The U.S. Department of Commerce reported last week that “real gross domestic product increased at an annual rate of 2.5 percent in the third quarter of 2011.”
Many economists were raising the possibility that the U.S. was slipping into another recession, so the increase in GDP growth from 1.3 percent in the second quarter to 2.5 percent in the third quarter was welcome news. It probably bodes well for the Minnesota economy because state-level economic activity general follows the ups and downs of the U.S. economy. And real GDP growth and job growth are positively related, so the news means that the unemployment picture should brighten, albeit slowly.
But let’s not get ahead of ourselves. Fresh employment numbers come out Friday, so we’ll wait and see if there’s good news. In the meantime, it’s important to keep in mind what GDP measures — and what it doesn’t.
Let’s start with the definition of gross domestic product: GDP is the market value of all final goods and services produced within a country during a given period of time. By taking apart the definition, we can understand what counts and what doesn’t in GDP.
Market value
“Market value” involves putting a dollar value on the goods and services produced. This is straightforward since we can identify the prices of the goods and the quantities sold in markets.
But what about goods and services not sold in markets? The Commerce Department does try to calculate the value of some of these goods by estimating the market price. Others, unfortunately, are excluded, among them cooking, cleaning and child care that are done at home. In fact, as more and more families purchase meals rather than cook for themselves, hire people to clean their homes, and send their children to formal day-care facilities, GDP will rise.
Does this reflect actual growth in the economy? It’s not clear that it does.
Further, GDP includes only legally produced goods and services and excludes underground market exchanges.
Final goods and services
These are the end products of the production process, not the intermediate goods used to produce other goods. For instance, a pound of flour bought by a household and used to make bread at home is a final good since the flour is not used to create other goods sold in markets. On the other hand, when a bakery purchases a pound of flour this is not counted in GDP. Instead, the value of the bread produced by the bakery is included in GDP since the bread is the final product and the flour is used in the production of the bread.
Within a country during a given period of time
All production of final goods that takes place within a country’s borders during a given time counts in that country’s GDP. Toyotas built in 2011 the United States count in 2011 U.S. GDP, but 2011 Toyotas made in Japan count in Japan’s 2011 GDP.
A big problem with the way we’ve defined GDP so far is this: It could rise solely because the prices of goods and services rise. Economists avoid this problem by calculating inflation-adjusted, or real, GDP. This involves choosing a set of prices for a starting year, say 2005, and then valuing each year’s production using these prices. (The actual procedure, called chain-weighted GDP, is more complicated but harder to explain; a complete explanation is available here.) The resulting series squeezes out price changes and measures the economy’s true production of goods and services.
What GDP doesn’t measure
Real GDP is a measure of production in a market economy; it is not a measure of our well-being.
Sen. Robert F. Kennedy put it well: “It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile. And it can tell us everything about America except why we are proud that we are Americans.”
On the other hand, real GDP is correlated with many outcomes we value. For instance, when we look across countries we see that higher levels of real GDP per person are associated with greater literacy, decreased infant and maternal mortality, and longer life expectancy.
This relationship varies with income: When a country reaches a GDP per person of $20,000-$25,000 this correlation breaks down. Life expectancy is longer in many European countries even though they have lower levels of real GDP per person, for example.
So it’s good that real GDP grew during the third quarter, but growth isn’t everything.
Economists know this, and we need to do a better job of getting across this message.
GDP actually tells us very little in big scheme of things. It ridiculous that the definition of a “recession” is pinned on GDP.
GDP doesn’t measure the economic condition of the population, which all that really matters. We’ve experienced several periods of positive GDP growth while the economic conditions for the majority of people in the country deteriorate. Affordability, disposable income, wages and salaries, standard of living, employment, debt, poverty, etc. It’s not just intangibles like how pretty our lakes are that GDP measures fail to capture. Positive GDP does tend to tell you how well the wealthy and corporations are doing, and to some extent investors, but it misses a lot. The economic conditions for most Americans have actually been deteriorating over the last few decades while the GDP has by and large remained positive.
I think GDP is largely a public relations instrument. Governments and economists use to sell the idea that the economy is good when in fact it’s in decline.
The tie between GDP and the health of the economy is broken as viewed by a typical worker.
First, the performance of many jobs by automated systems has not necessarily reduced the costs of goods and services and their value in the GDP but it has definitely reduced the number of jobs and the pay associated with jobs.
Second, the exclusion of intermediate goods as opposed to finished goods misses the massive decline in the production of intermediate goods in the US. A Toyota or a Ford may be assembled in the US, boosting the GDP as a final good, but virtually all of the intermediate goods (tires, transmissions, etc) are made elsewhere in the world. The GDP stays the same or is up, but the largest portion of jobs in the automotive industry is gone.
Interesting stuff. Clearly, there has to be a lot of detail-level error in these calculations, so is the main thing to make sure that it is calculated the same way each time, and to publicize when methodology changes? To take your flour example, I can’t imagine that costco or sams club reports when a local bakery buys 10 bags of flour differntly than when I buy 1. But supposedly the bakery sale should not be in GDP. Perhaps those that calculate these numbers assume all businesses buy from wholesale supply companies, and all retails sales go to indivisuals- but with the local-food movement that’s probably becoming less and less true.
Paul I generally agree with most of your thoughts, but lately it seems you are guilty of “selective reading”. Not trying to be rude, but Johnston includes the Bobby Kennedy quote and finishes with “So it’s good that real GDP grew during the third quarter, but growth isn’t everything. Economists know this, and we need to do a better job of getting across this message.”
It seems you’re inferring quite a bit more than the writer intended.
Jackson,
I take you point and I may be guilty, but the Kennedy quote does not mention any of the tangibles that mention, so I’m not sure Kennedy and I talking about the same thing. If the author and I are talking about the same thing, I don’t see it. Seems to me if the author really wants to say something about something other than GDP growth… nothing is stopping him. The Kennedy quote doesn’t address the issue I raise, I’m talking about quantifiable measures that actually exist, not devotion to one’s country.
My problem with the Kennedy quote, and I’ve seen this before, is that it reinforces the notion that while GDP isn’t a complete measure, it’s the best measure have. Since devotion to ones country and wisdom can’t be quantified, we’re stuck with GDP, although we’d like to do better.
I don’t know what the writer intended, I only now what he wrote, and he didn’t write anything about wages, cost of living, poverty, etc. I do think it’s interesting that an economist promising to explain what GDP doesn’t measure; would fail to include basic economic metrics that actually tell us something about the quality of our economic life other than GDP.
If you actually read it, this is more of a description of what GDP measures and how, rather than a description of what it doesn’t measure. Johnston certainly spends more time talking about the former than the latter, so how selective am I really being?
There’s also a certain degree of mission creep here. As with the previous article where Johnston definitions of economics seem to describe everything except economics, the reference to “well being” looks like a drift. I don’t think we expect economists to tell us how happy we are, or how wise we are. Call me crazy but I think we expect economist to tell us what kind of shape the economy is in. So the question is to what extent does GDP really tell us that? I think it’s actually a poor measure that frequently creates the impression that the economy is doing better than it really is, and can even make it look like the economy is worse than it under the right circumstances.
“I don’t think we expect economists to tell us how happy we are, or how wise we are. Call me crazy but I think we expect economist to tell us what kind of shape the economy is in”
So I take it you don’t see any value in the Consumer Confidence Index. [The Index now stands at 39.8 (1985=100), down from 46.4 in September.]
Dennis,
The CCI doesn’t measure wisdom or happiness. It measures how confident people are in their financial security. The CCI’s actual value as a measurement is debatable, but I wouldn’t say it has no value. I wouldn’t say that GDP has no value for that matter.
Great article! I wish more columns could be like this: Informative and not combative. This is truly high quality journalism!
I think there is a whole host of activities and interactions that contribute to our well-being that do not feature in the GDP. Products that are priced out in a marketplace with currency are easy to track; just follow the money. The numbers provide for easy comparisons and calculations. But what about activities that occur within groups, especially in a market downturn? Maybe a recent college grad opts to take care of her sister’s toddlers in exchange for a place to stay, or co-workers work out a ride share plan to save on parking and car expense. Both of these occurrences financially benefit all parties but do not feature in GDP.
Maybe, more interesting yet, these exchanges have a nature to themselves. Are there other obligations or expectations incurred that differ from the clean and immediate severance of cash purchased transactions? Do they as a group form a structure that can be evaluated?
Redefining Progress, an Oakland, CA organization, has developed the Genuine Progress Index (GPI) as an alternative to GDP. The work of economist Herman Daly is also on point regarding this issue. To see just how irrational it is to use GDP as a measure of well-being, consider the gigantic boost to GDP that Japan will benefit from as the Fukushima reactors continue to melt down.