Lies, damn lies and gross domestic product

Sina Ataherian looks at the dangers of misusing GDP

Gross domestic product (GDP) is the daddy of economic indicators. Not so long ago, all of the others were only seen as important in so far as they affected GDP. It is a measure of a country or region's productivity or output (i.e. how much it provides, sells or produces). GDP can be measure by total expenditure, income or the final value of products sold. In theory, these three measures are supposed to be equal (three sides of the same thing) and in practice they are very close. This does not stop GDP from being misunderstood and misused by people who should know better.

Most importantly, GDP is not a measure of living standards. The most obvious reason for this is that average price levels differ widely between countries. To compare the material wealth of people in different places Purchasing Power Parity (PPP) needs to be used. Even a comparison of "real" GDP, which is adjusted for inflation, leaves out important information. If a country needs to spend a lot on defence, this raises its GDP. This could mean increased security and better living standards or the exact opposite, depending on local circumstances. Likewise, greater spending on heating in a cold country does not mean its people are better off than those living in more temperate regions.

GDP figures include government spending. But fiscal incontinence does not necessarily mean people are better off and can sometimes imply the reverse. In other words, a budget deficit will not necessarily show up in the GDP figures. This does not stop some politicians claiming that growth (an increase in GDP) means a real economic recovery.

Even famous economists can sometimes misuse GDP. Step forward Robert Shiller (as in the Case-Shiller home prices index). One obvious way for countries to deal with a large debt is to devalue their currency. The US has been trying this trick. The problem is that the resulting inflation (or fear of inflation) causes government paper (bonds) to depreciate. Investors will start demanding higher rates of interest to compensate for the loss of real value - pushing bond yields up - making it more expensive for the government to borrow. This defeats the whole purpose of devaluing the currency in the first place.

Shiller's idea would see the creation of a new asset class: government bonds linked to GDP, called "trills". In theory, these would not be directly affected by inflation. By issuing these "trills" the government would be able keep borrowing at a stable rate and use the money to pay back older debts. But there are major risks associated with Shiller's idea because of the nature of GDP. Unlike Net Domestic Product, by definition GDP does not take into account any depreciation in fixed assets. So if a country sold all its gold reserves in one year the GDP would go through the roof but it would not be any richer. It has simply liquidated an asset. If it had issued a whole load of trills the year its debt would suddenly become a lot more expensive - and yet the country's means of repayment would remain the same.

Shiller's trills would also create some perverse incentives. GDP is not analogous to the government's earnings, most of which comes in the form of tax. If a capital market for trills were to be created, then GDP would be a cost and not a source of revenue. It is generally agreed that increasing taxes above their current levels would reduce GDP. So the government could simultaneously earn more and reduce its spending by raising taxes to deliberately lower GDP. Robert Shiller is an extremely successful economist but it just goes to show that even giants can trip up over a tricky little thing like gross domestic product.

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