January 1, 2010


Why bigger is not all that matters.

After two tough years of work, with little staff or money, Simon Kuznets, in January of 1934, was very clear and inspiringly humble about what he had produced. The nation was wallowing in the belly of the Great Depression, but had no statistical framework, no accounting, no spreadsheet, no reliable measurements of what was actually happening in the economy. Everyone could see the breadlines and the homeless. But there were no numbers to quantify the misery.

The Congress and President Hoover needed a management tool to assess activity in the economy and perhaps point a way toward recovery. They asked the Commerce Department to come up with something. Commerce turned to Kuznets, a professor at the University of Pennsylvania who was working in New York at the National Bureau for Economic Research, a predecessor to what is now called the Bureau of Economic Analysis (BEA).

Kuznets, the father of the economic index we call Gross Domestic Product, or GDP, in an exhaustive report to Congress in 1934 introduced his national statistical model in thoughtful, cautious, technical language. He pointed as much to the limitations of the numbers he had relied on and produced as he did to any conclusions that could be drawn from them. He knew he was creating a tool for managing a badly wounded economy. But he worried that the data were unreliable in some cases, incomplete in others and subject to overly ambitious conclusions. His index, he said, could measure market transactions, the things consumers and the government spend money on. He had set up the framework for the first national income and product accounts (NIPAs) that measure spending in the major sectors of the economy.

Today, as the U.S. staggers out of the worst economic downturn since that Great Depression, we are of course still using Kuznets’ invention to measure progress, strength and health in the economy and hence in the country. But it is quite clear that GDP offered little advance warning of our present Great Recession. And now with a raft of economists declaring the recession “over,” at least as the GDP measures it, we are also seeing a national and even international debate on the flaws and inadequacies of that measure. It does not explain, for example, how Wall Street and the financial markets can recover far faster than Main Street, with unemployment still a grinding drag on the economy. It certainly does not measure the growing gap between rich and poor and how that may affect a recovery. And it does not in some cases accurately measure what it was mainly designed to assess: the sheer size and output of the country.

Alternatives are proposed. Revisions are constantly in the works. But it remains crucial to understanding the economy that we also understand the pluses and minuses of its most-followed measure, the GDP, and what other measures may give us a fuller, more accurate gauge of the nation’s economic health.

A Great Invention

Still, Kuznets did revolutionary work and some 30 years later it won him the Nobel Prize in economics. When the Commerce Department, in 1999, reviewed all it had done over the previous 100 years, it declared the GDP “one of the great inventions of the 20th Century.” Paul A. Samuelson and William Nordhaus, the men who literally wrote the book on economics, the most widely used introductory college text on the subject (Economics, 18th Edition, McGraw-Hill), agreed wholeheartedly: “While the 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.”

For the first time, the government and economists had a consistent, quantifiable way to track some of what was happening in the economy. It gave them benchmarks to establish spending and subsidy priorities and then to see whether those policies made the economy, and targeted key parts of it, bigger or smaller. It must have been almost intoxicating to suddenly have numbers that reliably measured such things as factory production, from steel to tires, unemployment and hiring rates, and consumer and government spending on everything from bathrobes to xylophones. The NIPAs were credited by some with helping to pull the country from depression and winning the second world war. They allowed FDR’s war planners to track production of everything from tanks and bullets to K-rations and socks. They could assess productivity and distribution points to see where their defense dollars were going and how to spend them better. The Kuznets NIPA added a level of efficiency and planning to the war effort that was widely viewed as an important component leading to victory.

For the last 75 years, as you might expect, these national income accounts have been tweaked, tinkered with, added to, and polished. And that continues today. As the BEA describes it, “in the past decade, the accounts have been updated by introducing measures of real output and prices that reflect current expenditure patterns; quality-adjusted prices for high-tech goods; and most recently, investment in computer software and a new measure of banking output that recognizes ATMs, electronic funds transfers, and the wide range of other services that banks provide.”

The result: More than 50 national income and product accounts are now reported quarterly and individually and then are smashed together to measure the growth or shrinkage in the GDP by the BEA. Alan Greenspan is all but shunned in many quarters today for his admitted contribution to the collapsed economy, a hands-off, “let ’em eat derivatives” approach to financial regulation when he was Fed chairman. But when Commerce was patting itself on the back for 100 years of great work, Greenspan took the occasion to point out one of the singular strengths of the GDP and its process: political neutrality. “Though these estimates have a profound influence on markets when published and are the basis for federal budget projections and political rhetoric,” he said, “I do not recall a single instance when the integrity of the estimates was called into question by informed observers….It is a testament to the professionalism of the analysts that these judgments are never assumed to be driven by political imperatives.”

Data Gaps

But for all that, the GDP remains today a measure of size rather than quality. It tells us how much we spend on automobiles, for instance, but not whether those cars are more efficient, less polluting, or safer. And as Simon Kuznets explained carefully to the Congress back in ’34, the NIPAs that are combined into the GDP do not even attempt to measure two important parts of the economy.

First, the income and product accounts Kuznets created could not track the value homemakers and caregivers provide. “The volume of services rendered by housewives and other members of the household towards the satisfaction of wants must be imposing indeed,” he wrote in his report to Congress. Second, the accounts can’t track what we call the “underground economy” and what he called “odd jobs.” The vast range of commercial transactions in this country that are done in unaccountable cash, for trade, for barter, or simply donated, escape the reach of GDP numbers. Economists recognize these, among others, as important statistical holes in our national accounting.

Recently, for example, because the economy is increasingly focused on imports and exports, economists and the BEA have grown concerned that the GDP’s inability to measure accurately the value of goods shipped into the country may lead to overstating growth and productivity figures. This is especially important for manufacturing. If U.S. broadband network suppliers substitute a $7 switch made in China for a $75 American-made switch, the GDP does not pick up that difference. It continues to reflect that the American company is building the network with the American part, which because of the way GDP is calculated, overstates both growth and productivity. BEA estimates this could be exaggerating GDP growth by as much as 0.2%. The bureau also says it is working on a fix.

Some of these flaws are technical, but others, such as the value of “services rendered by housewives” and “odd jobs”, exist because trying to measure them accurately is extremely difficult or perhaps even impossible.

That difficulty is compounded when other crucial measures of economic health are included. “The GDP is appropriate as a measure of the size of the economy, but not as a measure of things like standard of living or distribution of income,” says Bill Seyfried, professor of economics at Rollins MBA in Winter Park, Fla. “It is an accurate measurement, but it is only a partial snapshot. Size is only one measure of the health of the economy.”

“GDP is the headline statistic, what we use mainly to describe the progress of the economy, but it is pretty limited,” says Peter L. Rodriguez, associate professor of business administration, associate dean for international affairs and director of the Tayloe Murphy International Center at The University of Virginia’s Darden School of Business.

“Highly Dissatisfying”

“It’s a bit like looking only at sales,” Rodriguez explains. “So we maybe can say, ‘Well, OK, we are no longer in a recession,’ but it’s still highly dissatisfying. It only means that sales have stopped falling. What GDP really represents is the value of all final goods produced in the economy. And that doesn’t tell you who produced it or how it was produced. It is a crude measure, sort of like saying, ‘I can tell you about your overall health just by taking your pulse.’ GDP doesn’t tell us much about the distribution of income, about unemployment or about production from all sources.”

For all these reasons, which Simon Kuznets fully recognized 75 years ago, he cautioned Congress most emphatically: “The welfare of a nation can, therefore, scarcely be inferred from a measurement of national income as defined above.”

Seventy-five years later, economists, politicians and journalists are still usually ignoring him. Last year’s third quarter GDP number was a stark example. This is a nation, after all, where few consumers of economic news get past the headline to the “but consider this” part of the story. So when, after shrinking for four consecutive quarters, the GDP grew by a seasonally adjusted annual rate of 3.5%, later revised to 2.8%, it may have seemed to the casual news consumer that prosperity was at hand. The recession was pronounced over. Economists, with few exceptions, began referring to it in the past tense. Even The Wall Street Journal headlined “Economy Snaps Long Slump”.

Anyone who troubled to read past the headline, or listen past President Obama’s opening remarks to his cautionary ones, would have known that the recession is far from over for many, perhaps most of us, in North America. It was not that the stories and economists failed to qualify their effusiveness. It is that people want to hear good news, and politicians and even economists and journalists want to give it to them. So even as they were noting that the GDP number was unduly inflated by the government stimulus, cash for clunkers and the like, and did not signal a recovery in jobs, household income and other important indicators, most everyone was unaccountably smiling. The public could be forgiven for being a tad confused.

Who Says It’s Over?

“The recession is over, huh? Tell it to my 4,000 colleagues who have been laid off,” said United States Steel Chairman, President and CEO John P. Surma at a Washington, D.C., conference on “Building the New Economy” in October. “We have lost 135,000 members since July of last year,” United Steelworkers International President Leo Gerard told the same conference. “The recession is not over for them.”

Nor for the rest of the nation’s unemployed, partially employed or fully employed who’ve had their hours and pay cut. Nor for the hundreds of thousands of families who are under water on their mortgages. Tellingly as well, once the GDP number was announced and celebrated, commentators, columnists and other bloviators offered a bewildering range of notions about which of the NIPAs within the GDP would be the clearest signals of “real” recovery.

The GDP is a limited snapshot, not a forecast. Its changes are measured. If it shrinks, economic times aren’t robust. If it expands, it means, very generally, that the economy is growing. But if anything, it is a following indicator. It didn’t predict the latest recession, it simply reported that we were in one. It also doesn’t predict the recession is truly over, but after enough quarters of consecutive growth, it can be dissected to tell us that it ended. By then we will have jobs and incomes again and be out buying cars, or whatever.

“When we look at whether or not we are in a recession, we look at lots of things, we don’t just look at GDP,” says Seyfried. “We look at jobs and job creation for instance, and industrial production and disposable income per capita to tell whether a recession has begun or ended. Economists understand its limits.”

“We do know that with 10% unemployment we would need at least two years of strong gains to get back to pre-crisis employment levels,” says Rodriguez. “To really look at the economy, we need to look at the health of business, and earnings per share, perhaps at income growth. One number doesn’t really help that much. We might want to strip out government spending and talk maybe about the private sector’s contribution— especially these days when the government is playing such a huge role. The government is now making the GDP look better than it really is.”

While the strictly economic limitations of the GDP are well acknowledged by those who understand the index, so too are its inability to measure what we generally call the nation’s quality of life, or social welfare. Though even here, someone who really knows better gets a bit effusive. James Tobin, the Nobel laureate and Yale University professor emeritus of economics, for example, once called GDP, “the centerpiece of an elaborate and indispensable system of social accounting.”

What Makes Life Worthwhile

The United States arguably is notorious for fostering the notion that bigger really is better. Forget any political views of the man for instance, and consider how Senator Robert F. Kennedy so eloquently put it when he was campaigning for the Democratic Party’s presidential nomination in 1968:

“Our gross national product…counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for the people who break them. It counts for the destruction of the redwoods and the loss of our natural wonder in chaotic sprawl. It counts napalm and it counts nuclear warheads, and armored cars for the police to fight the riots in our cities.

“Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages…It measures neither our wit nor our courage; neither our wisdom nor our learning; neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile.”

This was a common theme when the Senate Subcommittee on Interstate Commerce, Trade and Tourism held a day of hearings on “Rethinking the GDP as a Measurement of National Strength” as the bottom was falling out of the economy in March 2008.

“The purpose of an economy is to meet human needs in such a way that life becomes in some respect richer and better in the process,” author and activist Jonathan Rowe, co-director of West Marin Commons, a California community enhancement group, told the Senate subcommittee. “It is not simply to produce a lot of stuff. Stuff is a means, not an end.”

And Dr. Robert H. Frank, H.J. Louis professor of management and professor of economics at Cornell’s Johnson Graduate School of Management, explained how the GDP fails to measure human need in terms of income disparity and the effects of the nation’s income gap between rich and poor. “In the three decades following World War II, the relationship between income distribution and welfare was not a big issue, because incomes were growing at about the same rate for all income groups,” he said. “Since the mid-1970s, however, income growth has been confined almost entirely to top earners. Changes in per capita GDP, which track only changes in average income, are completely silent about the effects of this distributional shift.”

“When measuring the economic welfare of the typical family, the natural focus is on median, or 50th percentile, family earnings. Per capita GDP has grown by more than 85% since 1973, while median family earnings have grown by less than one-fifth that amount. Changing patterns of income growth have thus caused per capita GDP growth to vastly overstate the increase in the typical American family’s standard of living during the past three decades.”

Hidden in GDP calculations, as well, are the costs to the environment of producing more, whether it is mining coal, generating electricity or manufacturing chemicals. GDP does not measure the so-called externalities, such as the environmental and health issues caused by some industrial plants. The National Academy of Science reported in October, for example, that burning fossil fuels, from gasoline to fuel oil, costs the country some $120 billion a year just in health expenses from premature deaths from air pollution.

Disease-led Recovery

The GDP does, of course, measure the money spent by individuals and the government on health care. If we spend more, the economy is said to grow. But that also may mean we are growing more unhealthy.

“The aim should be healthy people, not the sale of more medical services and drugs,” Jonathan Rowe told the Senate subcommittee. “Yet today, we assess the economic contribution of the medical system on the basis of treatment rather than results. Economists see nothing wrong with this. They see no problem that the medical system is expected to produce 30-40% of new jobs over the next 30 years.… Next we will be hearing about ‘disease-led recovery.’”

But an increase in health care spending does not necessarily mean we are becoming less healthy. Accounting for health care innovation, and for the benefits of new technologies in general, is another of the more glaring gaps in today’s GDP. “The economy is good at innovating and it is hard for the data to catch up with innovations,” says Dr. Dana Johnson, chief economist at Comerica Bank in Dallas, Texas. “So it is difficult to measure the evolving economy.

“There is an increasing amount of goods and service with more intellectual content in them,” he says. “And it is hard to distinguish through pricing between change in quality and costs of many of these things. For instance, an operation on a knee injury may cost a lot more today than 10 years ago. But the outcomes are much better; less pain, shorter recovery. And it is very hard to capture that in a single number. You can say it costs more, but you don’t capture the improved result.”

Innovation and the Internet

The GDP, in fact, almost pretends that the Internet does not exist, along with the exploding world of producing, researching, sharing, and consuming information and other bytes, from music and videos to games and economic indices. Music CD sales have fallen out of bed, for example; terrible for the music industry. But big smiles from consumers who now buy individual song files for roughly a buck a piece, or get them free on the web. A new music industry is being born, but you will not find it in the GDP.

The BEA in fact, recognizes all of these problems. It is continually studying and trying to improve the basic GDP. It has announced, for instance, that it will include a measure of corporate investment in research and development beginning perhaps in 2013. Measuring the impact of that R&D spending, however, is much harder. At the same time, top BEA officials have said they would be more than happy to develop new NIPAs that attempt to address some or all of these issues, from innovation metrics to the impacts of better health care and education, if it had the funding to do so.

Meanwhile there is no shortage of suggestions either for ways to pull a social component into GDP, or to report measures of those components outside of GDP. The best developed of the latter is the Human Development Index (HDI) issued each year by the United Nations Development Programme. It is a massive undertaking, gathering data from more than 180 countries on six indicies in addition to GDP. It measures GDP per capita, adult literacy, school enrollment, education, and two measures of life expectancy, and then combines them into a single national ranking. The most recent, which uses 2007 numbers, puts the U.S. 13th behind countries such as Norway, Austria, Iceland and Canada, which were the first four in the development rankings.

The U.N. and advocates of this kind of index fully acknowledge the problems with it. Data is old, inaccurate and inconsistent. Countries often do not measure these things in the same way. Consequently, direct comparisons are dicey except in a general sense.

An International Critique

Even so, the most recent and extensive examination of broadening GDP to include other measures praised the HDI as a concept and suggested that each country do a more comprehensive and conscientious job of measuring and gathering data. The Commission on the Measurement of Economic Performance and Social Progress, established last year by French President Nicolas Sarkozy, urged the systematic publication of a broad range of economic indicators from salary and income gaps to environmental and health impact indices. The commission was chaired by Joseph E. Stiglitz, economics professor at Columbia University and a Nobel Prize winner, who said that more comprehensive reporting of this kind may well have given us an early warning signal of the present recession.

“Many commission members believe that one of the reasons why the crisis took many by surprise is that our measurement system failed us and/or market participants and government officials were not focusing on the right set of statistical indicators,” Stiglitz wrote in the report. “In their view, neither the private nor the public accounting systems were able to deliver an early warning, and did not alert us that the seemingly bright growth performance of the world economy between 2004 and 2007 may have been achieved at the expense of future growth.”

Nevertheless, most economists seem happy with maintaining the GDP as it is. Many do agree with Stiglitz and would like to see new and more sophisticated, quality-of-life-type indicators developed more fully and disseminated more widely. But as the Senate subcommittee and others have made clear, most would not want them crammed somehow into the GDP number.

“The GDP measures size and it is good for that,” says Seyfried at Rollins MBA. “I would not want to see them changing that part of it.”