The trouble with GDP

It measures everything except that which makes life worthwhile, say critics. But could the whole idea of gross domestic product do with a radical overhaul, asks Simon Wilson

What's happened?

The Bureau of Economic Analysis, the US government agency charged with calculating America's gross domestic product (GDP), is changing what it counts as an economic output. It will now include intangible' assets such as spending on research and development, and the economic value of artistic originals' such as Hollywood movies, TV programmes, books and even stageplays.

The overall effect will be to add around 3% to the size of the economy (something in the order of $450bn in 2007, the base year of the new methodology).

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The biggest chunk of this is R&D spending: from now on it will be treated as a capital investment (and hence show up in the GDP calculation) instead of being treated as a cost incurred in the production of other finished goods. Other nations can be expected to follow the US lead.

Why make the change?

"The world economy is changing and there's greater recognition that things like intangible assets play a role similar to tangible capital that was captured in the past", Brent Moulton, head of national accounts at the BEA, told the FT. The change is designed to recognise the importance of R&D to the creation of wealth.

And in the case of artistic originals, it's designed to reflect the importance and distinctive nature of creative capital the fact that a film or book might be created in one year but enjoyed for many. The great TV sitcom Seinfeld, for example, went off air in 1998 but has generated $3.1bn in revenue since then; the change to GDP is meant to recognise that value.

How is GDP calculated?

In the UK, the Office for National Statistics calculates the figure after collecting data from 46,000 firms, as well as government departments, and produces its first estimate just 25 days after a quarter has ended based solely on the output measure (and only 40% of the data) which is why the figure so often gets revised. However, in principle, all three measures of GDP (see below) should produce the same number.

It tells policymakers and others how fast the national economy is growing and allows for international comparisons. The calculation of GDP is a relatively new idea: it has its roots in the early 1930s, when the US government trying to deal with an economic slump but lacking a true picture of what was happening to the economy asked the economist Simon Kuznets to find a way to measure national income. Since then GDP has become a near-universal measure despite frequent criticisms of its purpose and usefulness.

What's wrong with GDP?

The most basic criticism of GDP is that the whole idea of a measureable national output misunderstands the nature of wealth creation. This is done by individuals and firms rather than nations. It also encourages policymakers to believe in their own ability to prioritise the needs of a mystical entity called the economy' rather than those of real people, and to make bad decisions as a result.

If a government decides to stimulate growth by building a pyramid, say, the GDP framework will regard this as economic activity. In reality, however, as Austrian-school economist Frank Shostak has pointed out, the pyramid adds nothing to the wealth of individuals, and instead diverts scarce resources.

The same goes for central banks who see GDP slipping and decide to loosen the money supply: they satisfy politicians by giving growth' a boost, but store up trouble for the future.

Are there other criticisms?

The father of GDP, Simon Kuznets, foresaw the danger that policymakers would put too much faith in one number. He also warned, as early as 1934, that the welfare of a nation must not be judged from measuring its economy, and that "economic welfare cannot be adequately measured unless the personal distribution is known".

This insight forms the basis of much of the more recent critics of GDP who say it has skewed global political objectives towards economic growth at all costs at the expense of social welfare and other priorities.

What other priorities?

The environment, for example. The damage done by pollution is not accounted for, and yet cleaning it up boosts GDP. A boom in prison building will also boost the metric, but only because far more crimes are being committed. Robert F Kennedy put this pithily 40 years ago, observing that it "measures everything except that which makes life worthwhile".

There are plenty of alternatives that challenge the hegemony of growth-centric thinking, from the Human Development Index (which combines economic, literacy and life expectancy data) to gross national happiness'. For the time being, though, GDP reigns supreme now with added intangibles.

What exactly does GDP measure?

The gross domestic product' is the market value of all the final goods and services produced within a given country in a given time. (It should not be confused with gross national product, which includes things produced abroad by enterprises owned by this country's citizens.)

There are three ways of arriving at the single GDP figure: the output measure (the value of goods and services produced by all sectors of the economy, including the government); the expenditure measure (the value of goods and services bought by households and government, investment in machinery and buildings, and net exports); and lastly the income measure (the value of income generated, mostly in terms of profits and wages).