Understanding GDP

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Gross domestic product (GDP) is the most commonly used measure of economic performance. It serves as a standard measurement to compare economic activity and production across countries. The US Department of Commerce’s Bureau of Economic Analysis (BEA) estimates real GDP and the GDP growth rate. GDP is measured in two different ways: the income approach and the expenditure approach. These use different numbers, and generally differ by millions of dollars, so they act as a check on each other.

The expenditure approach adds expenditures on consumption, investment, government purchases, and net exports. Net exports are total exports minus total imports. Some parts of both consumption and investment expenditures include imports. This is true to some extent for government purchases, but because most of what the government buys is produced locally by people who vote, this is generally less of an issue. Imported goods and services are not produced in the US, so they are not part of US GDP. Adding net exports, exports minus imports, subtracts any imports that were included in any other category such as consumption or investment. This arrives at the current market value of all goods and services produced in the US in a given year or quarter.

Figure 1—US Real GDP & Components 2000-2021

Consumption purchases generally account for about 70 percent of US GDP (Figure 1). Investment is highly volatile, and can account for less than 10 percent to more than 20 percent. For example, during a recession, investment generally falls, usually in greater proportion than any other part of GDP. Government purchases generally account for 20 percent of GDP. Net exports are negative for the US, since about 1970, and recently accounted for about -6 percent of US GDP. Figure 1 shows that investment fell rather dramatically during the 2007-2009 Great Recession. Note though that during the Covid-19 recession in 2020, consumption spending fell more, and took a long time to recover—this shows that the Covid-19 recession was highly unusual.

GDP is measured in dollar terms because there would be no other way to add up the value of all the things we produce in the US economy: tons of steel, barrels of oil, bushels of wheat, hours of management consulting services, and so on. The BEA adjusts this nominal GDP to reflect inflation with the GDP deflator. Because GDP is measured in dollar terms, it has to be adjusted to reflect changes in the dollar’s value and purchasing power. As the dollar loses value through inflation, a dollar of unadjusted or nominal GDP means less in real terms. Real GDP is adjusted with this estimate of the general price level, the GDP deflator. This is similar in concept to the consumer price index (CPI), except that the CPI only includes consumer goods, and does not attempt to remove imported goods. Real GDP for 2021 was about $19.3 trillion in 2012 dollars; that is, adjusted for inflation at 2012 prices.

Per-capita GDP adjusts GDP for population growth, and makes dollar-denominated real GDP figures comparable from one country to another. Because it’s adjusted for both population size and inflation, per-capita real GDP measures how wealthy countries are in relation to one another. The US economy is much larger than Luxembourg’s but our per-capita real GDP is $63,400 and theirs is a whopping $115,000. Neighboring Belgium’s is $45,000 and tiny Liechtenstein’s is an impressive $175,000–apparently all the middle-class people there live across the border in Switzerland or Austria. Monaco’s is the highest at $190,000.

The income approach is an alternative measure of GDP which acts as a check on the expenditures approach. The income approach looks at the income earned by the factors of production: land, labor, capital equipment, and management or entrepreneurial planning. This adds wages paid to labor, rental income on land, interest paid to rent capital equipment, and profits earned by firms. The largest component of income is compensation for labor, generally accounting for about 70 percent of US GDP.

GDP estimates the money value of what an economy produces in a year, but it does not consider the composition of goods and services that are produced, how equitably income is distributed, or how output is produced. A number of alternative measures of overall economic performance and well-being have been proposed to supplement, or even supplant, the GDP concept. The best known and most widely used is the UN Development Programme (UNDP)’s Human Development Index (HDI). The HDI combines relative measures of national income, years of education, and life expectancy.

Inequality-adjusted HDI (IHDI) adjusts the raw HDI downward the less equally income is distributed among the country’s households. The rationale is that if income is high but not equally distributed, it does not offer everyone the maximum benefit from the high average income. To appreciate the benefit of this, consider the extreme hypothetical of an economy where one person received an astronomically high income, but everyone else received zero. The average could be relatively high, if the one rich person were in fact rich enough. This hypothetical country’s relatively high per-capita real GDP would mask the fact that it was a nation of paupers.

What is produced, and how it is produced are just as important as how much is produced. The composition of GDP can vary dramatically within the approximately $20 trillion of GDP the US produces today. Of the nearly infinite different possible combinations of output, some satisfy people’s wants better than others, but this does not necessarily affect the total. The argument can be made that consumption expenditures are relatively optimal because the combination of goods and services are freely chosen by consumers who seek to maximize the satisfaction of their wants with their limited incomes. A similar argument can be made that entrepreneurial planners are disciplined by profit-and-loss accounting to make the best use they can of every dollar they spend on investment purchases. The same argument cannot be made for government purchases, because the benefits sought by the decision-making politicians and bureaucrats are always paid for by someone else, the taxpayers. This argues that we should seek to minimize the extent of government purchases as a percent of GDP. This would improve efficiency and ensure that expenditure decisions contribute the most to improving overall welfare, by restoring the direct link between costs and benefits.

It is important to realize that government purchases only include purchases by the government at all levels, federal, state, and local, of output that has to be produced and which provides income for the producers. Government purchases do not include transfer payments, such as welfare programs, the progressive income tax, or corporate subsidies, which aim at redistributing income more equitably. To the extent that these programs successfully increase household incomes, they enable those households to increase their consumption spending, enabling them to purchase additional GDP which has to be produced. Unfortunately, these programs are notoriously inefficient, with high percentages going to overhead, advertising, promotion, monitoring, evaluation, etc., so that only a small percent reaches the intended beneficiaries. Corporate subsidies are a perverse form of transfers that redistribute income from the poor to the rich, and serve to aggravate existing inequality. Far from being curious anomalies in the federal and state budgets, the amounts the US spends on this kind of redistribution are astronomical.

If GDP is produced through technologies that are particularly environmentally destructive or polluting, this could degrade the quality of life directly, but would not be picked up in GDP numbers. If it is bad enough to lower life expectancy, clearly the people are worse off, regardless of their material wealth. This would be captured in the HDI but not in GDP. Since pollution degrades the quality of life even if it does not lower life expectancy, this points to a limitation of both GDP and the HDI. The same is true for habitat loss and environmental degradation.

A further consideration is leisure. If two countries with the same population produce the same dollar value of output, but the citizens of one country enjoy more leisure while producing the same GDP, they are clearly better off. The leisure is beneficial even though it does not raise GDP. In this example, to produce the same GDP while working fewer hours, the workers of one country would have to be more productive, perhaps because they use a more advanced production technology, or produce higher-valued output. Too much leisure is clearly not beneficial to a poor country that is unable to employ its whole labor force, but voluntary leisure is clearly beneficial—a so-called first-world problem. Forced leisure, or in other words, unemployment, lowers GDP and is a problem.

To summarize, GDP is a crude measure of economic performance, but it has the value of capturing a tremendous amount of information in a single number. It provides a one-dimensional measure of the output of a complex and multidimensional modern exchange economy. For the US, as with virtually every modern economy, this is a mixed economy with a still dominant private sector but with a significant and still growing government sector.

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