GDP may be a good measure of output for a country. However, it measures the output of tangible things. In an economy where we our output is fast moving into intangible products, it may be time to look for a better alternative.
When I say “GDP” what springs to mind? If you battled through those irksome supply and demand curves in sixth form microeconomics and graduated to the much more interesting but murky world of macroeconomics, then you probably shouted, “gross domestic product!” and you would be right. But what is GDP and how is it calculated?
A simple measure with a complicated calculation
In simple terms, GDP measures the total gross output of a country. It is “gross” because the calculation does not consider depreciation when valuing assets. If depreciation was included, it would be called “NDP” or “net domestic product”.
I said “in simple terms” as there is nothing simple about how GDP is calculated. However, for the purpose of this article, all you need to know is that there are two main methods; you either add up all a country’s income, or all its expenditure. In theory both methods arrive at the same figure. In practice they don’t (but that is another story). It is generally recognised that the “expenditure approach” (the second approach mentioned) is preferable, so the calculation of GDP most widely used throughout the world is:
Gross Domestic Product = Consumption + Investment + Government spending + (EXports – IMports)
OR
GDP = C+I+G+(X-M)
In other words, if we add up:
- All the private sector, payments for consumable goods and services,
- PLUS the cost of all new investments (in this context “investments” means things like new cars or machinery – it doesn’t mean financial assets, like stocks and shares or government bonds),
- PLUS government spending,
- PLUS the value of all the things we export,
- MINUS the value of all the things we import,
- and ignore any asset value depreciation,
- we arrive at GDP.
Under “consumption” and “government spending” we include buying services as well as buying tangible items, which may vex the father of modern economics, Adam Smith, who regarded productive labour as only that which manufactured stuff. All else, including services, was regarded by the great man as a cost.
Why does GDP no longer work?
A contentious issue with GDP is that it only counts what changes hands for a price, which misses lots of activity, including voluntary work and unpaid homeowners’ DIY. Rather bizarrely, a widow who marries her gardener and stops paying him diminishes the country’s GDP, even if he continues to prune the roses and mow the lawn.
GDP doesn’t measure unforeseen production costs or consequences, such as pollution or other detrimental effects on society. In economic parlance, these are called “externalities”.
GDP’s shortcoming
Another thing GDP doesn’t measure is wellbeing, a shortcoming pointed out by the Nobel prize winning American economist Simon Kuznets when working on the definition of GDP during the 1930s and 1940s. At that time, governments simply wanted a measure that gave a fairly accurate indication of actual, and potential, national output so they could design fiscal policy to maximise production and minimise unemployment. In doing so, they could reduce the risk of another 1930s style “Great Depression”.
John Maynard Keynes, arguably the most influential economist of the 20th century, advocated for measuring output rather than wellbeing. It was not that Keynes didn’t care about wellbeing, but he was more concerned with using GDP to form policy that minimised unemployment. In other words, Keynes saw GDP as a tool to create better wellbeing, not as a tool to measure it.
Fast forward to today and most of the world’s developed economies use the classic calculation of GDP. This makes comparison between countries possible, as long as you know the exchange rates on currencies in the period under review.
I very much doubt GDP’s current definition, or perhaps GDP itself, will last into the next century. It has been described as an “abstract concept” which means that, unlike hard scientific facts, its future is not assured. As with most things in life, future generations will improve on the way their ancestors measured, and managed, their economies.
GDP was designed primarily to measure the output of tangible things, a measure that becomes compromised when the UK derives over 70% of its economy from intangible services.
What will GDP develop into?
GDP is ubiquitous. It is used to determine when we enter and exit a recession, to compare the management of the economy between different political parties, to measure the relative level of our national debt and to assess whether we are becoming more, or less, productive. GDP’s current format and use as a measurement may be less than 100 years old, but during that time an average family’s wealth and prosperity in a developed economy has increased at a rate unimaginable to our ancestors. GDP has helped us to track that progress and before we ditch it, we need to make sure its replacement does an equally good job for the next 100 years.
