An Austrian Critique of GDP
GDP, or Gross Domestic Product, has been a
pillar of macroeconomic analysis ever since the Great Depression. It is the
most commonly used method of estimating the health and productivity of an
economy. GDP is the most common iteration of “national income statistics”,
which are intended to estimate the entire income of a nation over a period of
time. GDP is the most common of these, although there are others that use GDP
and adjust it, such as Real GDP, which attempts to remove inflation from the
equation.
Although many economists view GDP as an
important, albeit imperfect, tool of economic theory, is this reputation well
deserved? I contend that GDP does not deserve this reputation, and that GDP is
much more limited in its usefulness than many economists give it credit for.
GDP can be used as a tool, but these uses are restricted and must be recognized
as such.
Composition of GDP
GDP is calculated by adding 4 different figures.
The first is all consumer spending on all final goods over a period of time.
Secondly, add to consumer spending all investment into final goods over a
period of time. Next, add all government spending on final goods. Finally,
subject all imports of final goods into the nation from all exports of final
goods out of the nation. Once all four of these numbers are added, the result
is GDP. The usual form of the equation is below:
GDP = C + I + G +(NX)
I will draw attention to a few details in this
calculation. First, note that the spending added is only new final goods and
services. Any previously owned final goods are not included in the equation. A
hat bought at a thrift store or a used suit jacket bought online do not add to
GDP at all. However, if one went down to a local department store and bought a
new hat and jacket, those purchases would contribute to GDP.
Similarly, purchases of non-final goods are not
included in the equation either. Any purchases of raw materials that a
businessman will use to manufacture consumer goods do not contribute to GDP. In
practice, this means that all purchases and exchanges of non-finished goods in
the process of production for a good are not part of GDP.
What GDP is Not
First we will examine what GDP is not, and then
what GDP is.
GDP is not a measure of the overall utility or
happiness of a group or nation of people. Utility or satisfaction gained from
any particular goods or services is completely subjective. If a country's GDP
is higher than others, but does not produce goods and services that customers
value, then it is obvious that the higher GDP is little consolation for the
consumers.
As Walter Block has pointed out, if society
became twice as productive, we could keep our current consumption levels
steady, but only work half as long. Even though everyone would undoubtedly see
a rise in their quality of life, GDP would not rise at all!
GDP only measures purchases. If goods are
produced, but never purchased, they do not contribute to GDP at all. A
businessman may produce 1,000,000 new widgets each day, but if they are never
sold, they do not contribute to GDP. Inversely, if the goods are sold, but
never used, it still contributes to GDP. A new car that is crashed driving off
of the dealership contributes to GDP just as much as if the car was used
regularly for the next 15 years. The productive capacity of a nation is wholly
different than the overall sum of final goods sold.
GDP is not a method to measure material
standards of living. As previously pointed out, any previously owned, or used,
goods that one may buy do not contribute to GDP. However, these goods do
contribute to one’s own standard of living. Hypothetically, one could buy
everything second-hand and these purchases would never contribute to GDP! Never
would one say that this lifestyle would be the lowest standard of living
possible, however. GDP only counts final goods, and thus can only compute the
new goods coming into the economy, and thus, cannot take into account goods
already present.
GDP is not a method to measure the health of an
economy looking forward or a forecaster of recession. Increases in GDP could be
the result of an unsustainable boom. Inevitably, the bust will be right around
the corner. This is often the case, and GDP usually does not forecast a
recession until it has already hit and GDP starts to drop.
GDP is not a method of measuring increasing
productivity in an economy. Increasing GDP is often seen as a sign that
productivity is increasing and that standards of living are on the rise. This
could certainly be the case, but not necessarily. GDP as such does not factor
out inflation. Real GDP, a separate statistic, accounts for inflation by
factoring out the inflation rate from the base year. For example, if one wanted
to know how much GDP has grown in real terms since 1970, you would take the
growth in GDP since 1970 as the numerator, and the value of a 1970 dollar today
as the denominator.
On the surface, this seems to be a valid method
for calculating how much GDP, and by extension, productivity, has risen over a
period of time. The crucial flaw is with the inflation rate. Inflation itself
cannot be calculated into a single rate, and thus, is not a method of
cancelling out its effect on GDP.
The reasoning for this is as follows: Imagine
over the course of a year we see an increase in price for Good A from $1 to $2,
an increase in price for Good B from $4 to $10, and a decrease in price for
Good C from $6 to $5. Let’s say that there is also an inflation in the money
supply amounting to a 50%. In this hypothetical situation, what is the rate of
inflation for the year?
This is more complicated than simply applying
the rate of inflation to the price of each good. If the only influence on
prices is inflation, we would expect a roughly 50% increase in prices for each
good. However, the price of each good is also influenced by the everpresent
factors of supply and demand. Increases in demand puts upward pressure on
prices just as an increase in the supply of money would. Therefore, in order to determine the effect
of inflation on prices, we would have to separate the effect on prices from
changes in supply and demand versus effects from inflation. Inflation, while
being an increase in the supply of money, must mean that someone is receiving
the money to spend, and thus, their income is temporarily increased. The
process of increases in prices from inflation starts with individuals with
increases in their own incomes increasing their demand for certain goods. Thus,
we can see that there is no qualitative difference between increase in demand
coming from inflation as opposed to an organic increase in demand!
Because of the impossibility of isolating just
the effects of inflation on prices, there is no way for us to put an exact
number on the “rate of inflation”. This does not mean that we can have no idea
whatsoever about inflation’s effect. No one would ever claim that we don’t
really know if the hyperinflation in the Weimar Republic was caused by increases
in the supply of money. Large increases in prices, seeing no large decreases in
supply or increases in demand, would be largely attributed to inflation.
However, a precise number cannot be determined, and thus, cannot be separated
from GDP.
What GDP Is
A very precise definition of GDP is necessary to
avoid any confusion about its nature or its legitimate uses in economic theory.
GDP is the total sum of all produced final goods or services sold over a period
of time. At the expense of sounding redundant, I will carefully parse through
the definition. GDP is the sum of only the final goods and services that have
been produced, and have been sold on markets in a given period of time. Any
definition that is more vague is likely to lead to error in application.
What Applications Exist for GDP?
Thus far, we have ruled out many different
possible applications for GDP in economic theory and policy. This begs the
question, what are the legitimate uses, if any, for GDP?
There are several useful applications of GDP,
but these are significantly more restricted than the mainstream uses. GDP can
be used to generally estimate the growth or shrinkage of an economy. However,
this can only be done where we can estimate inflation and its effects on GDP
growth. In a long-run scenario, this is much easier than in the short run.
Discounting as best we can the effects of inflation, we can then estimate by
how much GDP, and thus the economy overall has grown.
We can use GDP in the short-run in certain
scenarios, but only where there are sudden and drastic changes to the economy.
For instance, let us say that Ruritania declares war on Boldovia, but loses the
war badly and Ruritania has been effectively destroyed over the course of a few
years. In this instance, we could use GDP as a tool to roughly estimate by how
much the Ruritanian economy has diminished, because inflation is likely much
less than the discount in GDP, and can be estimated out of the result or
ignored altogether.
Ever since its inception, GDP has been used as
an economic crutch of sorts. Economists regularly point to it as an indication
of the progress of standards of living and society as a whole. GDP is,
fundamentally, an abstraction. Economics is a science of individuals, with only
limited room for aggregate concepts. GDP is the king of these concepts, but
should rightfully be demoted.
If you made it this far, thank you for reading!
If you have anything to add, the comments are always open below. If you enjoy
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