Night School: Gross Domestic Product (GDP)

Even casual followers of economic and financial news sense that GDP is critically important to economists, investors, and policymakers. What is it, and why is it so important?

According to the International Monetary Fund, “GDP measures the monetary value of final goods and services—that are bought by the final user—produced in a country in a given period of time (say a quarter or a year).”

GDP is often used as a metric for international comparisons as well as a broad measure of economic growth. The ratio of GDP to the total population of the region is the per capita GDP and is also called Mean Standard of Living.

Nominal GDP is the GDP at current prices (i.e., with inflation). “Real” GDP is the GDP after inflation has been subtracted. GDP is usually reported as real GDP to reflect actual increases in output or income, rather than what is due to inflation.

The U.S. GDP is primarily measured based on spending by households, businesses, government, and by the amount of net exports (what the U.S. sells to other countries versus what it buys from others).

If GDP is rising, the economy – along with the nation – is thought to be growing. If gross domestic product is falling, the nation is thought to be losing ground. Two consecutive quarters of declines in GDP typically define an economic recession.

The original measure was GNP, or gross national product, which measured a country’s national income that was generated anywhere in the world. GNP was developed in the 1930s at the request of President Roosevelt as an aid in assessing the impact of his policies and to assess the effectiveness of the shift to a wartime economy during World War II. Growth in output continued to be a national policy throughout the Cold War with the Soviet Union, as military might cannot exist for long without economic might.

The developer of the measure, Simon Kuznets, eventually became a vocal opponent of GDP, as GDP increasingly became a proxy for national well-being, rather than just a measure of economic performance.

There are quantitative and qualitative problems with GDP, however. GDP accounts for all commercial activity, whether it is good or bad for society. For example, coal mining and combustion are included in GDP, but the “externality” of air and water pollution is ignored. Yet, spending on environmental cleanup is also included in GDP, so the damage from coal is counted as positive to GDP twice.

The promotion of GDP fits with the orthodoxy of the economics profession. For decades, economists have developed increasingly complex mathematical models of an economy, with illusory precision. But economics is not a hard science such as physics; the simplifying assumptions for conventional economic theory fail broadly in describing how dynamic an economy is, as people are not always rational calculators who seek to maximize their own interests. The economy is far too complicated for a single statistic. The “laws” of economics assume that the overall economy can reach a state of equilibrium, at which markets are in balance, with individuals satisfied. Maximizing private welfare – letting the free market work its will – also fits with the dogma that the private sector is the route to maximizing utility, not the government.

Though economic growth in developing countries has lifted hundreds of millions of people out of abject poverty, in developed countries only the wealthiest have garnered the vast majority of gains from economic growth in recent decades.

With income and wealth inequity at the highest levels since the 1920s, something is seriously wrong with the simple goal of maximizing GDP. Furthermore, it is likely not even feasible for GDP to continue to grow in a world that’s heating up alarmingly fast and where another billion people will soon be drawing on the shrinking capacity of the planet to sustain human life.

Given the failure of economic theory as practiced over the last seven decades and the use of GDP as a proxy for national well-being, it is long overdue to consider alternative approaches, both in describing the economy and in measuring national well-being. In the last issue, we discussed one fresh approach toward describing the economy, Modern Monetary Theory (MMT). For a measure of well-being, other countries and several states in the U.S. have for years been publishing alternative measures to GDP, such as the Genuine Progress Indicator (GPI). We’ll say more on some of these alternatives in the next issue.