used in producing the output. If this depletion of the capital stock, called depreciation, is subtracted from GDP we get net domestic product.

Theoretically, GDP can be viewed in three different ways:

● The production approach sums the “value-added” at each stage of production, where value-added is defined as total sales less the value of intermediate inputs into the production process. For example, flour would be an intermediate input and bread the final product; or an architect’s services would be an intermediate input and the building the final product.

● The expenditure approach adds up the value of purchases made by final users—for example, the consumption of food, televisions, and medical services by households; the investments in machinery by companies; and the purchases of goods and services by the government and foreigners.

● The income approach sums the incomes generated by production—for example, the compensation employees receive and the operating surplus of companies (roughly sales less costs).

GDP in a country is usually calculated by the national statistical agency, which compiles the information from a large number of sources. In making the calculations, however, most countries follow established international standards. The international standard for measuring GDP is contained in the System of National Accounts, 1993, compiled by the International Monetary Fund, the European Commission, the Organization for Economic Cooperation and Development, the United Nations, and the World Bank.

One thing people want to know about an economy is whether its total output of goods and services is growing or shrinking. But because GDP is collected at current, or nominal, prices, one cannot compare two periods without making adjustments for inflation. To determine “real” GDP, its nominal value must be adjusted to take into account price changes to allow us to see whether the value of output has gone up because more is being produced or simply because prices have increased. A statistical tool called the price deflator is used to adjust GDP from nominal to constant prices.

GDP is important because it gives information about the size of the economy and how an economy is performing. The growth rate of real GDP is often used as an indicator of the general health of the economy. In broad terms, an increase in real GDP is interpreted as a sign that the economy is doing well. When real GDP is growing strongly, employment is likely to be increasing as companies hire more workers for their factories and people have more money in their pockets. When GDP is shrinking, as it did in many countries during the recent global economic crisis, employment often declines. In some cases, GDP may be growing, but not fast enough to create a sufficient number of jobs for those seeking them. But real GDP growth does move in cycles over time. Economies are sometimes in periods of boom, and sometimes in periods of slow growth or even recession (with the latter often defined as two consecutive quarters during which output declines). In the United States, for example, there were six recessions of varying length and severity between 1950 and 2011. The National Bureau of Economic Research makes the call on the dates of U.S. business cycles.

GDP is measured in the currency of the country in question. That requires adjustment when trying to compare the value of output in two countries using different currencies. The usual method is to convert the value of GDP of each country into U.S. dollars and then compare them. Conversion to dollars can be done either using market exchange rates—those that prevail in the foreign exchange market—or purchasing power parity (PPP) exchange rates. The PPP exchange rate is the rate at which the currency of one country would have to be converted into that of another to purchase the same amount of goods and services in each country. There is a large gap between market and PPP-based exchange rates in emerging market and developing countries. For most emerging market and developing countries, the ratio of the market and PPP U.S. dollar exchange rates is between 2 and 4. This is because nontraded goods and services tend to be cheaper in low-income than in high-income countries—for example, a haircut in New York is more expensive than in Bishkek—even when the cost of making tradable goods, such as machinery, across two countries is the same. For advanced economies, market and PPP exchange rates tend to be much closer. These differences mean that emerging market and developing countries have a higher estimated dollar GDP when the PPP exchange rate is used.

The IMF publishes an array of GDP data on its website (www.imf.org). International institutions such as the IMF also calculate global and regional real GDP growth. These give an idea of how quickly or slowly the world economy or the economies in a particular region of the world are growing. The aggregates are constructed as weighted averages of the GDP in individual countries, with weights reflecting each country’s share of GDP in the group (with PPP exchange rates used to determine the appropriate weights).

It is also important to understand what GDP cannot tell us. GDP is not a measure of the overall standard of living or well-being of a country. Although changes in the output of goods and services per person (GDP per capita) are often used as a measure of whether the average citizen in a country is better or worse off, it does not capture things that may be deemed important to general well-being. So, for example, increased output may come at the cost of environmental damage or other external costs such as noise. Or it might involve the reduction of leisure time or the depletion of nonrenewable natural resources. The quality of life may also depend on the distribution of GDP among the residents of a country, not just the overall level. To try to account for such factors, the United Nations computes a Human Development Index, which ranks countries not only based on GDP per capita, but on other factors, such as life expectancy, literacy, and school enrollment. Other attempts have been made to account for some of the shortcomings of GDP, such as the Genuine Progress Indicator and the Gross National Happiness Index, but these too have their critics.

How should we measure changes in an economy's standard of living, or compare living standards across countries? Typically, economists use GDP per capita as a proxy for a country's standard of living, but as International Monetary Fund head Christine Lagarde, Nobel prize-winning economist Joseph Stiglitz and MIT professor Erik Brynjolfsson noted at the recently concluded World Economic Forum in Davos, Switzerland, "GDP is a poor way of assessing the health of our economies and we urgently need to find a new measure."

Using GDP as a measure of welfare has well-known problems, which are among the first things macroeconomics principles courses cover. But the point of the discussions at Davos is that in the digital age, those problems are even deeper. Standard GDP statistics miss many of technology's benefits, so we need to rethink how we measure the typical person's well-being.

The textbooks generally point out five problems with using GDP as a measure of well-being:

The Davos discussion, however, is pointed at a different flaw in measured GDP: its inability to fully capture the benefits of technology. Think of a free app on your phone that you rely upon for traffic updates, directions, the weather, instantaneous information and so on. Because it's free, there's no way to use prices -- our willingness to pay for the good -- as a measure of how much we value it.

As a result, GDP statistics won't capture the benefits we gain from free apps, just as it has difficulties accounting for changes in the quality of goods over time.

How can this be fixed? Catherine Rampell provides a nice summary of the alternative measures that have been proposed, including China's "green GDP," which attempts to adjust for environmental factors; the OECD's "GDP alternatives," which adjust for leisure; the "Index of Sustainable Economic Welfare," which accounts for both pollution costs and the distribution of income; and the "Genuine Progress Indicator," which "adjusts for factors such as income distribution, adds factors such as the value of household and volunteer work, and subtracts factors such as the costs of crime and pollution."

Finally, there are more direct measures of well-being such as the Happy Planet Index, Gross National Happiness and National Well-Being Accounts.

However, none of these alternatives deal with the main problem discussed in Davos -- how to measure the full impact of technology on our lives. The problem is that GDP assigns a zero value to goods with a zero price, but those goods aren't valued at zero and as they become more prominent, we'll need to find a way of including the benefits they provide in our measures of the standard of living.

None of the measures proposed so far are perfect, and they won't replace the current GDP yardstick anytime soon.

But there's still something to be gained from this work. When you hear that your standard of living has gone up, ask yourself what has happened to leisure time -- are you working more or less for the same income? How much of technology's benefits might have been missed -- how often do you use Wikipedia? And how was the additional GDP distributed across the population -- did it mostly go to the 1 percent?

Inequality: GDP growth doesn't tell us how income is split across a population - rising GDP could result from the richest getting richer, rather than everyone becoming better off.

At the World Economic Forum’s 49th annual meeting in Davos, New Zealand Prime Minister Jacinda Ardern revealed that she would create the world’s first ‘wellbeing budget’ in order to prioritise the health and welfare of her country’s citizens. She said: “We need to address the societal wellbeing of our nation, not just the economic wellbeing.”

Economic growth – and, by proxy, wellbeing – is currently measured by gross domestic product (GDP). As the framework upon which governments build countless policies, GDP aims to track the production of all goods and services bought and sold in an economy each year.

The measure has become a critical tool used by economists, politicians and academics to understand society. It has been labelled “the most powerful statistical figure in human history” by author and lecturer Philipp Lepenies, and named “one of the great inventions of the 20th century” by the Federal Reserve Bank of St Louis. Today, however, GDP’s purpose is being called into question.

Coming up short Having become such a familiar macroeconomic metric, it is easy to forget that GDP is a relatively modern invention. The framework for monitoring economic growth was created for the US Government by Russian-born economist Simon Kuznets in the aftermath of the Great Depression, before modifications made by British economist John Maynard Keynes turned it into the indicator we know today.

In an independent review of the UK’s economic statistics published in 2016, Sir Charles Bean wrote that GDP is often viewed as a “summary statistic” for the health of the economy. This means it is frequently conflated with wealth or welfare, though it only measures income. “Importantly, GDP… does not reflect economic inequality or sustainability (environmental, financial or [otherwise]),” Bean wrote. What’s more, GDP is not the precise and flawless figure that many believe it to be – it is merely an estimate. “This uncertainty surrounding official measures of GDP is inadequately recognised in public discourse, with commentators frequently attributing spurious precision to the estimates,” Bean continued.

Sarah Arnold, Senior Economist at the New Economics Foundation (NEF), told World Finance that GDP as a measure of economic activity is simply a means to an end: “It has become so synonymous with national success that the rationale for pursuing economic growth in the first place seems to have been long forgotten.”

Putting the flaws highlighted by Bean and Arnold aside, GDP is still an inaccurate measure of prosperity, as it fails to convey much of the value created in the modern world. GDP was developed during the manufacturing age and, as David Pilling, Africa Editor of the Financial Times, wrote in his book The Growth Delusion: Wealth, Poverty and the Wellbeing of Nations: “[GDP] is not bad at accounting for production of bricks, steel bars and bicycles.” Where it struggles, though, is with the service economy, a segment that accounts for a growing proportion of high-income countries’ economies (see Fig 1). “[Try GDP] out on haircuts, psychoanalysis sessions or music downloads and it becomes distinctly fuzzy,” Pilling wrote.

GDP’s preference for tangible goods also means it is insufficient at capturing the value of technology. Where disruptive innovations have made life easier for consumers – allowing them to book their own flights rather than paying a travel agent, for instance – GDP only sees a shrinking economy. “Lots of what tech is doing is destroying what wasn’t needed,” Will Page, Director of Economics at Spotify, told Pilling. “The end result is you’re going to have less of an economy, but higher welfare.”

Countless free online services have moved outside the realm of economic activity measured by GDP, including Google, YouTube and Wikipedia. In the eyes of GDP, innovation – even if it means a better quality of service – is often a detractor of economic growth. Elsewhere, valuable areas of work have always existed outside of the GDP framework, including housework, caring for sick family members or friends, and volunteering. The impact of this work is unaccounted for simply because no money changes hands.

In a 2014 speech, Andrew Haldane, Chief Economist of the Bank of England, said the economic value of volunteering could exceed £50bn ($63.7bn) per year – and that is before tallying up the impact on the volunteers’ wellbeing, which includes reducing stress, improving physical health and learning new skills.

The bigger picture In 1968, Robert Kennedy, the brother of US President John F Kennedy, criticised gross national product – a similar measure to GDP – by saying it “measures everything, in short, except that which makes life worthwhile”. Arnold believes this observation is still true today: “GDP is not a particularly useful measure in and of itself because it doesn’t tell us much about the direction of our economic activity or help us to determine how to govern it.”

The NEF believes there are five indicators that GDP doesn’t take into account that could help measure national success more accurately: job quality, wellbeing, carbon emissions, inequality, and physical health. “We know what a good economy that allows people to flourish should be,” Arnold said. “A good economy meets everyone’s basic needs; it means people are healthy and happy, and it does not stoke potential long-term trouble, such as extreme inequality.”

The World Bank has also created a more robust measure of economic growth: comprehensive wealth. Comprehensive wealth, it argues, takes into account both income and associated costs in a number of areas, providing a fuller picture of economic wellbeing and a more sustainable pathway for growth. “Used alone, GDP may provide misleading signals about the health of an economy,” the World Bank’s The Changing Wealth of Nations 2018 report read. “It does not reflect depreciation and depletion of assets, whether investment and accumulation of wealth are keeping pace with population growth, or whether the mix of assets is consistent with a country’s development goals.”

For GDP, which does not distinguish between good and bad production, bigger is always better. “GDP includes activities that are detrimental to our economy and society in the long term, such as deforestation, strip mining, overfishing and so on,” Arnold said. Wars and natural disasters, too, can be a boon to GDP as a result of the associated increase in spending. Comprehensive wealth, on the other hand, accounts for all of a country’s assets, including: produced capital, such as factories and machinery; natural capital, like forests and fossil fuels; human capital, including the value of future earnings for the labour force; and net foreign assets.

GDP’s neglect of natural capital in particular has received more attention in recent years. Natural assets, such as forests, fisheries and the atmosphere, are often regarded as self-sustaining, fixed assets. In actual fact, all of these resources can be – and are being – depleted by humans. Since the 1990s, economists have looked into the possibility of putting a price tag on natural resources to ensure their value is taken seriously. Ecological economist Robert Costanza published a paper entitled The Value of the World’s Ecosystem Services and Natural Capital in Nature in 1997 that valued the whole of the natural world at $33trn. While Costanza’s research was highly controversial, the idea of accounting for natural depletion within the landscape of economic growth is becoming more common. As Pilling wrote: “If you don’t put a monetary value on something, people tend not to value it at all.”

The price of happiness Experts are working to pin down a number of intangible qualities that contribute to the health of an economy, such as happiness and knowledge. Several indicators have been developed to provide a means for countries to monitor their progress in these areas. One such example is the UN’s Human Development Index (HDI), which evaluates a nation’s citizens in terms of their health, knowledge and standard of living. To do this, it tracks achievements in areas such as life expectancy at birth, years of schooling and gross national income per capita.

The UN admitted its index only provides a window into human development and fails to account for aspects such as inequality, poverty, human security or empowerment. But since its development in 1990, the UN has also introduced other composite indices, including the Inequality-adjusted HDI, the Gender Inequality Index and the Gender Development Index. Other surveys and indices, meanwhile, aim to measure the even more subjective quality of happiness: Lord Richard Layard, a professor at the London School of Economics, has been a pioneer in this area, and believes the government should prioritise policies that boost happiness over growth. His research has gone on to influence international efforts to track happiness, such as the UN’s World Happiness Report, which provides an annual snapshot of how happy people around the world perceive themselves to be.

Arthur Grimes, a professor of wellbeing and public policy at Victoria University of Wellington and a former chair of the Reserve Bank of New Zealand, pointed out that these lists still show some correlation between GDP and happiness: “It’s very rare to find a country that, overall, has higher wellbeing that isn’t rich.”

According to the 2019 World Happiness Report, the top five happiest countries in the world are Finland, Denmark, Norway, Iceland and the Netherlands. South Sudan, the Central African Republic, Afghanistan, Tanzania and Rwanda, meanwhile, sit at the bottom of the list. Grimes told World Finance that the top-ranking countries on happiness lists tend to be wealthy nations with a welfare state, adding: “Unfortunately, we’re all in that situation where you do have to keep up on things like GDP. But you shouldn’t focus on that solely.”

While GDP does have a part to play, other aspects that contribute to the World Happiness Report’s ranking include social support, healthy life expectancy, the freedom to make life choices, perceptions of corruption, and generosity. These traits provide pockets of insight often missed by other metrics, helping to explain why the US and the UK, which rank among the top five richest countries by GDP, sit 15th and 19th on the list in terms of happiness, or why Costa Rica, which ranks somewhere in the 70s in terms of GDP, wound up in 12th place.

“There are some rich countries that aren’t quite as happy as the others,” Grimes said. “They’re still in the top 20 in the world, [but] that measure is a really useful one because it does say, in countries like the US and the UK, there is something going a bit wrong there – they should be happier than they are.”

A New (Zealand) approach While countries such as the UK, France and Australia have long been driving the conversation on welfare, New Zealand’s wellbeing budget – the specifics of which were unveiled in May 2019 – has been recognised as one of the first attempts to explicitly zero in on wellbeing across different parts of society.

For example, the budget set aside NZD 1.9bn ($1.25bn) for mental health initiatives in a bid to address New Zealand’s youth suicide rate, which is among the highest in the world. Spread over five years, the funding will establish a universal frontline mental health service aimed at helping the more than 300,000 people with moderate mental health and addiction needs in the country. “Mental health is no longer on the periphery of our health system,” Grant Robertson, New Zealand’s Minister of Finance, said at the budget’s unveiling. “It is front and centre of all of our wellbeing.”

In terms of mental health, Grimes said the budget has delivered above expectations. It also performed well in areas such as family violence and sexual violence – other categories New Zealand has typically struggled with in comparison to other developed countries. A record sum of NZD 320m ($210.6m) was announced for reducing domestic violence, while NZD 1bn ($656.3m) was earmarked to help vulnerable children.

Despite these positive steps, Grimes criticised the budget’s lack of concrete targets, with the exception of child poverty: “We have some major new expenditure initiatives, but they lack a corresponding set of outcome targets, making it difficult to evaluate whether the programmes are effective or not.”

New Zealand’s wellbeing budget is not perfect, but it is a clear step away from a purely growth-driven view of success. In order to accurately measure an economy’s health and wellbeing, and to change the way we think about prosperity, a range of robust indicators is needed. As Arnold said: “We pay attention to what we measure. Headline indicators that are widely reported shape the way we think about what it means to be successful.”

While GDP provides important insight into a country’s economic position, it is far from the whole picture. Armed with a clearer understanding of where true economic value is created, policymakers and business leaders will be able to determine new pathways to success.

• (i) Non monetary exchanges. GDP measures the goods and services produced in an economy during a particular period of time.
• (ii) Inflation. GDP does not take into account the level of prices in a country.
• (iii) Externalities.
• (iv) Income pattern.

Just as in America, in Britain too the story told by official statistics does not always match people’s lived experience. That is especially true in places like Newcastle, a former shipbuilding city, which lost out to competition from Asia in the 1970s and has seen living standards stagnate ever since. As in parts of the U.S. where opportunities for non–college graduates have stalled, health outcomes in Newcastle are below the national average.

The U.S. economy, we are told, is booming. In the past two quarters, gross domestic product has risen by more than 3%, the stock market is soaring and unemployment is down to a 17-year low of 4.1%. Many people, though, don’t feel that upside.

The perception gap is an abyss. Unemployment, more broadly measured, is higher than the headline number suggests because many people have simply given up looking for work or are working in part-time jobs when they want a full-time job. One of the prime faults of GDP is that it deals in averages and aggregates. Aggregates hide the nuances of inequality. And averages don’t tell us very much at all. Barring a few recessions, the U.S. economy has been on a near relentless upward path since the 1950s. Yet according to a Pew Research Center report, the average hourly wage for nonmanagement private-sector work was $20.67 in 2014, a measly $1.49 higher than in 1964, adjusted for inflation.

Studies suggest that people care more about relative than absolute wealth. If that is true, then as a minority have become richer, the majority have grown more miserable. In a famous experiment carried out at Emory University, two capuchin monkeys were put side by side and given cucumbers as a reward for performing a task. When one of the monkeys was given better-tasting grapes instead, the monkey receiving cucumbers became distraught, flinging its now despised reward at its trainer. The experiment is called “Monkeys Reject Unequal Pay.”

The problems with using GDP as a barometer go beyond masking inequality. Invented in the U.S. in the 1930s, the figure is a child of the manufacturing age–good at measuring physical production but not the services that dominate modern economies. How would GDP measure the quality of mental-health care or the availability of day-care centers and parks in your area?

Even Simon Kuznets, the Belarusian economist who practically invented GDP, had doubts about his creation. He did not like the fact that it counted armaments and financial speculation as positive outputs. Above all, he said, GDP should never be confused with well-being. Kuznets’ is a warning we have ignored. Growth as measured by GDP has become the king of numbers. Woe upon the politician who says he is going to sacrifice growth for something else, whether that is cleaner air, better health care or free pizza.

It is not all bad news. Because GDP is poor at capturing innovation, it may underestimate some aspects of our lives. A 19th century billionaire would have given half his fortune for a lifesaving course of antibiotics. Now antibiotics cost pennies and contribute virtually nothing to our measured economy. Wikipedia, which brings human knowledge to virtually everyone, adds not a cent to GDP.

That suggests we need to find different ways of measuring our success. For the most part, we have become enraptured with a single measure that offers only limited information.

A decade ago, former French President Nicolas Sarkozy commissioned a panel, headed by Nobel economist Joseph Stiglitz, to study exactly this. In what became the title of its report, it concluded that we were “mismeasuring our lives.”

In the foreword, Sarkozy wrote that the gap between reported well-being and people’s lived experience was creating a “gulf of incomprehension between the expert certain in his knowledge and the citizen whose experience of life is completely out of sync with the story told by the data.” That gulf, he wrote, in words that summarize the anger that is currently tearing so many societies apart, is “dangerous because the citizens end up believing that they are being deceived. Nothing is more destructive of democracy.”

Pilling is an associate editor at the Financial Times and the author of The Growth Delusion.

This appears in the February 05, 2018 issue of TIME.