When GDP is not a good indicator... and why.

GDP is widely used as an indicator of development. As a matter of fact it is the main indicator mass media, economists and politicians use to show how an economy is performing, and we rarely see other figures. However, GDP is not always a good indicator, taken alone. In this post I intend to demonstrate why not. We will find two main issues: average and market dependence.

To begin with, we ought to explain what GDP actually is. The standard definition is that Gross Domestic Product, or GDP, is the total market value of all final goods and services produced in an economy in a given year. It is to say, it's the sum of total consumption, investment and government spending plus the difference between exports and imports.

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We could more generally say that it is what an economy have produced in a given period, so GDP will roughly tell us the size of an economy, any given year. If we want to compare between different countries then, because countries can have very different number of citizens -think about comparing China and Sweden: there are 142 Chinese for every Swedish-, we need to calculate the GDP per person, just dividing the total GDP by the number of citizens. That’s called GDP per capita. Finally what matters most for checking how we are doing is not the static volume of the GDPpc, but its growth (or decline), because the GDPpc tells us where we are but not where we are going or how we’ve done recently.

The first problem with GDPpc as an indicator of performance is that it is an average, what means it gives you an information that can be hugely misleading if we don’t take into account the distribution of wealth. Imagine that you and me were a very simple closed economy ourselves, and we produce chicken. This year our outcome is just 2 chickens... and I eat them both. None for you. Now GDP will say we have 1 chicken per capita.

If this example feels too simple to you we can take the leap to the real world. There is an index (I might talk about it in another post) inspired by the Nobel-prize winner Amartya Sen and developed by the Pakistani Professor Mahbub ul Haq named Human Development Index (HDI), which is used by the United Nations to calculate development, taking into account not only income but also two more dimensions: health and education. Small oil-producer countries such as Qatar, Kuwait or the United Arab Emirates typically rank very high in GDPpc -being Qatar the richest country in the world. Nevertheless, when we also consider these other dimensions, they all fall to positions 30 to 40 in the HDI. Qatar ranked 36 in 2012. How come? That's because they are fairly unequal countries and GDPpc is overrating their average development: some Qatari are extremely rich and, as the country is small, they push up the average significantly -and also to some extent because their spectacular growth has happened in the last 30 years or so and it hasn't fully translated onto the other indicators... but that's another story. I'd suggest to take a minute to compare these two indexes in the map below:

Back to our question, the other big issue with GDP is that it only takes into account what comes through the market. Imagine now any economy which have a beautiful forest. We can decide whether we cut down the trees or we preserve the forest. If we decide to preserve the forest GDP would go unaltered.

We won’t be making any profit through any market and therefore, from a GDP point of view, our economy is not growing at all. But if what we do is cutting the trees down then we are paying wages to the lumberjacks and the truck-drivers, we are selling the timber itself, we make furniture with it and pay designers, retailers and management, during the whole process -hopefully- we pay taxes, we have been using (and paying for) energy, generating and processing waste... GDP is clearly growing in many ways.

But are we now -after destroying and selling the forest- richer or poorer than with the conservation option? From a GDP point of view there’s no doubt, we are much richer. As it does not exist a market for the environmental value of conserving the forest it simply has no room in the GDP indicator. Instead it only becomes valuable when we bring it down. But that is, of course, wrong. The forest has many values in its own right, even "merely economic" values: just think about the tourists that visit us for our beautiful environment, the soil and moisture that is kept thanks to the trees, the animals living within, the clean and fresh air, the real estate increased value of living close to it and so on and so forth. It's only that there is no market for them -they are (positive) externalities, a concept I'll also talk about in another post. In this category of not-market (or not visible through the official markets) goods and services we can find other sound activities that are not reflected in GDP: for instance, housekeeping and black economy might amount to a great deal of hidden economic activity.

Summarizing, GDP may not be a good indicator of performance when taken alone. Specifically when we face severe inequalities and/or impactant externalities it can be truly misleading. The United States' GDPpc has grown quite a lot in the last century, at an average 2%, nevertheless you can check in this website of the Economic Policy Institute how that growth has been distributed. I'd recommend to play with the tools it provides to check the trends in three periods: before the World War II, 1945-1980 and 1980-nowadays. Of course very different economy policies were taken place -further on we ought to talk about Keynes. The meaningful question that arises is: does the increase in GDPpc reflect a better life for most of today's Americans -namely 90% of them- than their parents had enjoyed?