The problems with Gross Domestic Product statistics explained

Today has opened with a revision of French national income statistics for the last quarter of 2011. In the event La Republic recorded an unchanged quarter on quarter growth rate of 0.2% but the year on year rate reduced to 1.3% from 1.4%. No doubt the media will report the change as something important when in fact it is well within the expected error range and is a clear example of spurious accuracy. It may mean nothing at all. Even worse using Gross Domestic Product as a measure of economic well being has many and varied flaws.

What is Gross Domestic Product?

Gross Domestic Product is the market value of goods and services produced by workers and property in the country concerned, regardless of their nationality. So it is defined with geographical boundaries.

Gross Domestic Product = consumption (personal)  + government spending + business  investment + net exports (exports – imports)

Seems reasonably simple How is it counted?

We immediately hit a problem in that their are three ways of measuring this and you have probably already guessed that they do not always agree. I examined the figures for Portugal a few months ago and they differed at the widest point by 4%. When you consider that 4% growth or reduction is very significant we have a problem. The best we can hope for is that the differences remain fairly static, although in the “expect the unexpected” era which we now appear to live in that is a long way from being convincing to me.

The three ways of measuring GDP are using expenditure in the economy,using output and using income. As discussed above they do vary and there is debate over which is the more accurate. In the UK a previous Chancellor of the Exchequer tried to silence this to some extent as when investigating the differences I was told that Nigel Lawson had instructed the statisticians to use the output measure and adjust the others to it. Why was I asking? In the United States research had suggested that in the credit crunch era using the income method was more timely and accurate.

In general the numbers published are for the output measure and I wonder how many of those who quote them know that there are in fact two alternatives.

For those wondering about the US situation then using the income method gives you a deeper recession and a stronger recovery but we are still in a worse position (about 3% worse). As economic policy depends on where we think we are we enter into a zone where it may be (frankly probably is inappropriate..)

For real economic growth we need to measure inflation

Here we have another problem as one of the most common complaints by the general public is that inflation is not measured well and is understated. Some economists (which include me) do think that there are problems here. If we just think of the UK then we have two measures of consumer inflation which are CPI (Consumer Price Index) and RPI (Retail Price Index) and they are usually different often by a wide amount.

To get a measure of real output we need to take the output we measure and use an inflation measure to take out the effect of inflation. Actually we do not use the two used above we use what is called a GDP Deflator. This adjusts the nominal figure to give us a real one.

The problem is how accurate this is and there are doubts to say the least. For the UK the 2010 number was 2.86% and whilst it covers the whole economy and not just consumer inflation I have less faith than I used to have that we can rely on it. The catch is that if it was higher then real economic growth was lower (perhaps as indicated by the income measure that some countries use….).

So added to the problems above we have another one.

Immigration/ Emigration is another issue

I do not wish to discuss these as to whether they are a good or a bad thing (although in general they are good) but they are something we need to measure. Otherwise if you have a lot of immigration into a country you will record higher GDP numbers due to their activity but whilst the country may be better off individuals may be worse off. Accordingly the numbers are often measured per person to allow for this effect.

Seem simple? Er well no as if my country is any guide where we have no real idea of how much immigration there has been over the past decade or so we are much less clear about its effect. As a  consequence we are also less clear what our population is. So we can say that as we stand per person or as it is usually expressed per capita GDP has a high error count.

The Reverse is also true

If we look at Greece, Ireland and Portugal we see countries which are likely to be seeing net emigration right now. Individuals have mentioned they are part of this on this blog. It is often forgotten that GDP falls will include this factor.

 The accuracy of trade figures is shocking

Using net exports or exports minus imports gives us perhaps the biggest problem for statistics which is that they are very inaccurate and can be revised years and even decades later. Just as an example the figures for the UK current account in the first quarter of 2011 have been revised favourably by £800 million this morning. When you see that exports were revised up by £2276 million and imports by £1476 I hope you see that we are dealing with a number (net exports) which is the difference between two numbers we measure poorly and even worse we are never entirely sure we get right.

Should we measure GDP anyway?

Having hopefully unsettled your view on whether we can measure GDP I now intend to raise some problems about whether we should measure it. One issue was put well by the French economist Alfred Sauvy.

Marry your cleaning person, and you will make GDP drop!

This highlights the issue of what I will label household production. Consider an economy where everybody cuts their own grass, now consider one where they cut their neighbour’s grass and get paid for it. Suddenly GDP has surged and yet if you argue that you are likely to cut your own grass more carefully then you are left with the view that economic well being has probably just deteriorated.

We have a similar problem with voluntary work particularly if it replaces paid work. On a stand alone basis very little if any will be captured by GDP statistics and if it replaces paid work then we will see a recorded fall in economic output.  Yet voluntary work can be valuable and if provided by people with specific skills it may be very valuable.

Accounting for public work is almost impossible and this part of government spending has lots of issues. As I am a fan of London’s parks lets us look at their upkeep. Our only way of measuring this is by what they are paid which may bear little or no relation to work done. i see examples of hard work and also no work and can only conclude,sadly, that my profession has no way of telling between the two.

GDP sometimes tells us the wrong thing

The earthquake,tsunami and subsequent Fukushima nuclear power station problem that hit Japan just over a year ago is a case in point, which I raised at the time. The destruction of the event was not recorded by GDP statistics but any reconstruction efforts will be. So Japan as a nation is worse off but GDP numbers will show an improvement over time.

Another example is the problem of issues such as crime. An increase in crime will make everyone worse off but a response involving more police will increase GDP. If we move onto consider the legal profession we have a deeper problem. What do they produce? As we struggle to cope with that we realise that we are in an era where their significance has increased but also at a time where many would argue that their influence is often far from beneficial. Their influence on our political class may well be an example of institutional capture.

Resource use is another problem. If we look at the UK we have used up a lot of the gain from the natural resource that was/is North Sea Oil. This will have boosted UK GDP over time but there is no deduction anywhere for using up a finite resource. If we think of say deforestation it is easy to argue that economic activity here boosts GDP but is usually a bad move. Another example of this was the (in)famous Exxon Valdez oil spill in Alaska where the highly expensive clean-up effort provided a boost to US GDP because there is no measure used for damage to the environment.

The Financial Sector

I have left perhaps the worst problem of our times for last. Let me give you a simple sounding question. How do we measure the output of the financial sector? As we look around and see some factors ignored and others at danger of double,triple or even worse counting we should be increasingly unsettled. Millions then billions and more often latterly trillions pass before our eyes.

I am left with the view that the financial sector was overvalued on our way into the credit crunch and that it has discernibly shrunk since. Has our economic growth measure allowed for this? No! Mostly this is due to all the government and central bank intervention creating false markets in so many areas. You may wonder if this is a reason for some of the intervention……

So when we thought we were well off we were not as well off as we thought we were and now it is worse. Not exactly a cheery conclusion but the truth I think.

Conclusion

It is plain that GDP statistics do not stand up to the analysis that they are often used for. We can see that they are not accurate enough and measure many of the wrong things. Accordingly we are left with the view that as we do not know where the economy is at any point in time those who argue for what is called economic “fine-tuning” will only be correct by chance if they use official statistics. In fact they may turn out to be a malevolent influence as they may be acting in the wrong direction. My tutor at the LSE Willem Buiter put it well I think.

I know I know nothing; but at least I know that

Now if we bring this fully up to date how significant does it seem now that UK economic growth in the last quarter of 2011 dropped from -0.2% to -0.3%? That is what has been released whilst I was typing this.

This entry was posted in General Economics, Quantitative Easing and Extraordinary Monetary Measures, Stagflation, UK Inflation Prospects and Issues. Bookmark the permalink.
Subscribe Find an Adviser
  • The_forbin_project

    ok so I can save us all

    Buy stamps,  invest in them , they are the only thing we have with a gold plated garanteed return

    they will rise from 45p to 60p  ,  we’ll make a mint

    just use QE to buy billiions and we’ll solve the debt crisis

    I sure there’s a flaw here some where…….

    And GDP will improve to boot !  Whooo Hooo! whats there not to love here?

    Forbin

    Ps; Dire straits – money for nothin’ and your cheques for free :-)

    PPS: IMHO  exports minus imports are the only true measure of wealth – Micawber  style . Just difficult to measure …..
     

  • The Kings Park

    I like it! A very nice return on investment oppotunity there…as well as a monster boost to GDP. 

  • Anonymous

    I know that Forbin’s comment is light-hearted but it does illustrate something I did not fully realise until I read today’s update. If we have inflation numbers which are not accurate and are too low then it is the case that we have economic growth too high.

    As the first part may be true I know wonder if things are in even more of a bad shape than I thought!

  • Critic Al Rick

    I agree with you – Balance of Payments should be the benchmark criterion for the success of an economy.

    Balance of Payments equates to Profit (of a business)

    GDP is more akin to Turnover (of a business)

    There is a little rhyme in self-employed circles:

    Profit is sanity.
    Turnover is vanity.

    So so true.

    UK plc has been making a loss for nigh on 30 consecutive years!!

    God help us.

  • Anonymous

    Hi Forbin

    It’s certainly an interesting investment choice! For it to work you would need someone to buy them presumably in a fairly large quantity.

    As for the UK doing it we would be buying the stamps off ourselves in effect although there are plenty of “experts” around who will likely tell you that this is an act of genius……Sadly those types of acts of genius usually end in ignominy.

    As to the song it even encapsulates my advice to the Monetary Policy Committee.

    “That ain’t workin’, that’s the way you do it”

  • Anonymous

    Hi Critic Al

     I was  looking at the UK balance of payments numbers earlier and we have been running an annual current and capital account deficit since 1997. So I think we can call that a trend!

    However the numbers are very unrelaible so whilst it is clear I think we have run a sustained deficit it remains unclear and murky as to how much.

    As to your prescription it sounds very much like the Mercantilism of the Kings and Queens of the 15th and 16th centuries I think. This represented itself in countries trying to accumulate as much silver and  gold as they could.This was the other side of the balance sheet of a trade surplus.

    Of course anyone following that policy would have had a storming credit crunch as the price of silver and gold has risen a lot. Unfortunately the past UK  government decided (incorrectly) that it knew better…

  • Anonymous

    Hi Josephine

    I am afraid that doubts about our inflation numbers and thoughts that they have been too low do imply that we have overstated UK economic growth. This comes at a time where we have so little of it as it is..

  • David Lilley

    Shaun,

    This is why we read your blogs. This is such an education. And we need to know, we need educating.

    I need educating.

    I posted heavily before the election that to “half the deficit in four years” would double the National Debt in five years. This was simple arithmetic and born out by the budget document despite the Treaury Secretary, Stephen Timms, being unaware of this when asked by Jeff Randal on the “Jeff Randal Live” show.

    I was also concerned that the “nice decade” was no more than taking a sub and telling everyone you were on £200 per week when you were on £100 per week and storing trouble for the future, next week.

    The biggest error in GDP in the “nice decade” was that a significant proportion of GDP was tomorrow’s earnings brought forward; £400b of home equity release, £216b of PFI, £200b robbed from pensions via the elimination of pensions tax credit, £30-£40b of government borrowing each year since 2003, a massive expansion in personal and corporate debt due to demutualisation and “mortgage securitise bonds”.

    The growth in personal debt alone was near equal to one year’s GDP in the period 1997 to 2007 and, assuming this was linear, 10% personal debt growth pa, then this alone would reduce GDP in the “nice decade” from plus 3% to minus 7%.

    My big concern was that when we moved from rushing into debt to rushing out of debt we would start taking 10% from GDP rather than adding 10% to GDP.

    Am I wrong. I would like to be wrong.

    Our calculation of GDP may have errors but as long as it is “apples for apples”, the same errors each year, it doesn’t matter. What does matter is if we kid ourselves that we have had a “nice decade” when we have worked up a debt of four times GDP in that period.

    Please tell me I am wrong and need educating.

    Please also remember that we need 0.8% growth in GDP to stay still due to the rise in population (according to Jim, Sorros’ sidekick).

  • Mrs Weka

    Shaun – thanks for your informative blog, I’ve learned an enormous amount about some very esoteric subjects.  I still have one basic question which I’ve never seen anyone answer sensibly.  Why can’t the UK govt print the currency it needs for public spending and control inflation through taxes, instead of selling interest-bearing bonds?

  • Anonymous

    Hi Mrs Weka, thank you for the compliment and welcome to the comments section of my blog.

    To answer the question literally it could do that and for a while it might look like it was working but it would in the vast majority of circumstances fail.

    Let me give you the likely response of one instrument the exchange rate of the £. It would fall and probably heavily as we would be correctly perceived as monetising our debt. In simple terms increasing the supply of pounds with a fixed demand would reduce the price.

    This would generate inflation and possibly a lot of it depending on how far the £ fell and against which currencies ( because so many goods are priced in the US dollar it is the most important of our exchange rates).

    The problem with controlling inflation by taxes would be that you would probably have to take most if not all of the money out of the system to stop the inflationary fires burning…

    So it could but the costs which are indirect are likely to be worse than the direct costs of issuing bonds.As I often write on here if you get a real.surge in inflation it is very hard to get it back under control if our economic history is any guide.

  • Critic Al Rick

    Hi Shaun

    My prescription is that the UK in economic terms should be run as UKplc, effectively a single business. It is effectively currently run as a rudderless ship, i.e. with no sensible direction, and you know what happens to such businesses.

  • JW

    Brilliant post Shaun.
    The US is even worse shape. GDP has been high in the ‘nice’ decade simply by borrowing from the future. All the statistics that look at the situation of ‘average Joe’ are awful over the same time horizon and indeed since the 70s.
    I know I keep repeating it, but all the western economies have a 30% reduction to be made to get back to reality. All governments know this, which is why they are trying desperately to maintain the ‘looking glass world’ as long as possible.

  • http://federaldebtrelief.uks1.com/eurozone-crisis-live-merkel-and-samaras-discuss-greece-as-it-happened/ Eurozone crisis live: Merkel and Samaras discuss Greece – as it happened

    [...] Economist Shaun Richards has written a nice piece here about the flaws in the way GDP is calculated. [...]

  • http://treasurybond.buildyourfoodsupply.com/eurozone-crisis-live-merkel-and-samaras-discuss-greece-as-it-happened/ Eurozone crisis live: Merkel and Samaras discuss Greece – as it happened – Treasury Bond

    [...] Economist Shaun Richards has written a nice piece here about the flaws in the way GDP is calculated. [...]

  • http://debtservicecoveragecalculation.businessandfamilylaw.com/eurozone-crisis-live-merkel-and-samaras-discuss-greece-as-it-happened/ Eurozone crisis live: Merkel and Samaras discuss Greece – as it happened – Debt Service Coverage Calculation

    [...] Economist Shaun Richards has written a nice piece here about the flaws in the way GDP is calculated. [...]

  • http://ukdebtrelief.businessandfamilylaw.com/eurozone-crisis-live-merkel-and-samaras-discuss-greece-as-it-happened/ Eurozone crisis live: Merkel and Samaras discuss Greece – as it happened – Uk Debt Relief

    [...] Economist Shaun Richards has written a nice piece here about the flaws in the way GDP is calculated. [...]

  • Anonymous

    You have , thankfully, not mentioned ” Growth”. The figures are largely meaningless and yet small increases or decreases and seized upon by Politicians as if they had been sent by God. Worse still they are sown to one place of decimals. A change from 2.49% to 2.50% is therefore trumpeted as meaninful

  • http://www.mindfulmoney.co.uk/wp/shaun-richards/what-is-happening-in-the-uk-economy-is-our-services-sector-keeping-us-out-of-a-depression/ What is happening in the UK Economy? Is our services sector keeping us out of a depression? | Mindful Money

    [...] have written before about the problems with measuring Gross Domestic Product ( http://www.mindfulmoney.co.uk/wp/shaun-richards/the-problems-with-gross-domestic-product-statistics-… ) and they are high in areas where there is no readily measurable visible product which is much [...]

  • http://www.mindfulmoney.co.uk/wp/shaun-richards/will-the-us-economy-really-be-3-larger-in-july/ Will the US economy really be 3% larger in July? | Mindful Money