Gross domestic product (GDP) is the standard measurement for gauging a nation’s economic health. But, it’s also one of the oldest, which may mean it needs some updating. GDP is computed by adding the monetary values of final goods and services produced within the geographical boundaries of a nation over a specific time period. As a measurement, GDP is solely focused on output volume (in money units), and that’s where it misses the mark in gauging an economy’s full potential.
A Brief History of GDP
Long before GDP garnered worldwide recognition as the go-to indicator of a nation’s economic health, rudimentary versions were traced back as far as the 17th century when British scientist William Petty sized-up Britain’s income and other assets to uncover additional sources of tax revenues. At the time, Britain was trying to fund the Second Anglo Dutch War (1665-1667). Another set of income estimates was devised by Charles Davenant in 1695 titled “An Essay upon the Ways and Means of Supplying the War.”
However, it was probably not until the Great Depression that the concept of national income accounts was catapulted into the mainstream. Spurred by the urgent need to “plug” information gaps to stave off depression, Simon Kuznets and his team at the National Bureau of Economic Research developed a set of national income accounts titled “National Income, 1929–35” and submitted them in 1937 to Congress. The reports were further consolidated into “Gross National Product,” as part of planning for World War II expenses in the 1940s. Also, around the same time, economist John Maynard Keynes played an important role in formulating the modern version of the GDP calculation.
It’s clear that the earliest calculations of GDP were borne out of necessity amid turbulent conditions to estimate an economy’s potential to produce goods and services. But, such crisis conditions weren’t supposed to last forever. Below we took a look at a few shortcomings of the GDP calculation.
“Less is More” – But Not in GDP Stats
GDP’s volume-centric approach inadequately addresses the tech sector, as technology’s huge strides have made “less is more” the new mantra. Case in point—smartphones. With decreasing prices and increasing functionality, a smartphone has replaced the need for a lot of gadgets including watches, calculators and even PCs for some. But, the declining trend in so many goods would be counted as deductions from GDP, without fully accounting for increased efficiencies resulting from the substitution of so many products by a single device.
“Zero price = Zero Value” Approach Underestimates Value
Another serious drawback of GDP is its exclusion of items that are devoid of “price tags,” and yet are pivotal in making thousands of lives healthier and richer. These may include household chores, knowledge received from parents, family members caring for elderly/sick relatives, pro-bono work and even free use of parks and bridges. A 2012 study estimated that including the value of non-market household production raised nominal GDP by 26% in 2010 (Accounting for Household Production in the National Accounts Study).
And, the wealth of information available to us instantly from websites like Google, Facebook and Twitter, can’t be fully appreciated by the mere internet connection charges—yet another glaring shortcoming of using GDP to weigh productivity in the age of information.
Personal Wealth Gets Underappreciated
GDP accounts for only first-time production values of goods and services for a particular time period, and therefore does not include the resale of properties and capital gains on financial assets. However, financial transactions are wealth-creating instruments and therefore should be counted as important indicators of individuals’ purchasing power and standards of living.
Bottom Line for Investors
We’re not saying that GDP should be completely dismissed—the aggregate value of production is one of the necessary components of economic prosperity. But, so are factors like output quality, non-marketed essentials and technological efficiencies—all factors that GDP does not adequately capture.
As socio-economic paradigms transform, so should the parameters for assessing their strength. A developed nation may rank high in terms of aggregate output, but may be suffering from rising inequality in income distribution and/or stagnating quality levels—serious impediments to sustainable growth. As investors, it’s important to evaluate growth beyond just the GDP figure. Close attention should be paid to other metrics, such as corporate earnings growth, hiring, fixed private investment, research and productivity gains.
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