The Truth about GDP

IIM Tiruchirapalli

The Truth about GDP

Prasenjit Debnath (1301082)
10/28/2013

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The Truth about GDP

When we talk about the productivity of a country, the most common measurement unit is the Gross Domestic Product (GDP). The total cost of all the final goods and services produced within a country is the GDP of that country. Since GDP relies on the assumption that all citizens of a country will benefit from higher expenditures or economic activity of a country, GDP is used as an indicator to measure standard of living of the country. GDP might be indicator of a countrys growth, but how true is the GDP in itself? Does it really portray a true picture of a countrys growth? Does it take into account all the aspects of production and services before coming to a conclusion on the growth of the country? Well, the answer to many of these questions are NO. Many economists use the terms the economy and GDP interchangeably. It is to be noted that GDP is an accounting device and poor measure of economic health. On the other hand, household wealth comes closest to what we mean by economy. Saying that a countrys GDP is say 10 Trillion is one measure, but not a good one. Rather saying that the combined household wealth of a country is 15 Trillion is a better reflection of the countrys economy. While GDP measures output, it doesnt highlight the quality of output (products and services) produced. At the same time it doesnt consider the efficiency of production. Inefficient ways of producing goods will probably cost more than efficient ways of production thereby increase GDP. Again, low quality products will have shorter life due to which there will be more production of those goods which in turn will increase GDP. Also, GDP doesnt improvements in product quality unless they are included in the price. GDP considers a few unsustainable products. Products and services like Armed forces, police & courts (crime and justice system), steps to prevent environmental change. At the same time, GDP fails to consider some important sustainable products or services such as natural resources, domestic work (cooking, cleaning, child-care etc), non-monetary or voluntary work and non-market transactions. By bringing this disparity between sustainable and unsustainable products, economists are reflecting the notion that any economic activity is productive and any other non-market activity in not valuable and unimportant. One of the main issues pertaining to GDP is that it only adds. GDP also doesnt have the system in place to differentiate between expenditure on good things and on bad things. So, there is no way it can differentiate between the spending on good things like education and bad things like alcohol or cigarette. Also GDP doesnt consider the social harm that happens when an event transpires. Rather than subtracting the social harm, it is added to the social good. Say for example a train crash which essentially requires crores of rupees work of track repairs, medical bills and insurance, train repair etc. By considering these costs in GDP, these costs are deemed beneficial and an uninterrupted service which generates costs in the form of sales. One more example can be cited of building a house. When we build a house, it considered as adding to

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The Truth about GDP

the GDP. Few years later, if the house is torn down, it is also considered to be a part of the GDP of the country as people were paid to tear the house down. It can conceal growing inequalities and encourage depletion of resources. At the same time it doesnt take into account the economic services the nature provides, like the Western Ghaats which act as a wall and protect cities from natures fury. It also doesnt consider the harmful effects of pollution in the country. For example, the effects of oil spills, increased incidence of cancer, destruction of natural habitat and wildlife are not considered and are not deducted from the GDP. Also, it doesnt include payments that are made to clear up oil spills or remuneration to the cancer victims as a part of cost of healthcare. GDP fails to measure the output from the Underground Economy. Underground economy can consist of output from illegal activities like illegal trade as well as any legal activity which is part of tax avoidance. Black money from both legal and illegal activities forms 11% of Indias GDP. These results in underestimating of a countrys GDP. GDP doesnt measure the well being of the citizens of a country or the happiness quotient of the citizens of the country. As Sen. Robert F. Kennedy put it well: "It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile." [1] We also use GDP to compare two economies or countries. This can also be inaccurate as we dont take into account the local differences in quality of goods even though it was adjusted for purchasing power parity. Making such kind of adjustments to an exchange rate is controversial as there lays many difficulties in finding the right basket of goods to compare purchasing power across countries. For example, citizens of a country X may consume equal number of locally made Tea as citizens of country Y does. But it wont take into account the variety of the tea consumed or the taste of the tea consumed. This difference in quality wont show up in GDP statistics. This is also true for goods that are not traded globally, such as housing. We also use debt-to-GDP ratio to understand the condition of the economy. As it was seen in Greece crisis where Greece had a debt-to-GDP ratio of 160% which resulted in prediction of economic collapse by the rating agencies. This is not necessarily a true indicator of economic collapse. Japan has a debt-to-GDP ratio of over 200% but credit rating agencies dont really bother. There can be many factors which can determine the stability of the economy based on debt-to-GDP ratio. Buyers of debt A higher debt-to-GDP ratio is sustainable when the buyers of the debt are either domestic investors or repeat buyers that have their own reason for buying. Two good examples of this are Japan and the USA. Japans

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The Truth about GDP

buyers are domestic and the buyer of USAs debt is China, who purchases it to keep a favourable trade balance with its largest consumer. Economic Growth A higher debt-to-GDP ratio is possible when an economy is rapidly expanding, because its future earnings will be able to pay off the debt more quickly. A country which is projected to grow 5% next year will automatically see the ratio decline, whereas a country projected to contract will see it grow. Plan of Action Countries with a credible plan to address a high debt-to-GDP ratio may receive some leniency from ratings agencies. But those without a viable plan or with a plan which is not being implemented often face sharp degradation and criticism.

Real GDP gives us a better overview of the health of the economy of a country as it considers the inflation over a year while the Nominal GDP doesnt. Also, comparison of countries may be made based on Real GDP and not nominal GDP. Economists understand that the GDP may not be a true indicator of the welfare or growth of the economy. They are bringing about umpteen numbers of modifications and factors to be considered while finding out the true value of the GDP of a country. With these factors, GDP would be able to portray a true picture of an economy as well as human welfare. Economists have meanwhile come up with the concept of Genuine Progress Indicator (GPI) which is far better equipped to take into account activities that diminish financial and social well being and impact the environment negatively. GPI quantifies externalities such as Ozone depletion or loss of wetlands as harmful costs whereas GDP fails to take into account and differentiate these harmful costs from positive economic activity so long as money are spent. Many countries have taken National Income (NI) and Gross National Income (GNI) as a better indicator of the growth of the economy. As GDP fails to recognise the income to a certain extent, it doesnt always tell us if spending a lot is growth or just a deception of growth. National Income and Gross National Income meanwhile measures the net income of the country which actually can be related to the spending and earning potential of the country.

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References
1. Zperovic (2012), 3 misconceptions about GDP, http://zperovic.wordpress.com/2012/11/04/3-misconceptions-about-gdp/ 2. http://www.econation.co.nz/external-costs1.html#.Um3X9vmmi8o 3. Harding.J (2011), Why GDP Is Useless and Deceptive: There Was No Recovery, The Daily Capitalist 4. Faul,M (2013), Spending is Not Growth: The Case Against GDP, Common Dreams Building Progressive Community. 5. Scissors.D (2013), GDP: I Do Not Think It Means What You Think It Means, The Foundry Heritage blog 6. Rothkopf. D.J (2011), Redefining the Meaning of No. 1, The New York Times Sunday Review. 7. en.wikipedia.org/wiki/

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