12 Dec 2011

## Illustrating the Problems With GDP Accounting

In the comments I chimed in, giving an example to demonstrate the dangers of the standard discussion of GDP accounting. (Note that I’m not sure if anyone in the comments was saying something wrong; it was just a springboard for me to pontificate.) Let me embellish the example here:

Suppose Country A is composed of vegetarians whose sole occupation is to raise pigs. Each year they export all \$1 trillion of them to their carnivorous neighbors in Country B. The meat-lovers, in contrast, do nothing but grow apples (\$1 trillion per year) to sell to their vegetarian neighbors in Country A.

Further suppose that in each country, there is no investment (neither gross nor net). Each year, consumers in each country spend \$1 trillion on food. There is no government.

So GDP = C + I + G + Nx = \$1 trillion + \$0 + \$0 + (\$1 trillion – \$1 trillion) = \$1 trillion.

That’s a tautology and obviously true. But when commenting on it, pundits might say something like, “Our country is driven 100% by consumption. Foreign trade contributes \$0 to GDP, and thus has nothing to do with job creation.” Based on this misleading description, people might erroneously conclude that erecting a trade wall would do little to affect the economy.

#### 22 Responses to “Illustrating the Problems With GDP Accounting”

1. Silas Barta says:

In the comment you were replying to, my point was regarding the situation where both sides increase their exports, and I was saying that this would not (necessarily) increase GDP.

I was imagining the situation where before, each country produced its output and consumed it. Then they knock down the trade barriers and create a Pareto improvement by trading and consuming the others’ output instead. There’s no change in consumption in dollar terms, and so no change in GDP, even though both groups are obviously better off.

We can make it an even more extreme example by taking the specialties you described: let’s say the vegetarians are self-hating pig farmers that don’t believe in eating their own pigs (or otherwise using them for consumption), so (before the trade barriers came down), they just “threw away” their consumption. (Since they love animals so much, let’s say they just turn the pigs loose.)

The meat eaters likewise harvest their apples and even buy them from each other, but just throw it away because they hate apples. (Yes, this an economy of idiots … entirely unfamiliar to those of our present world, of course.)

Then they’re *definitely* better off by selling to each other, though the simple “consumption substitution” doesn’t show up as increased GDP.

• Tel says:

I think that in order to make any sense of GDP at all, you have to presume that people spend their money on something useful to them. As we have mentioned before if a bunch of people just create transactions between each other for the fun of it (especially import / export transactions) then you get arbitrary fruitloop GDP values.

That’s why GDP is only a useful measure providing there is no incentive to deliberately bork the measure.

There’s a theory of why you can use any given variable as either a metric, or a control parameter but not both, and by gum I once knew the proper name for it (not something I invented, it’s a real economic theory) I just can’t think of the words tonight. 🙁

• Silas Barta says:

That sounds like Goodhart’s Law, which I refer to quite a bit.

(This comment, including copying of URL, was made without use of the mouse, thanks to Pentadactyl Firefox extension.)

2. Nick says:

Cut the Gordian knot.

GDP = (tax income / tax rate) * (1+black market percentage).

Tax income is known accurately
Tax rate is known accurately.
Black market percentage is small.

So you have a GDP figure that is robust, and difficult to fiddle with.

• Joseph Fetz says:

LOL!!!

• John Becker says:

I might be missing out on the joke but tax rate isn’t known accurately at all. It would be very difficult to figure out how much people spend on sales taxes, county taxes, local taxes, tolls, and different marginal rates on income. It would be hard enough for one individual to keep track of all this.

3. Bill Woolsey says:

This only follows because of the way you treat net exports.

It is C + I – imports + Exports

(C – imports) + Exports.

Consumption provides no jobs in this economy, it is only exports.

Which is kind of true, but really, the failing isn’t GDP accounting it is rather the assumption
that the purpose of economic activity is to create jobs.

The purpose of GDP accounting is to measure the value of output. And C + (exports – imports)
works just fine. But that is only because it is equal to C – imports + exports.

• Bob Murphy says:

Bill right, but that quantity isn’t as conceptually well-defined as “net exports.” You could do (C+I-Imports) and call it “domestic private spending on domestically produced goods” or something.

Anyway, we’re in agreement here: I’m not denying that the equation is true (given the definitions of the components), I’m just saying in practice it is deployed to awful ends.

4. Silas Barta says:

Eh, now I get the feeling Bob and I may be talking past each other.

• Bob Murphy says:

Silas, we’re definitely making different points. I think you are making the point that GDP doesn’t necessarily correlate with economic well-being (or something), and I agree. But I’m trying to say that the components of GDP don’t “cause” it the way pundits typically imply.

5. Bala says:

How did C become \$ 1 trillion? Shouldn’t it be zero? What am I missing out here? Truly clueless….

• Bala says:

Just to elaborate on what I said, why use terms like “\$1 trillion apples” and “\$1 trillion pigs”? If all the people are doing are

1. Country A – Raise pigs, exchange for apples produced by citizens of country B, consume apples
2. Country B – Produce apples, exchange for pigs produced by citizens of country B, consume pigs

why does C enter the picture at all? My problem is that I am unable to see the C. What am I missing?

• Major_Freedom says:

You are missing the dollars that are exchanging hands.

Yes, in principle, both country inhabitants are just trading apples for pigs. But they are using a medium of exchange of dollars. This is necessary in order for the GDP example to portray what Murphy wants to portray. It has to be related to “real world” GDP calculations in this respect.

Each period, \$1 trillion of money is going from country A to country B, and \$1 trillion of money is going to from country B to country A.

C enters the picture because C in the GDP calculation, is measured in dollars spent, not physical goods produced and exchanged. Yes that is a weakness, yes it tells us more the quantity of money and volume of spending more than anything else, but that’s where the \$1 trillion in C in each country is coming from.

• Major_Freedom says:

If I may, I think C becomes \$1 trillion, because in each country, the citizens are physically importing food from the other country, and spending \$1 trillion on it.

The carnivores in country B are importing pigs from the pig producers in country A, by spending \$1 trillion, and the vegetarians in country A are importing apples from the apple producers in country B, also by spending \$1 trillion. (I think Ricardo would have a s\$%t if he saw this example, LOL)

Each country’s C is \$1 trillion, because each country is spending \$1 trillion on consumer goods.

C cannot be zero because that would imply nobody is spending any money on consumption, which I hope you realize contradicts the very assumptions in the example.

Hope that helps.

• Bala says:

Thank you for the response, but pardon my extraordinary density for I am still confused. I shall therefore try to take undue advantage of your immense patience to understand this point.

If you say

“If I may, I think C becomes \$1 trillion, because in each country, the citizens are physically importing food from the other country, and spending \$1 trillion on it.”

did the citizens not pay the \$1 trillion at the time of the physical import? Aren’t we double counting the same \$ 1 trillion?

Just to extend this further, if the citizens of country A were to produce \$1 trillion worth apples and consume them directly, would we still say that the GDP is \$1 trillion?

Looked at from this angle, it appears to me that the consumption happens outside the nexus of exchange and hence that counting the \$1 trillion as consumption after accounting for it as \$ 1 trillion of imports is not OK. What is wrong with my understanding?

• Major_Freedom says:

did the citizens not pay the \$1 trillion at the time of the physical import? Aren’t we double counting the same \$ 1 trillion?

Yes, at the time of physical import, money was paid. At the end of the year, total money paid is \$1 trillion by country A (and country B).

Just to extend this further, if the citizens of country A were to produce \$1 trillion worth apples and consume them directly, would we still say that the GDP is \$1 trillion?

Only if they SPENT \$1trillion on them, would they “count” in the GDP statistic.

Looked at from this angle, it appears to me that the consumption happens outside the nexus of exchange and hence that counting the \$1 trillion as consumption after accounting for it as \$ 1 trillion of imports is not OK. What is wrong with my understanding?

Ah, I see what you’re doing. You’re attributing a dollar value independent of money spent when certain goods are consumed physically. You see a bunch of apples, and you say “OK, apples were consumed, so let’s attribute the value of those apples consumed to be \$1 trillion.” The problem here is that you can’t attribute such a dollar value to the apples that is independent of the money spent for them. The dollar value you think you can arbitrarily assign to the physical act of consuming apples, is not correct, because the dollar value that can be assigned IS the very acts of spending money on them. The dollar value derives from the money spent on them, and in the case of GDP, the dollar value assigned has no independent “reality” apart from the money spent on the apples.

So if there is no money spent on the apples, then this may shock you, but that consumption won’t show up in GDP calculations. Only if apples are BOUGHT for \$1 trillion would you be able to say that “consumption was \$1 trillion.”

I think you should get it now.

• Bob Murphy says:

Bala, it’s a good question, and don’t feel dumb…but MF is right. I confess I don’t know how it’s literally done in the real world, but as far as the textbook treatment of GDP accounting, it goes like this:

The people working at the BEA would look at all the consumer expenditures in Country A during the course of the year. They’d see that each of the 100 million households spent on average of \$10,000 on apples, and nothing else. (Their average wages during the year were exactly \$10,000 per household, if that interests you.) So the C in the GDP equation is \$1 trillion.

The BEA would also determine that businesses in Country A spent \$1 trillion importing apples during the year. I confess I’m not sure even theoretically (let alone in practice) where they “clock” this. I’m guessing it has to be watching how much businesses spend to bulk up their inventory of apples, because the consumers (we can suppose) have no idea where the apples come from, they just go to their local grocery store and buy them.

Notice though that the business spending is only being considered here because it happens to be on foreign-made goods; if the grocery stores were spending \$1 trillion buying apples from domestic farmers, that spending wouldn’t go into GDP because then there would be double-counting.

But then we also have to add the \$1 trillion that foreign grocery stores spend on Country A’s pork. This is because just focusing on spending done in Country A would miss out on that spending. (Thus the “C” we calculated originally, wouldn’t catch all of the foreigners who consume stuff made in Country A.)

So then when all is said and done, GDP is C + Exports – Imports = \$1t + \$1t – \$1t = \$1t.

I am 85% sure I’ve got this exactly right, and 99% sure I’ve got the general principles right and might just be botching the specific way they do the adjustments. The big picture is, GDP is actually supposed to measure production, but in practice it’s easier to get data on expenditures. But things get tricky when you realize that your citizens might be spending money on consumer goods that were actually produced elsewhere, and that your workers might be producing stuff for which there is no corresponding domestic spending. So that’s why you need the Net Export adjustment, to correct for those discrepancies.

• Bala says:

Thank you Prof. Murphy and Major Freedom. I think I get it now. The \$1 T + (\$1 T – \$1 T) did the trick for me. Thanks once again.

• Bob Murphy says:

Thank you Prof. Murphy and Major Freedom. I think I get it now.

Bala, no problem. Wherever someone doesn’t understand macro aggregates, we’ll be there.

6. Tel says:

By the way, Steve Keen tried to start a metric that subtracted out rising debt from GDP (and added in falling debt). That is to say that GDP this year generated by creating a debt that you need to pay in future years is not real production, but merely bringing forward consumption (i.e. time shifting without improving the overall outcome).

http://www.debtdeflation.com/blogs/2010/09/07/gdp-plus-change-in-debt%E2%80%94and-the-us-flow-of-funds/

Personally I think Steve Keen is interesting not because he has any useful answers, but because he is asking the right questions (and very few people are).

• Silas Barta says:

I’m confused — it makes sense to substract out increases in debt from GDP, but all of his figures show increases in debt being *added*. Why?

7. william says:

How a foreigner buying a new house would affect a nation’s GDP and which component of GDP it would enter: C, I, G, Nx