Comment 80: What is GDP? Why it should not be taken as a serious gauge to measure the economic well being. (February 28, 2011)

Many use GDP as a gauge to measure how a country is performing economically. However there are numerous misunderstandings about GDP, even among experts. This writing is to highlight the concept of GDP, the way it is compiled and its shortfalls and limitations. Also touched upon is the reason why we and the government data collectors should pay more attention to NDP (Net Domestic Production).

(1) The definition of GDP is to compile total values of domestically produced goods and services within a set period, say within a calender year.

(2) To calculate GDP according to the definition of (1) is very difficult. Let us take a car as an example. The value produced at each production stage needs to be estimated and be added up. We need to start from the mining of iron ore, collecting rubber from rubber trees for the tires, chemicals obtained for paint and plastics, and so on and so on. Then iron ore needs to be refined into iron and then to various kinds of steel, raw rubber processed, and so on until the car is finally sold to a consumer. It is humanly impossible to calculate added values in all intermediate stages of the production. The short cut is to forget about all the intermediate stages and just take the final sale price of the car to a consumer as the total produced value of the car. By this short cut the total amount of final sales of goods and services to consumers are summed up to form a category called “Final Sales” or “Personal Consumption Expenditure, abbreviated as PCE”. In US the “Final Sales” accounts for about 75% of GDP.

(3) The short cut of using “Final Sales” creates over counting when imports are concerned. Suppose a made-in-Japan digital camera is sold to a consumer for $500, and the imported price of the camera is $200. “Final Sales” just adds $500 but ignore the import price since it is incurred in an intermediate stage. However, the first $200 of the camera is the value produced in Japan so it belongs to the GDP of Japan but not to US. To remedy this over counting, $200 of import price must be subtracted and put into a different category. Of course, statisticians of GDP do not need to track imports one by one. The total amount of imports are recorded by US Custom Office. From this discussion we can see that increased imports do not cause current GDP to go down since on one hand more needs to be subtracted in the import category but same amount as subtracted is added to “Final Sales”. This point is severely misunderstood by many experts, leading the general public to think that if imports increases, current GDP will go down. This argument is strictly about the the current compilation of GDP. Excessive amount of imports, of course, will damage the structure of the economy and will harm future GDP.

(4) Exports are goods and services produced domestically but they are not counted in “Final Sales" since they are not sold to domestic consumers. Thus exports also need to be added separately. Bureau of Economic Analysis that compile GDP groups imports (as a negative number) with exports (as a positive number) into one category, and call their balance as "Net Exports" though the reasons of inclusion of imports and exports in separate categories are very different in nature.

(5) “Final Sales” only covers the sales to consumers, so the consumption by governments is added as a separate category.

(6) The last, but not the least important category is called "Fixed Asset Investments". Suppose a business buys a $1 million machine to produce goods and the machine lasts for 10 years. In the sale prices of the goods produced by the machine, the business will not add the whole $1 million as the cost in the first year since the machine lasts more than 1 year. If the business uses straight line 10 year depreciation scheme, it will book $100,000 as the cost of the machine in the first year and include this $100,000 in the final sale prices. Thus "Final Sales" captures $100,000 from the newly purchased machine. However, this $1 million machine is the domestic production of the current year so the whole $1 million needs to be included in GDP. That is why this $1 million is included separately in the category of "Fixed Asset Investments". Newly constructed office buildings, factories and residential structures are also included in this category.

(7) With (1) to (6), what is GDP and how to compile it have been outlined. From (6) we can see the deficiency and the arbitrary nature of GDP vividly. Let us go back to the case of the $1 million machine. In the first year the business allocates 10% of the price of the machine, $100,000, as the cost of the machine and include this $100,000 in its baseline final sale price so "Final Sales" captures this $100,000. However, GDP claims the gain of $1 million through the category of "Fixed Asset Investments, not $900,000, double counting $100,000. In the second year the business will allocate another $100,000 as the cost of the machine into its sale prices, so "Final Sales" captures another $100,000 as the cost of the machine. After 10 years, "Final Sales" captures the whole $1 million of the machine's purchase price cumulatively, whereas GDP of the first year gets $1 million boost through "Fixed Asset Investments" from the purchase of the machine. This means that the $1 million machine is counted twice, as $2 million contribution to GDP.

(8) We should note that "G" in GDP stands for "gross", and "gross" means "not accurate". The discussion in (7) shows why GDP is not accurate. For a country with huge fixed asset investments, the artificial inflation of GDP through double counting will become very significant. Then what is the remedy? The remedy is to go to NDP (Net Domestic Product). NDP requires depreciation of "Fixed Asset Investments". For the case of $1 machine with 10 year straight line depreciation scheme, in the first year the depreciation will reduce "Fixed Asset Investments" by $100,000 whereas "Final Sales" is boosted by $100,000 as discussed before. In the second year as "Final Sales" gets another boost of $100,000 due to the depreciation of the machine in the hands of the business, in the category of "Fixed Asset Investment" another $100,000 is subtracted as the depreciation of the machine, and so on. Thus the double counting problem is solved in NDP.

(9) GDP can be easily manipulated. If government spends $1 billion to build a "bridge to nowhere", GDP is boosted by $1 billion. If the government builds 1,000 such "bridges to nowhere", GDP is boosted by $1 trillion. To blanket the country with economically not viable high speed railways is similar to build a large number of "bridges to nowhere". Can NDP prevent such abuse? It all depends on how the depreciation is carried out. Suppose government spends $1 billion each to build a bridge on a busy traffic route and a "bridge to nowhere". Suppose the two bridges are very similar and both will last for 30 years. If NDP treats the depreciation of two bridges under the same schedule, then NDP is also subject to manipulation. Only if NDP depreciates $1 billion spent to build the "bridge to nowhere" instantly but allows the viable bridge to be depreciated according to the 30 year schedule, then the abuse can be prevented.

(10) Bureau of Economic analysis also publishes NDP regularly though with much less details than GDP data. The current depreciation scheme used in NDP is not able to prevent abuses as discussed in (9).

The above discussions are about the current values of GDP and NDP, called Nominal GDP and Nominal NDP. To derive Real GDP and Real NDP inflation adjustments become necessary. The compilation of "inflation" is another thorny issue since it is easy to be manipulated to cater for political situations but the discussion of "inflation" will be postponed to another occasion.