GDP

What GDP Actually Measures (and What It Misses)

GDP: From the 1934 report by Simon Kuznets to Congress, to the $27.4 trillion U.S. economy of 2024, we'll look at how the world began to measure a nation's total output and what the number still doesn't include.

Prior to 1934, there wasn't a dependable method for measuring the economic production of an entire country. The Great Depression was heavily impacting the United States, and policymakers were largely in the dark about the true severity of the situation. Congress asked economist Simon Kuznets to create a system for tracking a country's income; and by 1937, the structure that would become Gross Domestic Product was beginning to form.

GDP is the total value of all finished goods and services created inside a country's borders over a particular period of time, typically a year or a quarter. This includes every loaf of bread from a bakery, each haircut, every Toyota Camry made at the Georgetown, Kentucky plant, and every hour of legal work. All of these things are included. In 2023, US GDP was approximately $27.4 trillion.

The word "final" is essential in that explanation. Tires Goodyear sells to Ford are considered an intermediate good; their cost is already included in the price of the finished car. Counting both the tires and the car would be counting things twice, artificially inflating GDP. Only the finished item being bought by the final customer is included in the total.

"Domestic" is equally important. A Honda factory in Marysville, Ohio (owned by Japan) is counted as part of U.S. GDP because the actual manufacturing happens on American land. An Apple supplier factory in Shenzhen, China is counted in Chinese GDP. It's about where something is made, not who owns the company making it. The United Nations System of National Accounts set this rule for boundaries in 1953, and it has been the international standard ever since.

The Expenditure Approach: C + I + G + NX

The Expenditure Approach, expressed as C + I + G + NX, is the usual method for calculating GDP, and it works by adding up all spending on finished goods and services. This way of breaking down spending into four groups became the standard for U.S. national accounting by the late 1940s.

Consumption (C) is the largest part of this, being around 68-70% of the U.S. GDP recently. Think of groceries, rent, your Netflix membership, and a visit to the dentist - in short, pretty much anything people buy for themselves.

Investment (I) refers to spending by businesses on things like factories, machinery, software, new home building, and any changes in the amount of goods businesses have in stock. This one frequently causes problems in exams! "Investment" in the context of GDP doesn't relate to buying Apple shares; it's about actual, productive assets. Intel starting construction on a $20 billion chip factory in Ohio in 2022 was investment, but your uncle purchasing 100 Intel shares isn't investment in the GDP sense.

Government purchases (G) are the expenses of the federal, state and local governments on actual goods and services - teachers' salaries, military hardware, and highway construction, for example. Social Security payments aren't included because the government doesn't receive a new product or service in exchange for the money.

Net exports (NX) are found by subtracting imports from exports (X - M). When Boeing sells a 787 Dreamliner to a Japanese airline, it increases U.S. GDP, but when someone in the U.S. buys a Samsung TV, it decreases it. Because the U.S. has had a trade deficit (imports exceeding exports) almost every year since 1976, net exports are usually a negative number.

Therefore, GDP = C + I + G + NX. This is a basic accounting fact, not a theory or a forecast. Every dollar of final production is bought by someone, and that buyer will fall into one of these four categories.

Nominal vs Real GDP and the GDP Deflator

When GDP goes from $20 trillion to $21 trillion, it sounds good, doesn't it? But it could be that prices simply increased by 5% and the economy didn't really grow very much at all. From the very beginning of national income accounting, figuring out how to separate actual growth from price increases has been a problem, and the distinction between nominal and real GDP is the way economists have dealt with it.

Nominal GDP uses current prices. If both the amount of goods and services made and their prices go up, nominal GDP goes up too, but it's difficult to say which factor is causing the increase.

Real GDP uses the prices from a specific base year. This removes inflation, letting you see if the economy really did produce more. Real GDP is the figure economists use to measure growth and decide if the economy is in a recession. In fact, the National Bureau of Economic Research (NBER) used real GDP to determine the 2008 recession.

The GDP Deflator provides a link between the two:

GDP Deflator = (Nominal GDP / Real GDP) x 100

It is different from the Consumer Price Index (which the Bureau of Labor Statistics has been publishing since 1913 and looks at the prices of a standard set of goods bought by consumers). The deflator shows the price level of everything produced in the country: consumer goods, business equipment, government spending, everything. If the deflator moves from 100 to 105, it means the domestic price level has gone up by 5%.

The recovery from COVID in 2021 and 2022 made this difference very clear. Nominal GDP in the U.S. increased sharply, but much of this was simply rising prices. In June of 2022, inflation reached over 9%. Growth in real GDP was much lower than the main figures indicated.

Worked Example: Calculating Real GDP

As an example of how to calculate Real GDP, let's say an economy only produces two items: tacos and textbooks.

Base Year:
Tacos: 100 units at $2 each = $200
Textbooks: 20 units at $50 each = $1,000
Nominal GDP (base year) = $1,200

Current Year:
Tacos: 120 units at $3 each = $360
Textbooks: 25 units at $60 each = $1,500
Nominal GDP (current year) = $1,860

The nominal GDP this year is $1,860, a nominal increase of 55%. But that sounds better than it is – how much of that is actually more production, and how much is simply higher prices?

Calculate Real GDP by using the base year's prices with the current year's amount:
Tacos: 120 x $2 = $240
Textbooks: 25 x $50 = $1,250
Real GDP (current year) = $1,490

The GDP Deflator (calculated as ($1,860 / $1,490) x 100) is 124.8.

This means real production rose from $1,200 to $1,490, a 24.2% increase, and prices increased by around 24.8%. Roughly half of that 55% nominal increase is real growth, the other half is inflation. Without calculating Real GDP, we'd think the economy grew by more than twice as much as it really did. Simon Kuznets actually told Congress about this very problem in the 1930s – simply looking at dollar amounts, without accounting for price changes, can be very misleading.

Limitations of GDP

GDP became the main way of judging an economy after World War II, when the Bretton Woods organizations made it the standard measure of a nation's economic success. Even Kuznets, who created it, said it had weaknesses, and those weaknesses still exist.

Unpaid jobs aren't included. If a parent stays home to raise children, that's valuable economic activity, but GDP doesn't acknowledge it. However, if that parent hires a nanny and goes to a paying job, GDP goes up, even if the total amount of useful work hasn't changed at all. Volunteering, looking after family, housework... all these are invisible to GDP. Some economists think that if we included all the unpaid work done in American homes, it would add trillions to the GDP.

The 'underground' economy is also left out. Things like off-the-books work, money that isn't reported to the authorities, and illegal dealings aren't counted. In some poorer countries, this unofficial economy can be 30-40% of all economic activity, so GDP gives a very inaccurate view of what's going on.

GDP doesn't tell you how the wealth is divided. A country with a $10 trillion GDP could have almost all of that money held by a small number of families, whilst most people have a hard time getting by. GDP per person is just an average, and averages can hide huge differences. There is something called the Gini coefficient which measures inequality, but it doesn't get as much attention as GDP.

When something is destroyed, GDP can even go up. The Deepwater Horizon oil spill in 2010 led to billions of dollars being spent on cleaning up (people, equipment, lawyers) and all of that was included in GDP. The damage to the Gulf of Mexico's environment? Not taken out. Cutting down a rainforest boosts GDP when you sell the wood. The value of the lost forest isn't considered a cost in the national accounts.

GDP ignores quality of life. Free time, how people are mentally, how safe they feel when out at night, how free they are politically, and how content they are with their lives…GDP doesn't deal with any of this. The United States has the biggest GDP in the world, but many smaller countries have longer lives and people who say they are happier.

GDP is still probably the best single figure for how much is being made in the market. But it measures production, not how good people have it, and that's what Kuznets said back in 1934. And his warning is still important ninety years later.