GDP and the Proper Way to “Measure” an Economy

Bardhyl Salihu

You know, there’s a joke which goes something like: “teach a parrot to say supply and demand and you have an economist.” I think it should be changed to: “teach a parrot to say GDP and you have a sophisticated economist.” Mainstream economics is full of numbers, mathematical models and complicated “answers” which purport to explain reality—or better—to change it to fit them. GDP is one of the measures which are oh-so-often used.

There are several problems with it, but most of what I present here will be a rehash of this article by financial analyst and economist Frank Shostak. So what does GDP attempt to measure? Well, the GDP attempts to measure the size of an economy by looking at consumption, government spending, investment and net exports. In top of that, GDP’s only concern is finally-produced goods and services during a particular interval of time. This immediately leads us to the first problem.

By concentrating only on final goods, GDP is completely disregarding the crucial process of production which takes time and involves different other goods (called capital goods) along with land and labor. It just happens that this production process is also part of the economy, and when it runs into trouble so does the output of consumable goods that GDP measures. It’s senseless to say that X is the size of the economy if that X doesn’t contain this crucial process.

The second problem with GDP is that it’s built on the Keynesian assumption that consumption drives growth. As long as there is demand (ah, aggregate demand), businesses will make profits, hire more people which will decrease unemployment, and so on. The problem, however, is not demand but the accommodation of demand. A bunch of consumers with pieces of paper are not enough to make goods magically appear; what is needed is production. All production must precede consumption, for how can one consume something which doesn’t exist? Keynes famously claimed to have turned Say’s law on its head by stating that demand creates supply. But if demand for goods generated them by itself, poverty would have been eradicated a long time ago.

The third problem with GDP is its treatment of goods and services as homogenous. The prices of total goods are summed up and multiplied by their quantity, thus giving us the so-called “national output.” But goods are not homogenous but rather heterogeneous; they have different characteristics because people view them differently. Their value is not embedded in them, but rather attributed to them by the minds of subjects who evaluate them (individuals). Therefore, it doesn’t make sense to take shirts, TVs, computers and add them up together and then divide them to find a price level. The legendary Austrian economist Ludwig von Mises had this to say: “The attempt to determine in money the wealth of a nation or the whole mankind are as childish as the mystic efforts to solve the riddles of the universe by worrying about the dimension of the pyramid of Cheops.”

The fourth problem with GDP is its inability to make a distinction between a productive expenditure and a waste of capital. For example, if a pyramid is built at the cost of $1 trillion, GDP will shoot up by that much and people will be struck in awe thinking: “Wow, GDP says we’re more prosperous by $1 trillion!” But who needs the pyramid, who will use it, to whose advantage is it? It’s a waste of capital, a waste of scarce resources diverted from a possible productive activity. Yet the GDP doesn’t make this crucial distinction.

The fifth problem with GDP is its qualification of government spending as a positive thing. In reality, whenever a government spends, it diverts funds (which it has taken by force through taxes) from uses which consumers demand (through the price mechanism) to uses which government bureaucrats and politicians deem as important. These funds attract labor and capital goods (for example in the construction of a building) from private sector because the government has an almost unlimited source of funding whereas private companies are limited by what consumers reward them with. Not only are these goods then unavailable for private use, those other similar goods which are available become more expensive due to the mammoth increase in demand caused by government spending. This is known as the crowding out effect and even mainstream economists acknowledge it.

The sixth problem of GDP is its inability to measure household services, which are services nevertheless, and in top of that—leisure. Nobel Prize-winning economist Joseph E. Stiglitz has gathered a team of economists to create a model which measures how much I have fun while on holidays, while having sex, or while watching a movie. I wish him good luck on that and whatever numbers he comes up with I will use in my next lottery ticket.

The seventh problem with the GDP is that it measures aggregates which nobody needs. Businesses want specific information about profit opportunities, not general data about a whole economy. “Chinese economy grew by 10%”—big deal! How’s that going to help me as a manager? Yes, it tells me that China is growing as an economy but this information can be obtained causally without going through the trouble. Besides, it’s ambiguous: do I invest because there’s a growing demand or do I hold back because the competition is already there?

The eighth problem with GDP is that by measuring the “price level” it simply reflects monetary growth. Since the “national output” is made up of the quantity of goods times the prices, an increase in these prices will increase GDP. Real GDP (which accounts for price inflation) solves this problem to a degree, but it’s still inadequate in doing so because monetary growth leads to higher spending whereas price inflation picks up later. When new money is printed out of thin air (such as through fractional-reserve banking for example) and enters the economy, prices will increase only after some time. Until they do, real GDP will not account for them and will show a flawed result.

These are only the most important objections. I’m sure greater in-depth analysis can reveal more. There’s the argument that yes, GDP is not perfect, but it’s the only tool we have so we should still use it. But this is akin to a surgeon saying “the scalper is the only tool I have, so I should nevertheless continue with the surgery.” Just because it’s our only tool it doesn’t mean we should be using it if it doesn’t work.

The Proper Way to “Measure” an Economy

But enough ranting, so what can we do about it? How can we measure the economy? Let me be upfront with you: the economy cannot be measured. The valuation of goods and services, which make up the standard of living, is purely subjective. It can’t be translated into numbers. Prices are not values, they reflect exchange ratios between goods and they are historical and have geographic and temporal properties. Prices only tell the “past prices,” because future prices are on the continuous process of formation. Market can’t be freezed in a particular moment so that we can take a snapshot of it—it is a continuous process. The geographic and temporal properties of prices mean that the price of a McDonald’s hamburger in Vienna is different to one in Bratislava simply because we’re talking about two distinctive regions. Here I can add the Penn effect which stipulates that GDP exaggerates the differences between countries when it comes to their economy by failing to take wages rates into account. And the price of a McDonald’s hamburger this year can’t be compared to one from last year—simply because we’re talking about two different periods in which things have changed at least to some degree. It’s clear therefore that we can’t quantify “the economy” or the standard of living.

What we can do, however, is resort to the methodological tools of economics—tools which we use to find economic laws. Austrians are famous for explaining that the sole proper way of deriving these laws is through logical deduction from undeniable axioms, done so by studying individuals who act rationally (employ means to attain ends) and not groups which are unconscious. For example, the simple axiom that “humans act” is undeniable because any attempt to deny it would constitute an action itself. This means that whatever laws we derive from this truth will hold so in every situation simply because logic is consistent. If we establish that two and two amount to four, we need not go around gathering two apples and then adding another two to prove its validity. By the same token, if we establish through the Pythagorean theorem that the area of a square on the hypotenuse is equal to the sum of the areas of the squares on the legs, it is futile to go out in the open and test it. If we get results that “disprove” it, we know we’ve made a mistake somewhere because it is an undeniable truth.

By using economic laws that we derived through the rigorous logic of praxeology (the science that studies human action), we can rest assured that they will unfold themselves in one way or another. To put it in blunt terms: if we establish that government intervention is bad and that the free market works we don’t have to measure the economy to know that Hong Kong is more prosperous than North Korea.