July 16, 2019: GDP
Last week I wrote about a few of the various categories of unemployment, isolating “U3” – the one most commonly cited by the news and government – and “U6” – the one that serves to aggregate all disenfranchised labour. The difference between these two factors gives us a peek into how the current hiring “boom” has benefited some, not all. [https://www.kentbhupathi.com/blog/july92019]. This week we will explore the next of the usual suspects – Gross Domestic Product (GDP).
In our economy, GDP is commonly cited as the benchmark measure for “growth” and “growth rates”. It is not quite as frequently cited as unemployment (as reported by Google Trends), but that is primarily because unemployment is easier to explain and visualise.
Nevertheless, GDP is simply an attempt to aggregate the value of all economic activity within a region. It is composed of four parts that are reported in different time intervals and later re-reported quarterly, when aggregated:
Personal Consumption [https://fred.stlouisfed.org/series/PCE];
Government Spending [https://fred.stlouisfed.org/series/W068RC1A027NBEA#0];
Business Investment [https://fred.stlouisfed.org/series/W987RC1Q027SBEA#0]; and,
Net Exports (Exports minus Imports) [https://fred.stlouisfed.org/series/NETEXP].
Keeping in-line with unemployment as a metric, GDP seems simple enough – if we consume more, then businesses grow, which means that the economy grows, and that is a positive. If the government invests more into the public (e.g. schools, infrastructure, etc.) or provides subsidies to new business development, the potential for future innovation grows, which expands the economy, and that, too, is a positive. A similar analysis can be made for business investment and net exports. If these components increase positively then the economy grows. If these components contract, then the economy contracts. Hence one would conclude based on these factors that GDP is a stable factor to measure economic growth. But, unfortunately GDP is far from being a stable measure for conducting an economic check-up and the reasons for this rest in how over-simplistic the metric truly is.
Let’s breakdown GDP into its components from 2000 Q1 through 2019 Q1:
Right-off the bat we can see the first issue with GDP – its uncanny resemblance to Consumption. This is based on the fact that Personal Consumption accounts for more than two-thirds of GDP (68%). This is not by accident! To reference a personal anecdote, while tutoring through my current doctoral programme, I often tested undergraduate economics and business majors to identify which graph reflected GDP and which one reflected Consumption by removing the y-axes. This simple test showed approximately 50% of the students were unable to identify the correct graph -- a coin toss, essentially. Now, I must admit that although I enjoyed watching my students struggle to point out the correct graph, it ultimately validated a point – there is little to no difference in the nature of the measure’s movement when Personal Consumption Expenditures are included. To better understand this problem we need to study the formulation of the measure.
GDP, as we know it today, dates back to 1934 as a quick fix by the US Nobel Prize-winning economist Simon Kuznets to aid Congress in assessing whether the US economy was recovering from the Great Depression. In other words, it was to measure the populace’s ability (or inability) to consume as it increased. In this, GDP was designed with a bias to track consumer consumption over time. This consumer bias, however, continued to grow disproportionately to the other inputs when the GDP became the universal benchmark for assessing economic growth across countries at the 1944 Bretton Woods Conference – a conference amongst world diplomats to develop international trading standards and to develop a global gold standard.
The gold standard contributed greatly to heightening the importance of GDP. Given that the gold standard ensured that prices would not vary by much (fixing a dollar value to an otherwise volatile ounce of gold), Consumption could also be easily assessed at a near-constant monetary structure. Moreover, this was a time for profound industrialism in the US while all other major industrialized countries were severely impacted during WWII, which resulted into the rise of the American purchasing power at levels unseen before and throughout the history of the GDP measure. This, too, entrenched the GDP as a measure of political fancy.
But, why is this an issue? The issue from the Consumption bias comes from the fact that it is easier to track goods and services that are easily recorded – for e.g., shopping at a grocery store, getting haircuts, a trip to the movie theatre, purchasing a pizza, etc. On the other hand, economic activities such as volunteering, using a software-as-a-service to bypass cashiers for purchasing, parenting, illegal sales of goods or private sale of, used goods, sale of intermediate goods (goods used to make other goods), any of Google’s freemium products/services, or the sale of goods produced by American companies outside of the US, are all items are not include when calculating GDP. It is the exclusions of these goods and services, especially given an economy so heavily dependent upon the use of the internet and professional services, that the GDP becomes, ultimately, more about the exclusion of current business innovation for the maintenance of older industrial norms (GDP’s second, major issue). Moreover, since divesting from the gold standard as a measure of the value of currency (which, on the whole, was best – not discussed here), this means that so long as prices increase (typical inflation expectations) for time-constant bundles of goods, GDP is all but guaranteed to be increasing, over time (at the end of the day, GDP is primarily measures cash transactions).
GDP’s designed positive trendline renders GDP itself as a culprit to inciting market speculation cycles. It would be easy to lay blame on GDP’s creator; but, to add insult to injury for all politicians and political “pundits” that have built their careers by reporting their supposed contributions to this measure, I often like to quote Dr. Kuznets himself – “The welfare of a nation can scarcely be inferred from a measurement of national income as defined by the GDP” (within his 1934 report to Congress).
Where do we go from here? Fortunately, the twenty-first century has provided many refreshing ways to define growth:
Want to proxy for consumer behaviour -- instead of GDP’s “Consumption”, use the “Consumer Confidence Index”;
Want to better understand the business landscape -- use the “Business Confidence Index” and the “Total Business: Inventories to Sales Ratio”;
Concerned about the amount of Federal spending -- since GDP does not account for State and Local government expenditures -- use the ratio or State and Local over Federal to help to shed light into the expansion or contraction of American federalism.
There is no shortage of alternatives to each component of GDP these days. Each alternative has its own nuance and economic narrative. So long as we are staying abreast of new measures and remaining critical of “be-all and end-all” metrics, we can better forecast business cycles and manage our expectations.
[GDP will return on the topic of Recessions]
Thank you for taking the time to read this post,
Best,
Kent Bhupathi
https://www.linkedin.com/in/kentob/
For more fun insights, check out my colleague:
Chunyu Qu