Gross Domestic Product (GDP) is – alongside inflation and unemployment – perhaps the world’s most important financial measure used. Insofar as it is understood by the public, it is seen as an objective snapshot of the total economic worth of a country. Many see it in more totemic terms: Diane Coyle, author of GDP: A Brief but Affectionate History, describes it as “an important measure of the freedom and human capability created by the capitalist market economy”.
Inevitably, GDP is held up by politicians as a barometer of economic health (or sickness) and comparisons are made between countries that are very different: more than a few elections have been lost because of a downturn in GDP. As Lorenzo Fioramonti, professor of political economy at the University of Pretoria and author of The world after GDP, writes: “GDP is the most powerful statistic ever invented. It is not just a number, but the ultimate objective of policy and a global benchmark for success.”
A meaningless number
In recent years there has been growing frustration with GDP’s prominence. Put simply, “GDP is a meaningless number for the average person – it has no relevance,” says Rob Carnell, chief international economist at ING Wholesale Banking. “No one gets paid based on GDP. Perhaps most importantly, GDP is no reflection of whether people feel happier or more comfortable in their lives. Many of the figures that go into creating GDP statistics are questionable at best: statisticians around the world are constantly engaged in trying to make their GDP figures as impressive as possible.”
Part of the problem with GDP comes with how it is calculated. A simple change in methodology can transform the outcome. For example, in 2015 an EU change required the inclusion of international business by a handful of large foreign firms based in Ireland: previously only their domestic activity was included. As a result, the country’s 2015 economic growth was revised from around 7.8% to 26%. But while Ireland’s joined the ranks of the fastest growing countries in the world, no-one in the country actually enjoyed the benefits of that growth.
Rule changes are far from the only problem associated with the calculation of GDP. The expenditure method of GDP calculation includes a subjective assessment of quality changes – a so-called hedonic adjustment. “That means that from year to year, GDP appears to increase not necessarily because we spend more on cars, but because some statisticians reckon that on average, the improvements in fuel consumption, addition of satellite navigation as standard, and lower emissions means they can impute a higher ’value‘ to the spending,” says Carnell.
A changing society
While many of the problems associated with calculating GDP have always existed, a number of changes are taking place in society which may make it less useful as a measure of wealth than in the past.
For example, the gap between rich and poor is widening in many countries but GDP (as calculated by income) can’t reflect this. “The figure used is an aggregate – it does not reveal the experience of the median person,” says Carnell. “Two of the most important elements of income are income paid to households, and income paid to capital (firms). But over successive decades the proportion of income dolled to corporates has risen while that given to labour has fallen. This might be great for stock market performance but as shares are generally only owned by the richest in society, it does nothing for ordinary people.”
Another problem is that as GDP is a measure of total production in a country, countries with larger working population have larger GDP (when measured by the output method): if a country’s working population is shrinking, GDP growth is trickier to achieve. GDP’s validity is therefore challenged by changing demographics, such as an ageing population and a shrinking workforce.
A study by Cindy Li and Sean Creehan of the Federal Reserve Bank of San Francisco highlights why GDP may appear misleading in circumstances where the number of workers changes. Japan experienced “essentially zero nominal GDP growth over the past 20 years,” write Li and Creehan. However, the day-to-day lifestyle and contentment of most Japanese people did not decline as GDP suggests because of changes in population. “Since 2000 Japan’s real GDP per capita has grown at roughly the same rate as the United States’”. They add: “Accounting for GDP per working age person, Japan actually has the highest rate of GDP growth among G7 countries since 2000.”
“There is a pressing need to think more deeply about how we measure wellbeing in society"
One answer to these problems might therefore be to adjust for population or the number of workers. Carnell concedes that using a per capita measurement fixes part of the problem associated with GDP. But he says that while adjusting GDP for population is helpful in circumstances where there are changing demographics – and is certainly a useful first step towards a more meaningful measure – “there is a pressing need to think more deeply about how we measure wellbeing in society – an aggregate measure is no longer valid in such an unequal world.”
Seeking an alternative
Should we just abandon GDP? As a measure of economic wellbeing, it has many faults. Even disregarding concerns about income disparities or population changes, it is hard to be satisfied with a statistic that measures economic activity so indiscriminately. Since 2014, EU countries have included potentially harmful activities such as illegal drugs and prostitution in their GDP figures; yet volunteering, which undoubtedly benefits society, is excluded from calculations as it does not involve a monetary transaction. Similarly, activities that harm the environment are part of GDP, while the loss of natural resources is not taken into account.
Some argue instead for a measure focused on welfare like Bhutan’s gross national happiness (GNH) index, which takes into account material, social, spiritual, and environmental factors and rejects the notion that economic growth automatically increases wellbeing. “The GNH index and policy tools have helped to turn the notion of measuring and maximising human well-being into an operational concept,” says Sabina Alkire, director of the Oxford Poverty and Human Development Initiative at the University of Oxford. She calls for the international community to “hammer out the details of the measures, accounts, and financial mechanisms required for a new economic model based on the well-being of all of the planet’s citizens.”
However, as well as being an (inaccurate) proxy for the wellbeing of citizens, GDP is also an important gauge of economic activity that enables policymakers to adjust fiscal and monetary policy. As the Federal Reserve Bank of San Francisco notes: “GDP is probably the best measure of the overall condition of the economy because it includes the output of all sectors of the economy”.
GDP’s role in facilitating informed economic decision-making will therefore continue – even if it remains imperfect in many ways. However, with a few simple additions, such as adjustment for the number of workers and income distribution, GDP could become more relevant – and valuable – as the demographic profile of society changes.