Comment 78: The Folly of GDP Mania (August 26, 2010)

It is well known that GDP stands for "Gross Domestic Products" and is a measure to gauge the economic performance of a society. It is not well known that "Gross" stands for "not accurate". A more accurate gauge usually comes with a prefix "Net". GDP is not an exception. NDP (Net Domestic Product) is, thus, a more accurate measure than GDP when it comes to represent the actual economic status of a society. In this writing we discuss why GDP is not accurate, how to tabulate NDP, and why even NDP needs to be improved to reflect the true status of the economy.

A reasonable way to measure the economic vitality of a society is to look at the total amount of goods and services produced within a fixed time period, say within a year. In principle we can look into each stage of the production of a product, calculate how much value is added at each stage, and then sum over the added values at each stage for all products to come up with a grand total that we call "Domestic Product". Let us take an iron skillet as an example to illustrate the calculation of added values at various stages of production. Suppose a mining company mined iron ore and sold the ore to a steel company. The ore just enough to make one skillet was sold for $1. This means that at the first stage of the production $1 worth of value is added to the final skillet. The steel company refined the ore into iron and sold the iron enough for one skillet to the skillet maker for $3. The value added in the second stage is thus $3 - $1 = $2. The skillet maker sold the skillet to a retailer for $6; the value added in the third stage is $6 - $3 = $3. The retailer sold the skillet to a consumer for $10; the value added in the final retail stage is $10 - $6 = $4. Adding up all the values created from stage one to four, we get $1 + $2 + $3 + $4 = $10, exactly the final price sold to a consumer. This example shows that instead of tabulating the value added in each production stage, we can just take the final sale price as the value of the newly produced skillet. The tabulated result by adding up all the final sales to consumers for both goods and services is called "Final Sales", or "Personal Consumption Expenditure" as used by Bureau of Economic Analysis, a branch of Government of The United States that is in charge of compiling Domestic Products. GDP is composed of four major components, "Final Sales", "Net Exports", "Fixed Asset Investments" and "Government Expenditures". We will discuss the first three components in this order but will ignore "Government Expenditures" in this writing.

Since "Final Sales" is a short cut to calculate all the new values created in the society, what should be included in "Final Sales" and what should not be included are scrutinized vigorously. For example, when we sell our houses, the proceeds are not included in "Final Sales" since the values of those existing houses are not produced in the current period of concern. Only new houses sold within the current period is included in "Final Sales". Actually the proceeds of selling anything "used" are excluded from "Final Sales". Services is a little more tricky. When we go to see a medical doctor, an accountant, a lawyer and so on, new services are considered to be created so those fees are included in "Final Sales". How about gambling gains and losses? They have nothing to do with creating new values, so they are not included in "Final Sales". Some one has suggested the following example: A and B made a bet ended up for A to pay B one million dollars. Subsequently they made another bet ended up for B to pay A one million dollars. At the end neither A nor B gained anything. Does the tabulator of GDP foolishly include this two million dollars in "Final Sales"? Of course not, since such bets have nothing to do with creating new values. How about the following example? Suppose I made a ball out of some clay (a new production) and sold the clay ball to a friend for one trillion dollars. The friend immediately sold the clay ball back to me for one trillion dollars. How will GDP compilers handle this case? The second transaction is about a "used" clay ball so apparently has no place in "Final Sales", but how about the first one trillion dollars of transaction? The clay ball is a "new" creation, isnít it? The compilers of GDP will thrown out the first one trillion dollars from "Final Sales" because they will point out that the first transaction is a sham transaction since the market value of such a clay ball is probably like $1 only. Thus GDP compilers will book only $1 for the clay ball in "Final Sales" but not that arbitrary one trillion dollars. However, in old days there was a market mania called "tulip mania". In Netherlands one tulip bulb was sold at the price of equivalent weight of gold. GDP compilers would have no choice but to include the sale proceeds of each new tulip bulb in "Final Sales". However, when the tulip bubble collapsed and the price of tulip bulbs came back down to the earth, "Final Sales" should have shrunk enormously and so was GDP.

So far in the discussion foreign trades are ignored. Now let us introduce foreign trades into the picture. Suppose the iron to make a skillet, that is, $3 worth of iron is imported from a foreign country. The value created domestically is now $3 from the skillet maker and $4 from the retailer. This means the domestic value generated by the skillet business is $3 + $4 = $7 only. However, the final sale price of a skillet still remains at $10 per skillet. In other words "Final Sales" is taking $3 worth of value produced in a foreign country as domestic production. To correct this short coming, all the imports, including this $3 for one skillet, is subtracted from "Final Sales", but in a different item in GDP called "Imports". The values of exported goods and services are values created domestically, so exports should be included in GDP, too. However, exports are sold to foreigners at the whole sale level so "Final Sales" does not catch exports. In GDP compilation exports need to be added separately. Imports as negative numbers, and exports as positive numbers are combined to form the component of "Net Exports". We should note that the subtraction of imports and the addition of exports are done from very different reasons. Their combination into one category has caused a lot of confusions and misunderstandings even among experts. When the trade deficit expands due to the increased imports, quite a few analysts will lament that GDP will go down due to the larger subtraction of imports. However, those experts have failed to notice that if imports increase, "Final Sales" is boosted by exactly the same amount as the amount subtracted due to increased imports. In other words the movement of imports does not affect GDP directly. It is not like many think that less imports is better for GDP. The addition of exports to GDP causes misunderstandings, too. Mercantilists want to see exports expand so that GDP will go up. They fail to recognize that exports deprive the chance to create domestic values at the retail level. If all the consumable goods and services are exported, exports apparently will reach its maximum level. But that also means that the society will be wiped out due to the lack of consumable goods and services.

The third component of GDP, "Fixed Asset Investments", introduces inaccuracy into GDP. Let us see why it is so. Businesses, like the iron skillet maker, routinely buy new machineries to sustain their businesses. Suppose the skillet maker bought a new machine to make skillets for $100,000. The machine has a life-span of 10 years and straight-line depreciation method is used to depreciate the machine. In the first year the skillet maker depreciates the machine by $10,000. The skillet maker considers this $10,000 as a part of its cost to make skillets so the price of a skillet that is sold to the retailer has taken into account of this $10,000 cost already. That means "Final Sales" is already boosted by this depreciated amount of $10,000. Now let us see how GDP compilation handles this investment of new machine. GDP puts the whole $100,000 into the component of "Fixed Asset Investments". Thus the first $10,000 is counted twice in GDP, once in "Final Sales" and the second time in "Fixed Asset Investments". In the second year the skillet maker still depreciate the machine by $10,000 so that "Final Sales" of the second year is boosted by this second batch of $10,000, but GDP does nothing. Thus this second batch of $10,000 is counted once in "Fixed Asset Investments" of the first year and the second time in "Final Sales" of the second year. This double counting process in GDP will continue for 10 years until the machine is totally depreciated. The same double counting occurs when businesses elect factories, construct buildings and other infrastructures. Such double counting applies to residential structures as well. Apparently GDP is artificially inflated by this kind of double counting. The obvious way to counter the double counting is to depreciate the investments in the component of "Fixed Asset Investments", and the result is called "Net Domestic Production", abbreviated as NDP.

Bureau of Economic Analysis pours a lot of resources into the compilation of GDP. As for NDP, though there is a place to publish the data, it is far less detailed than GDP. The accuracy of NDP depends on how to apply the depreciation. We have two comments to make about the method of depreciation:

(1) Inflation must be taken into account. In the case of the new machine of the iron skillet maker that costs $100,000 with 10 year straight-line depreciation method, yearly depreciation is $10,000. This amount does not take inflation into account. If after 10 years the price of the same machine rises by 40%, the yearly depreciation put aside will not be able to cover the cost of a replacement machine. Business people know this inflation impact well, so they price the extra cost besides the officially allowed depreciation into the price of a skillet. Thus in the ten year period, the aggregate amount related to the depreciation of the machine that shows up in "Final Sales" will be $140,000 but not $100,000. To prevent double counting, NDP compilers also need to take into account of inflation in the depreciation of fixed asset investments, otherwise the resulting NDP will not eliminate double counting completely and still inflates the actual domestic production by certain degree.

(2) Depreciation in NDP is usually applied uniformly in the following sense: Suppose a specific depreciation scheme is adopted for a special kind of bridges, then no matter where that kind of bridge is built, the same depreciation scheme is applied. We disagree with such a uniform approach. Readers should have heard on the media the phrase "a bridge to nowhere". That is for governments to spend money to build a bridge that connects the mainland to a valueless rock. The project certainly creates jobs for the local people, but generates scant other economic benefits. In such a case common sense tells us that the government better distributes money to the local people equal to the wages that they will receive from the project but asks them to stay at home so that the natural resources used to build the bridge can be saved and the environmental damage from the bridge building can be avoided. For such bridges-to-nowhere and similar meaningless infrastructure constructions, the depreciation should be rapidly accelerated so that NDP will not be politically polluted. If we examine carefully about "Fixed Asset Investments", we will probably find many such bridge-to-nowhere type investments. By annexing them via accelerated depreciation the true NDP will be less than NDP we know today.

Though NDP is apparently a better measure of the economic condition than GDP, it still needs vigorous examination to eliminate unintentional, or intentional inflation of the actual domestic production for political purposes. When it comes to GDP, due to its explicit double counting and the lack of depreciation scheme, it is the fertile ground to inflate the numbers. For example, governments can enact massive numbers of bridge-to-nowhere type projects to boost GDP and claim that they are creating many (construction) jobs but with the heavy economical and environmental damages left behind in long term. It is truly the dance of fools if a society just targets the growth of GDP.