There’s a need to fix GDP as an economic measure

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

Is the use of GDP (Gross Domestic Product) still viable as a measure of economic progress? Or do we instead need a whole new measure that addresses its current gaps?

In a previous article, I discussed the different issues surrounding the use of GDP as an economic measure, despite the introduction of derivatives to address discrepancies in exchange rates, income distribution, among others. Examples of derivatives discussed in the same article included GDP Purchasing Power Parity (PPP) and GDP per capita.

The issues that I have identified with GDP could be summed up into: 1. GDP is susceptible to upward adjustments as countries change calculation methods; 2. GDP is vulnerable to movements in commodity prices; and 3. GDP is inflated by favourable trade positions.

GDP’s formula consists of four main pillars: Private consumption; government consumption, spending, and investments; private investments; and net exports.

This oversimplicity of grouping different economic components into one big formula is problematic as much as it simplifies the understanding of GDP.

Three of the four pillars capture consumption, spending, and investments, whether accounted for by the government or the private sector.

As a result, GDP as a measure fails in its essence to capture what matters to individuals engaged in a country’s economic activities, rather than general consumption and investment levels.

Therefore, and if we were to rethink the way we measure GDP, its main formula can be adjusted to address the following.

Capturing today’s economies

One, GDP formulation has to be broken down further, especially in regard to its government component and the investment component. That is, government spending should be separate from what it invests in the economy, and the latter should be split further into what qualifies as capital investments and what doesn’t.

The reason why this is important is because by doing so, there will be a better understanding as to which government activity is having a more significant impact on job creation, and reducing unemployment eventually without the government necessarily being the major employer.

Unemployment rates matter to individuals, and thus a better understanding of what drives it must be reflected on a more complex GDP calculation.

Two, GDP must be sub-national. To better explain this, let’s consider China as an example. China has been reporting impressive economic growth rates for the past few years.

And despite gloomy predictions of an imminent economic slowdown, it has still managed to navigate through the uncertainty and deliver sustainable growth rates. The problem is, the same could not be said of different provinces in China, where regional governments’ debt as well as corporate could bring the whole Chinese banking and financial system to its knees.

Therefore, GDP has to account for variances in regional/provincial/governorate/state economic performance compared to the country, and have such variances reflected in the country’s final GDP calculation.

This could for instance be implemented through a sub-nationally calculated GDP that is then weight-averaged to arrive at the country’s GDP.

Three, GDP needs to incorporate sources of income. Even though it rightfully captures government and private consumption and investments, GDP does not boast of a direct link to where the money is coming from.

In the government’s case, its spending and investments are influenced by revenues from commodities’ exports, taxes, etc. However, such a link is an indirect one that fails to accurately capture how an increase or a decrease in revenues truly affect a country’s GDP.

That is, a country that exports oil will see its GDP revised downward with disregard to it possibly financing the gap through international debt markets. While this could be another source of criticism towards the country’s economic management of its affairs, this shouldn’t be a grave issue as long as measures are being taken to ensure sustainable economic growth, not abrupt bubbles and busts.

The above recommendations are not in any way the ultimate fix to GDP. They are instead aimed at initiating a debate that is becoming increasingly important with regard to how economic progress is being measured and how it reflects individuals’ livelihoods.

The different derivatives or GDP — such as per capita — is one stark evidence of gaps in its formulation. Whether by breaking the formula down, measuring it sub-nationally, or accounting for revenue sources, the main point is for GDP to capture as much of today’s economies as possible.

The last thought that I want to leave you with: is GDP per capita an accurate measure of income levels for individuals? (Hint: compare GDP per capita with poverty rates in countries).