Tag Archives: GDP

GDP – A poor and misleading economic indicator

GDP or Gross Domestic Product is the most popular concept used to quantify the total output of goods and services in an economy. It is the sum total of the value of

  1. Private spending on consumers’ goods
  2. Private spending on durable capital goods (like plant & machinery)
  3. Government spending
  4. Net exports (Exports (X) – Imports (M))

The figure thus obtained would be called Nominal GDP or GDP at current prices. However, one of the primary uses of GDP is to compare economic output across different time periods. In such a comparison, we need to bear in mind that

Value of spending = Volume x Price

So, Nominal GDP can go up from one year to the next due to 2 reasons

  1. Increase in the volume of goods and services produced
  2. Increase in the prices of goods and services produced

Spending more for the same volume of goods and services does not indicate greater well-being. Therefore, to make GDP a measure of well-being, it is considered essential to adjust the Nominal GDP figure for the increase in prices that occurred from one period to the next.

This is called the inflation adjustment of GDP and the resulting figure is called Real GDP or GDP at constant prices. With this, economists feel that they have a good measure to track improvement in human well-being through the greater production and consumption of goods and services. The GDP growth rate figures we read about in newspapers and magazines are nothing but percentage changes in this Real GDP figure from one year to the next.

Why GDP is considered important

GDP is supposed to measure the total output of goods and services in a certain geographical region. The logic is that the more we are able to consume, the more ends we are satisfying as human beings and therefore the better off we are. Rich people (and rich nations) consume more while poor people (and poor nations) consume less. In fact, this is the reasoning behind using Per Capita Income (PCI) calculated as

PCI = Real GDP/Population

as a measure of the income of individuals in a geographical region. Typically, rich countries have high PCI and poor countries have low PCI.

Is GDP a good economic indicator?

GDP is definitely a popular and the most commonly used measure of economic output. Governments across the world, their economists and statisticians and even those in academia use it extensively a measure of economic output and prosperity. Despite all its popularity, however, the concept GDP is a deeply flawed measure of economic output.

Explaining why GDP is a very poor economic indicator

{This is going to be a fairly long explanation. So do bear with me and stay on and read it all (if you have come this far). I am taking as much effort as possible to keep it simple.}

Understanding the organisation of production

Consider an economy that uses silver as the money, where the unit of the money is 1 ounce of silver (1 oz = 31.1034 gms). Let us say that in this economy, the total output of consumers’ is goods is 100 oz. Clearly, these consumers’ goods have to be produced for people to consume them. Let us further say that these consumers’ goods were produced through a production process involving 6-stages of transformation. Of these 6 stages, only one stage, which we label Stage 1, churns out consumers’ goods while the others produce producers’ goods that are further transformed in subsequent stages to eventually get transformed into consumers’ goods in Stage 1.

Any production process uses 3 types of producers’ goods (also known as factors of production) – Land, Labour and Capital Goods. Of these, Land and Labour are considered the Original Means of Production while Capital Goods are understood as Produced Factors of Production. In our stylised view of the economy, Stage 6 (the stage farthest from the stage of consumption) applies only Land (L6) and Labour (l6) to produce a Capital Good. Let us label this CG5. In Stage 5, CG5 is applied along with more Land (L5) and Labour (l5) to produce a further Capital Good, CG4. Generalising this, in Stage i (i >1), CGi, Li and li are applied to produce CGi-1 till eventually, in Stage 1, CG1, L1 and l1 are applied to produce Consumers’ Goods worth 100 oz.

This may be summarised in an even more stylised form as shown below

Stylised representation of a 6-Stage Production System

Please note that in this construct, each capitalist is buying the services of the capital good and not the whole good itself. A simple instance of this is that land used in production is rented and not bought. This, however, does not present a challenge to economic theory, as the price of the whole capital good is just the net present value of its future rentals. Let us now assume the following table of prices of factors of production (their services).

Table 1 - Prices of Factors of Production

So, we see that the capitalist in Stage 1 gets 100 oz upon sale of his consumers’ goods but he immediately turns around and spends 95 oz on buying factors of production so that he may produce the next period’s consumers’ goods. This 95 oz is the saving made by the Stage 1 capitalist period after period. The same is true of capitalists in all stages. The table below illustrates the income and saving by capitalists in every stage of our 6-stage production system.

Table 2 - Prices of Factors of Production

The time element in production

One important aspect of production that is mostly ignored is the time taken to produce. All production takes time. We should not get misled by the fact that at the time consumers’ goods are being produced in Stage 1, producers’ goods are being produced in every other stage. These producers’ goods are intended to and will eventually be transformed into consumers’ goods in subsequent periods. If we take the time taken in each stage to be 1 year, the table below illustrates the important time element of production.

Table 3 - The Time Element of Production

We see that in order for 100 oz worth of consumers’ goods to be available now (Year 0), it is necessary that the Stage 6 capitalist should have initiated a round of production of CG5 6 years ago. Similarly Capitalists in stages 2 to 5 should have initiated a round of production of their capital goods 1 to 5 years ago respectively. In other words, the production process for the consumers’ goods that we buy today started 6 years ago. If those capitalists had not started the production process 6 years ago, we would have no consumers’ goods to consume today.

Similarly, the capital good of which the capitalist in Stage 6 starts production now becomes a consumers’ good only 6 years from now, i.e., at the end of year 6. At the end of each year, the capital good produced moves to the next stage of production till it comes out as a consumers’ good 6 years later.

Alternatives in organising production and the role of the capitalist

There are 2 ways in which this production can be organised.

  1. Joint ownership of the factors of production – In this case, the Land and Labour factor owners jointly own the capital goods till the last stage where they become the owners of the final consumers’ good at the time of sale. In this case, they will have to wait until the final sale to earn an income and be able to consume.
  2. Capitalist ownership of the factors of production – In this case, capitalists at every stage advance money (from their saved capital), and get to own the factors of production (their services in our construct) and hence the output of their stage. Further, the owners of Land and Labour factors get to consume right at the beginning of the process while the Capitalists do the waiting till the end of their stage.

Case 2 is the almost universal one, especially in more advanced economies. The important point to note is that the Capitalist in the production process plays a very important role. He offers his capital (created by prior savings or deferral of consumption) to factor owners and thus makes production without waiting (to consume) possible for others. For instance, the capitalist in Stage 1 offers savings of 95 oz (80 for CG1 and 15 for L1 and l1) and applies them to produce consumers’ goods worth 100 oz. This division of roles makes organised production more possible. The capitalist’s offer of his capital is made at the beginning of each stage while he gets income from sale of the output of his stage at the end of his stage.

The source of factor incomes and the importance of Capitalist Saving

A common misconception in economic theorising is to treat the economy as some kind of circular flow. This error is especially committed by proponents of the Keynesian School of Economics. This erroneous view leads most people to imagine incomes to factors of production as originating from consumers’ spending. The image many carry in their mind is of the capitalist getting income from the consumer and passing it on to factor owners while doing little himself and pocketing a portion of the income (some like the Marxists claim unfairly).

What really happens, as we have seen in our example, is that incomes to all factor owners come, not from consumer spending but from capitalist saving. This is true of every stage of production where the capitalist of that stage offers his savings to factor owners to make that stage of production possible without further waiting by the factor owners. Each capitalist at every stage makes a saving at the start of each round of production to buy the services of the factors of production, including those of capital goods produced in the previous stage. The table below illustrates this. Row 3 represents the Year with 0 standing for “now” and –i standing for i years ago.

Table 4 - Timing of Income and Saving of Capitalists at all stages

In the real-world case of a production system that produces 100 oz worth consumers’ goods every period, we see that such a production system is possible on a sustained basis only if the capitalists of all 6 stages keep engaging in the same saving period after period. In this specific example, the total saving required is (95+76+57+43+28+19) = 318 oz.

Without this saving, the production process will soon come to a standstill and there would be no consumers’ goods output to buy and consume. This total savings by all capitalists, also called Gross Savings, is the true measure of the magnitude of economic activity. While it appears as though adding together the savings of different stage capitalists involves some double counting (the payments made for CG2 are already included in the price of CG1 and hence of the consumers’ good), the error in this notion is that it fails to account for the fact that at any point in time, the payments made in different stages become part of the value of consumers’ goods output of different periods. For instance, while the Stage 1 capitalist gets 100 oz for the consumers’ goods offered now, the 95 oz that factor owners get now is for the 100 oz worth consumers’ goods output of Year 1. Further, it completely glosses over the fact that it is the cumulative saving by ALL capitalists that makes sustained production possible. The charge of double counting is therefore completely unjustified.

Under this system of thought, the total output of the production system is the total payments made at all stages of the production system, i.e., consumers’ goods payments of 100 oz + gross savings of capitalists, i.e., 418 oz. We may call this figure Gross Domestic Expenditure (GDE).

What is really wrong with GDP

Given this complexity of a capitalist system of production, the concept of GDP takes into account only the payments made by consumers and those payments by capitalists that are for durable capital goods. In our construct, since every capitalist buys only the services of capital goods and not whole capital goods, GDP in this system would be just 100 oz (the amount spent on consumers’ goods).  This view completely misses out the total advances made by capitalists towards the purchase of the services of capital goods, land and labour. By doing so, it misses out the heart of a capitalist economy and hence tells us very little about the real magnitude of economic activity.

Thus, we see that GDP is a highly deficient measure of economic output.

Things get worse for GDP

The onset of a recession is always marked by a spike in interest rates and a consequent sharp drop in spending in remoter stages of production. This results in a fall in spending on consumers’ goods, which manifests itself as a drop in GDP. Many modern governments looking at this and guided by Keynesian macroeconomic theory say “Hey! GDP is falling. So let the government spend more and boost GDP and thus income. After all, Y = C + I + G + X – M. If I has fallen inexplicably and C too as a result, then higher G will make up for these.” So governments spend more and boost GDP. A general feeling of economic recovery spreads. The truth, however, is that while GDP might go up, GDE still remains low because boosting GDP does not influence the underlying factors that caused capitalist spending on production in remoter stages to drop. The economy remains moribund or, worse, the recession deepens.

The conclusion

GDP is a poor measure of economic well-being. It does not even measure economic output well. To make matters worse, it is even misleading and guides policy makers towards wrong-headed policies. The sooner we get over this misplaced faith in GDP as an indication of economic well-being, the better off we will all be.