What are the shortcomings of using GDP as a measure of economic welfare

Gross Domestic Product (GDP) is one of the most widely used measures of an economy’s output or production. It is defined as the total value of goods and services produced within a country’s borders in a specific time period—monthly, quarterly, or annually.

GDP is an accurate indicator of the size of an economy and the GDP growth rate is probably the single best indicator of economic growth, while GDP per capita has a close correlation with the trend in living standards over time.

As Nobel laureate Paul A. Samuelson and economist William Nordhaus put it:

While GDP and the rest of the national income accounts may seem to be arcane concepts, they are truly among the great inventions of the twentieth century.”

Key Takeaways

• GDP enables policymakers and central banks to judge whether the economy is contracting or expanding and promptly take necessary action.
• It also allows policymakers, economists, and businesses to analyze the impact of variables such as monetary and fiscal policy, economic shocks, and tax and spending plans.
• GDP can be calculated either through the expenditure, income, or value-added approach.
• GDP isn't always flawless and overlooks several important factors.

Why GDP is Important?

Samuelson and Nordhaus neatly sum up the importance of the national accounts and GDP in their seminal textbook “Economics.” They liken the ability of GDP to give an overall picture of the state of the economy to that of a satellite in space that can survey the weather across an entire continent.

GDP enables policymakers and central banks to judge whether the economy is contracting or expanding, whether it needs a boost or needs to be restrained, and if threats such as a recession or rampant inflation loom on the horizon.

The national income and product accounts (NIPA), which form the basis for measuring GDP, allow policymakers, economists, and businesses to analyze the impact of such variables as monetary and fiscal policy, economic shocks, such as a spike in the oil price, and tax and spending plans on specific subsets of an economy, as well as on the overall economy itself.

Along with better-informed policies and institutions, national accounts have contributed to a significant reduction in the severity of business cycles since the end of World War II.

GDP Calculation

GDP can be calculated either through the expenditure approach—the sum total of what everyone in an economy spent over a particular period—or the income approach—the total of what everyone earned. Both should produce the same result. A third method, the value-added approach, is used to calculate GDP by industry.

Expenditure-based GDP produces both real (inflation-adjusted) and nominal values, while the calculation of income-based GDP is only carried out in nominal values. The expenditure approach is the more common one and is obtained by summing up total consumption, government spending, investment, and net exports.

GDP = C + I + G + (X – M)

where:

• C = private consumption or consumer spending;
• I = business spending;
• G = government spending;
• X = value of exports
• M = the value of imports.

GDP fluctuates because of the business cycle. When the economy is booming, and GDP is rising, there comes a point when inflationary pressures build up rapidly as labor and productive capacity near full utilization. This leads the central bank to commence a cycle of tighter monetary policy to cool down the overheating economy and quell inflation.

As interest rates rise, companies and consumers cut back spending, and the economy slows down. Slowing demand leads companies to lay off employees, which further affects consumer confidence and demand. To break this vicious circle, the central bank eases monetary policy to stimulate economic growth and employment until the economy is booming once again. Rinse and repeat.

Consumer spending is the biggest component, accounting for more than two-thirds of the U.S. economy. Consumer confidence, therefore, has a very significant bearing on economic growth. A high confidence level indicates that consumers are willing to spend, while a low confidence level reflects uncertainty about the future and an unwillingness to spend.

Business investment is another critical component of GDP since it increases productive capacity and boosts employment. Government spending, too, assumes particular importance as a component of GDP when consumer spending and business investment both decline sharply, as, for instance, after a recession. Finally, a current account surplus also boosts a nation’s GDP, since (X – M) is positive, while a chronic deficit is a drag on GDP.

Drawbacks of GDP

Some criticisms of GDP as a measure of economic output are:

• It does not account for the underground economy: GDP relies on official data, so it does not take into account the extent of the underground economy, which can be significant in some nations.
• It is geographically limited in a globally open economy: Gross National Product (GNP), which measures the output from the citizens and companies of a particular nation regardless of their location, is viewed as a better measure of output than GDP in some cases. For instance, GDP does not take into account profits earned in a nation by overseas companies that are remitted back to foreign investors. This can overstate a country's actual economic output. For example, Ireland had a GDP of $210.3 billion and a GNP of $164.6 billion in 2012, the difference of $45.7 billion (or 21.7% of GDP) largely being due to profit repatriation by foreign companies based in Ireland.
• It emphasizes economic output without considering economic well-being: GDP growth alone cannot measure a nation's development or its citizens' well-being. For example, a nation may be experiencing rapid GDP growth, but this may impose a significant cost to society in terms of environmental impact and an increase in income disparity.

Global GDP Trends

Discussions about GDP growth invariably turn to the torrid pace of growth recorded by China since the late 1970s and India from the 1990s, following revitalizing economic reforms.

Smaller nations such as the Asian Tigers—Hong Kong, Singapore, South Korea, and Taiwan—had already achieved rapid economic growth from the 1960s onward by becoming export dynamos and focusing on their competitive strengths. But China and India succeeded despite their massive populations, with an average 10% GDP growth rate in China since 1978, and a slower growth pace in India enabling hundreds of millions to escape the clutches of poverty.

While the emerging market and developing nations have been growing at a faster pace than the developed world since the 1990s, the divergence in growth rates has begun to narrow since the end of the Great Recession in early 2009.

For instance, in 2011 developing countries collectively recorded GDP growth of 6.2%, while developed nations only grew by 1.7%. By 2019, that gap tightened, with developing countries' collective GDP shrinking to 3.7%, while developed nations' GDP stayed steady at 1.7%.

Future GDP Shifts

The Organization for Economic Cooperation and Development (OECD), in a report released in March 2020, addressed the potential impact of COVID-19 on the global economy. Understandably, the prognostications were grim as they noted that:

output contractions in China are being felt around the world, reflecting the key and rising role China has in global supply chains, travel and commodity markets. Subsequent outbreaks in other economies are having similar effects

The report goes on to state:

annual GDP growth is projected to drop to 2.4% in 2020 as a whole, from an already weak 2.9% in 2019, with growth possibly even being negative in the first quarter of 2020

Effective mitigation is expected to see the global economy recover to 3.75% by 2021. However, a longer-lasting coronavirus outbreak and spread, especially throughout the Asia-Pacific region, Europe and North America could see global GDP:

drop to 1.5% in 2020, half the rate projected prior to the virus outbreak.

Assuming that the world survives COVID-19 and normal activity resumes then, thanks to their sheer size, China and India appear to be inexorably on track to become the world’s biggest economies in time. The largest and best-run companies in these countries will be among the biggest beneficiaries of long-term economic expansion.

An investor wishing to participate in these growth prospects can easily do so through exchange-traded funds (ETFs), such as the iShares China Large-Cap ETF (FXI), which tracks the performance of 26 of the largest Chinese companies, or the India Fund (IFN), a closed-end fund that was introduced in February 1994 and holds some of the subcontinent’s best-known companies.

Using GDP Data

Most nations release GDP data every month and quarter. In the U.S., the Bureau of Economic Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the quarter ends, and a final release three months after the quarter ends. The BEA releases are exhaustive and contain a wealth of detail, enabling economists and investors to obtain information and insights on various aspects of the economy.

The advance GDP data has the most impact on the markets as it is the first snapshot of how well the economy is performing. Subsequent releases have limited market impact, unless there is a significant variance from the advance GDP figure, since a substantial amount of time has already elapsed between the quarter-end and these releases.

The market impact can be severe if the actual numbers differ considerably from expectations. For example, the S&P 500 experienced a sizable decline on Nov. 7, 2013, following reports that U.S. GDP had increased at a 2.8% annualized rate in Q3, compared with economists' estimates of 2%. The data fueled speculation that the stronger economy could lead the Federal Reserve (Fed) to scale back its massive stimulus program that was in effect at the time.

Total Market Cap to GDP

One interesting metric that investors can use to get some sense of the valuation of an equity market is the ratio of total stock market capitalization to GDP, expressed as a percentage. The closest equivalent to this in terms of stock valuation is the market cap to total sales (or revenues), which in per-share terms is the well-known price-to-sales ratio.

Just as stocks in different sectors trade at widely divergent price-to-sales ratios, different nations trade at stock-market-cap-to-GDP ratios that are literally all over the map. For example, the U.S. had a stock-market-cap-to-GDP ratio of 172% as of Q4 2019, while China had a ratio of just over 139% and India a ratio of 75%.

However, the utility of this ratio lies in comparing it to historical norms for a particular nation. As an example, the U.S. had a stock-market-cap-to-GDP ratio of 136% at the end of 2015, which then surged to 172% by the end of 2019. Given the rise in the U.S. stock market by the end of 2019—and with the benefit of hindsight—these readings might be viewed as zones of undervaluation and overvaluation.

The Bottom Line

In terms of its ability to convey information about the economy in one number, few data points can match the GDP and its growth rate.

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