Commentary: The GDP is a grossly defective product. We need to knock it off its pedestal

It is the economic ring of rings, the number that rules all. Gross domestic product is the measure that preoccupies policymakers and obsesses markets. Traders fine-tune their predictions of Federal Reserve policy based on expectations about GDP’s performance. Nowcasters seek to provide real-time estimates. And yet, more than ever, it is apparent that this economic lodestar is a treacherous guide.

Rising or falling? Tokyo and the Bank of Japan disagree over the country's gross domestic product. REUTERS/Kim Kyung-Hoon

Consider the controversy over how the Japanese economy performed in 2014. According to official figures, GDP declined by 0.9 percent. But a recent Bank of Japan study, which drew on alternative sources of data, found that it had expanded by 2.4 percent.

Another case in point: The recession in the United Kingdom in the early 1990s appeared grave at the time, with GDP slipping from its peak to trough by 4.3 percent. The figures now reveal a decline of only 2 percent. Which was the truer picture: The reverse experienced and countered by policymakers using definitions and data available at the time, or the milder one airbrushed by subsequent revisions?

Such discrepancies corrode confidence in GDP as a measure of economic health. More generally, a seemingly endless string of revisions raises questions about how differently policymakers might have behaved  on the basis of revised estimates. Two years ago, there was alarm in the euro zone as an already-faltering recovery stalled in the second quarter of 2014. The halt in growth was one reason the European Central Bank gave for moving toward quantitative easing in early 2015. Yet, according to the latest figures, the euro zone actually grew by 0.2 percent in the second quarter of 2014, a feeble but less dispiriting performance.

GDP is measured both quarterly and annually by calculating the inflation-adjusted sum of value added in an economy. That number can be compared with estimates of potential GDP to assess whether economies are operating at, below or above capacity.

Yet despite its theoretical appeal, GDP is, in practice, a fallible measure – and increasingly becoming one that could be described as a grossly defective product.

For one thing, the number shifts as more complete, up-to-date data becomes available. For another, national accountants change their definitions and approaches to better reflect the changing shape of the economy, such as the recent inclusion of research and development as investment.

A deeper concern is that the concept of GDP – a measure of output within an economic territory is becoming less and less relevant to the way economic activity is actually conducted. Devised in an era of largely closed industrial economies, GDP is much harder to estimate in today’s more open service-dominated economies. In particular, determining where value is really added becomes far trickier as multinationals use global supply chains to exploit intellectual property and move business around to minimize taxes.

It is no accident that GDP figures for Ireland have become distorted beyond recognition because the country’s small, open economy attracts American multinationals lured by its low corporate tax rates. An upward revision in economic growth would normally be welcomed, but the increase reported this summer in Irish GDP prompted disbelief. Official number crunchers rejigged the increase in 2015 GDP from an already-rapid 7.8 percent to an extraordinary 26.3 percent. Rather than embellish Irish economic performance, the revision brought the GDP number into disrepute because it merely reflected the fact some big companies had relocated some business to Ireland. Nothing fundamental had changed, except that Irish debt – typically (and misleadingly) expressed as a share of GDP – suddenly looked less onerous, falling from 108 percent of GDP in 2014 to 79 percent in 2015.

Even more fundamentally, GDP falls increasingly short of reflecting the digital age. Internet giants such as Facebook provide their services free, but GDP excludes zero-priced products. More and more people book travel online rather than through an agent, yet their efforts do not count toward GDP any more than other unpaid work in the home. And beyond the difficulties of measuring the contribution of digital products to GDP, the demarcation of economic activity by national boundaries is increasingly obsolete in a digital world.

The shortcomings of GDP as a gauge of economic welfare are longstanding, however. Half a century ago, Robert Kennedy deplored closely related gross national product (GNP) as measuring everything “except that which makes life worthwhile.” Today, China’s dash for GDP growth, promoted by targets, has taken a severe toll on the health and quality of life of the Chinese people through air and water pollution.

It’s time to knock GDP off its lofty pedestal. China should abandon its pernicious growth targets. Investors, as well as policymakers, should embrace the  data revolution to find new and better ways to measure the pulse and health of economies. On the eve of the new millennium, GDP was celebrated as one of the great inventions of the 20th century. The trouble is precisely that: It is so last century.

About the Author

Paul Wallace is a London-based writer. A former European economics editor of The Economist, he is author of “The Euro Experiment”, recently published by Cambridge University Press.

The views expressed in this article are not those of Reuters News.