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How to think about GDP

09/09/2012 21:05 (587 Day 14:06 minutes ago)

The FINANCIAL -- Stock in New York are tense.

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The GDP number for the first quarter of 2012 is about to come out. It is 0.4% lower than expected. The market tanks: stock prices drop dramatically. What is this GDP number that the market seems to care about so much?

What is the Gross Domestic Product? The Gross Domestic Product of a country measures how many final goods and services that country produces in a given period of time. The equation that every student of economics learns is Y = C + I + G + NX, which says that a country’s GDP equals all consumption, all investment, all government spending, and net exports (exports - imports). GDP is the most widely used measure of economic activity.

A common misunderstanding is that GDP measures how rich a country is. While it is correlated with wealth , GDP is a flow measure, instead of a stock measure. Think of it as a water meter: GDP doesn’t measure how much water is in the tank, but how much flows into it within a defined period of time.

GDP is also not a measure of how much money consumers have to spend. A common term for this is disposable income. Theoretically, a country can have a high GDP while its people are starving, by producing a lot of stuff and exporting all of it, or by using everything that is produced for investment, and not consumption.

I won’t go into the technicalities of measuring GDP, but it is important to know the difference between real GDP and nominal GDP. Nominal GDP measures the dollar value of Y (all the final goods and services produced in your economy). This means that when you produce the same amount of goods and services, but the price of those products goes up, nominal GDP goes up. Real GDP takes this into account, and uses the same prices for the same product every year, so if it increases, it only captures a real increase in production, and not an increase in inflation.

GDP growth -- The number that policy makers and others pay the most attention to is the growth rate of real GDP. Often small differences in growth rates are taken quite seriously. However, what difference does it really make for a country to grow at 3% instead of 6%? Would the average citizen even notice a small 3% difference? Maybe not. But GDP works the same way as compound interest. Take two countries that both have a real GDP of $5,000. One of them grows at 3%, and the other at 6%. Most of their citizens will not notice the difference initially. 20 years later, while the 3% country has a GDP of $9301, the 6% country is at a level almost double as high, at $16998. Growth matters!

Critiques of GDP -- However, there are some critics, who assert the need to look beyond GDP. One of the things that they propose is looking at income or wealth distribution: while a high GDP might indicate a high-income country, this might not be positive if the wealth is distributed very unequally - if there is a small group of haves and large group of have-nots. For this, a measure called the Gini-coefficient is used: the higher your Gini coefficient is, the more unequal the income or wealth distribution in your country. According to the World Factbook, as of 2009, Georgia’s Gini coefficient was 40.8, which places it in the middle of the pack, between Morocco and Turkmenistan. Some of the countries with the worst inequality are African countries like Namibia and South Africa, while the most equal countries are Sweden, Montenegro, and Hungary.

An attempt at finding an alternative to GDP is the Human Development Index, developed by the United Nations Development Program. The HDI assigns a score based on life expectancy at birth, mean years of schooling, expected years of schooling, and Gross National Income (similar to GDP). This list is topped by Norway, Australia, and The Netherlands. Georgia finds itself in the “High Human Development Category” at place 73, much higher than its level of income would justify, because of its performance on the education indicators.

Why do we keep using GDP? GDP is not a perfect measure of progress. In 1968, Robert Kennedy said the following about the Gross National Product, a measure that is very similar to GDP: “[it] does not allow for the health of our children, the quality of their education or the joy of their play. [..] It measures neither our wit nor our courage, neither our wisdom nor our learning, [..] it measures everything in short, except that which makes life worthwhile.”

Others assert that a focus on GDP leads us to destroy the world we inhabit. We are facing an environmental doomsday, it is said, and growing our economies will only bring it closer. Proposed economic expansion in Georgia for example, namely the building of the new city of Lazika, is destroying protected wetlands that are vital to the local ecosystem, and environmental economists have long argued for balancing economic growth and environmental sustainability.

There is something to be said for all of these arguments. If you believe in the value of relative equality, then GDP doesn’t capture that. GDP doesn’t tell us how many years a child spends in school, and it doesn’t necessarily makes us better people. And it is true that a single-minded focus on economic growth will probably lead to environmental degradation.

Perhaps we should recognize developed countries should stop focusing on GDP growth, although this can often lead to negative social consequences, as chronicled by my former professor Benjamin M. Friedman in his book The Moral Consequences of Economic Growth. However, GDP does correlate with a whole range of indicators that we value. People in high-GDP countries are generally happier, live longer, and have more economic freedom. Georgia is a good example: not only has GDP at constant prices almost doubled since 2003, people have also seen a noticeable improvement in the quality of their lives. Their children get better medical treatment, they have electricity whenever they need it, and incomes have gone up dramatically. For developing countries, economic growth brings real and tangible benefits.

 

 

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