Muddling through the many ways defining economic progress

This article appeared originally in Gulf News: link to original article

How can you tell if a country is at a better economic standing than another?

You ask the average Joe that question, and the typical answer would be how the gross domestic production, or GDP, of that country measures against the other.

Raise the complexity level a notch, and you may hear someone quoting GDP per capita — which is GDP divided by population — to check how relevant the GDP is versus size of population, which is crucial when trying to determine how much economic growth may have trickled down to individuals in the country.

Lift the conversation another notch, the answer will include GDP measured in Purchasing Power Parity (GDP PPP), a reflection of a country’s economy that considers and adjusts for the given country’s currency’s exchange rate.

Confused? There’s more.

Enter gross national income, or GNI. From the name itself, GNI has to do with income mainly. Now a fancy definition will include terms such as domestic and foreign output, and what residents earn versus non-residents, etc. Allow me to spare you all of that and to reword the definition as income claimed by the country versus income claimed against it.

GNI is an upgrade to GDP and not an alternative to it. Think of it as an update that fixes software bugs, with more severe consequences since it has to do with a country’s economy and its growth, which subsequently can affect its positioning in debt markets and how investors perceive its potential.

GNI, like GDP, also boasts per capita and purchasing power parity derivatives that are used for similar reasons as those behind the use of GDP derivatives.

So, how to tell which economy is doing better than another? If you are to be fair, you would have to cite all of the above introduction plus numbers for each country, acknowledging here that memorising GDP, GDP PPP, GDP per capita, GNI, GNI per capita and GNI PPP is nothing short of inhumane, especially when the general expectation is for you to know them as long as you know that “Pi” in mathematics equals 3.14159.

To keep it simple, it must be noted that GDP and its per capita and PPP derivatives, not GNI, are the most commonly used to understand, in relative terms, how economies compare. However, and despite its wide usability, GDP and Co. is old and flawed.

For one, GDP could be adjusted upwards and downwards depending on a change in how a country calculates it. Despite the allowed flexibility, such adjustments could be very distorting. Take for example Nigeria’s economy, assumed to have almost doubled in size based on 2013 GDP calculations when the base year to calculate GDP was changed from 1990 to 2010, discarding key changes in its economy’s structure.

Two, GDP’s calculation can shift dramatically with fluctuations in commodity prices. Though this could be specific for countries where extracting and exporting commodities constitute a decent proportion of a country’s revenues and economy, associating commodity prices with GDP calculations can be very misrepresentative.

That is, the association is based on a questionable assumption that higher commodity prices will affect a country’s income positively, leading to spending and investing in its economy. Thus, GDP is adjusted upwards. If commodity prices drop, GDP is adjusted downwards.

Three, GDP accounts for net trade position, exports minus imports. When a country’s exports exceed its imports, its GDP gets inflated and vice versa.

Besides being vulnerable to protectionist trade measures, the calculation of net trade position does not account for the source of exports. In other words, the calculation does not cater to whether higher exports are driven by re-exports, or by genuine economic activity taking place in the country, as well as inward investments.

A couple of years ago, I walked into a meeting believing that I am very well prepared to answer any questions that may be directed at me, with vivid recollection on how GDP, GDP per capita and GDP PPP compare for the two countries. However, towards the end of the meeting, the other country’s representative started discussing Gini coefficient, the measure of income distribution, and how it compares to other countries.

The measure is statistically unavailable for most countries with the exception of academic literature, where calculations of Gini coefficients are mostly the result of the author’s own assumptions and calculations. That, however, is not the right answer in official meetings.

The last thought that I want to leave you with: what is a more appropriate measure of an economy and its progress?