By Matteo Roscio
“Gross Domestic Product measures everything, except that which makes life worthwhile”; this was the concluding sentence of Robert Kennedy’s speech at the University of Kansas on March 18th, 1968, a statement embodying debates regarding the dominant use of this index to measure and direct wealth and development globally.
Gross Domestic Product (GDP) is the most widespread index used in both economic and statistical analyses. It is defined as a monetary measure of the market value of all final goods and services produced in a defined period in a country. In theory, GDP is a measure of economic production, while in practice it is commonly employed as a comparison tool for development and wealth between countries. It is extremely versatile and is employed in a wide range of sectors; countries are ranked by GDP, development goals are set on the basis of percentage growth in GDP and, most importantly, nations obtain benefits from high GDP growth rates such as credit, aids and investments (Stiglitz et al., 2015). The appeal of this magic number comes from its simplicity; it is rather convenient to have the power to summarize the global status of a country on the basis of a few digits. However, it is very easy to fall into the trap of using GDP as a comprehensive measure of well-being.
The GDP measure has a long and complex history. The first steps to create this type of monetary measure were initiated by the need to quantify the volume of the United States economy after the Great Depression in the 1930s. However, the measure was mainly shaped between 1940 and 1945 under urgent pressure to create a method for calculating the amount of production needed to sustain the war effort and all necessary expenditures. GDP was preceded by GNP (Gross National Product), which was a measure of the production of all the economic activities undertaken by operators (workers, companies and so forth) from the same nation (instead of in the same nation, which is the parameter set by GDP). GNP quickly became a popular estimator of wealth in Western countries, especially the United States and nations under the European Recovery Program. This was, firstly, because it described the growth of such economies that needed to rebuild all of their productive structure relatively well, secondly because it gave a single numeric value that was easy to understand, and lastly because it coincided with the start of the Cold War, which was significant because war expenditures were a pillar in GNP determination (Cousins, 1980).
The early GNP measure was not without its problems. Simon Kutznets, the greatest contributor to the birth of GNP, later argued that his creation was a good measure of military production capacity rather than a measure of wealth. Moreover, he suggested that GNP use should be avoided in developing countries because the presence of strong but unmonetized production would distort the results. Despite these warnings, GNP had a strong influence on global economic policies during the last half of the 20th century (Kutznets, 1951).
Relying solely on one measure like GDP has its risks. It is worth pointing out the numerous issues related to its calculation; the previous, rather simple definition of GDP hides behind it a universe of complex calculations and estimates. The document outlining the indications for the measure is 722 pages long, which speaks for itself about the level of simplification and generalisation that goes into the final result (Lequiller, 2006). There are plenty of political choices about infused into the calculations that deliberately damage many countries. For instance, in 1991, GNP was replaced by GDP with significant macroeconomic implications. With GNP, the output of a multinational corporation that worked in a country was not accounted for in calculations for that country, since a very small fraction of the wealth product would remain there. With the introduction of GDP, that output would be part of the host country’s production. From the accounting side, this arbitrary choice may not seem important, but if we imagine that this country were asking for a loan from the International Monetary Fund (IMF), which requires certain conditions such as economic reforms, the difference can be substantial. In order to improve GDP growth, this country could be pressured into allowing foreign companies to work within its border without any real advantage to the local population, perhaps to the extent of offering easy access at the expense of environmental or local needs (Cobb, 1995).
Another similar problem concerns domestic production. Since GDP can only quantify the monetary, domestic production is omitted. However, domestic production could represent a high percentage of GDP. Domestic production accounts for 30% of GDP in the United States, 40% in Finland, and more than 70% in the poorest countries. Consequently, with greater domestic production, the risk of GDP being underestimated increases. As an example, Spain and Portugal, two countries with poor balance sheets during the recent financial crisis, would see their negative indicator become positive after the introduction of domestic production into the measure. It is clear that the quality or the level of a country’s development does not depend on whether that same good or service is bought on the market or produced for free within households (Coyle, 2014)
Another strong element of distortion comes from the fact that GDP is a gross measure and does not account for depletion. Many countries, especially developing ones, look robust from the GDP side due to the exportation of raw materials. This hides the fact that these same countries are often depleting their natural resources, polluting water sources, and causing deforestation. A net measure would provide a more accurate view on wealth as well as sustainability (Kutznets, 1937).
What is included and excluded from the GDP measure is a political decision, as is the way some variables are calculated. The most relevant example is the method for calculating financial output. According to the definition of GDP, the only price of final goods or services supplied by financial entities are tariffs and commissions that commonly are not even applied since the gain of a financial institution is the difference between the rates of interest practiced. In this way, the contribution of the financial sector to GDP would be very scarce.
Faced with a situation where finance appeared to contribute relatively little to the economy, economists introduced the concept of indirect measurements of the financial sector in 1993. In this intricate calculation, the contribution from banks is directly proportional to the leverage of risk that they assume. Through this method, the estimated percentage of finance is about 8% in a given developed country. As a result of the adoption of this calculation, finance became a key sector in GDP, making it worthwhile for a nation to invest in and improve this sector (Haldane, 2010).
As mentioned previously, military expenses are another pillar of GDP. Some economists argue that the exponential economic growth that characterized the decades after WWII was due to the constant military expenditures required by the Cold War. It seems legitimate to ask whether military costs can denote a growth in wealth. Such expenditures may be seen as necessary, but it is questionable whether anyone benefits from them directly. Some researchers even claim that military expenditures are not absolutely necessary for wealth growth; Costa Rica dismantled its army in 1948, and there is no evidence that citizens’ wealth would have been damaged since then. On the contrary, Costa Rica is one of the only countries in the region that did not suffer from civil wars or political instability (Higgs, 1990).
Overall, the main problem with the GDP measurement is that, as stated by the Nobel laureates Joseph Stiglitz and Amartya Sen, what we measure determines how we act. If our measures are distorted, incorrect, or simply not related with what we consider important, our actions could be inefficient or even dangerous. Using GDP as a target and not as a tool can generate numerous paradoxes (Stiglitz et al., 2015). This raises the question that if GDP is not a robust measure, why, over the years, has it survived all attempts to replace it? From the 1970s, different alternative indexes have been proposed, starting with William Nordhaus and James Tobin’s Measure of Economic Welfare (MEW) and Robert Eisner’s Total Income System of Accounts. Both methods suggested the removal of war costs and negative externalities while adding free time and domestic production into the calculation. In the 1990s, the integration of sustainability into development indexes was introduced, such as in the Genuine Progress Index. In 1990, the Human Development Index (HDI) was created, and it would become the greatest competitor for the GDP measure. The HDI combines economic data with statistics about education and health levels. Despite this, GDP has never been fully replaced due to a variety of factors. Firstly, all the alternative indexes have been extremely correlated with GDP and always maintained its structure without adding anything substantially innovative. Secondly, other attempts to create a more subjective measure failed due to their low versatility. It is difficult, for example, to apply a useful, quantifiable value based on the levels of happiness declared by individuals. In short, roughly half of the new indexes have been too similar to GDP, while the other half have been inefficient (Neumayer, 1999).
Does this mean we are at a dead end? Fortunately not: in 2000, the United Nations set eight Millennium Development Goals which 193 countries have agreed to work towards. In 2015, following the global financial crisis, there was a need for a new way of measuring quality of life, and the development goals were renewed and renamed Sustainable Development Goals (SDG). They were also extended, with a deadline set for 2030. These comprise seventeen main goals, including pursuing peace and equity, fighting poverty and hunger, and improving the environment, and are divided into 169 targets.
The new global strategy is to provide a range of indexes in order to touch various dimensions of well-being. Despite the fact that this solution is less convenient than a single numerical value for cross-country comparisons, it provides the opportunity to impact people’s lives in more tangible ways and to undertake useful policy decisions not only based on economic considerations. The SDG are based on the principle of capabilities, paying particular attention to the weakest and must vulnerable groups, such as the poor and marginalized, and women. Moreover, sustainability is also an integral element of these goals. For the first time in the history of wealth indexes, it seems that we are on the right track, pushing governments to reconsider their measures of evaluation and hoping for a political world that places more importance on the real experiences of people rather than on economic interests.
Matteo is a Master’s student at the University of Bologna. He studies Economic Policy and he is very interested in development economics, economic fairness and human rights.
Cobb C. (1995). “If the GDP Is High Why Is America Down?” Atlantic, 276(4): 6.
Cousins N. (1980). Reflections of America: Commemorating the Statistical Abstract Centennial. Washington DC.
Coyle D. (2014). A Brief but Affectionate History. Princeton: University Press.
Haldane A. (2010). The Contribution of the Financial Sector. London
Higgs R. (1990). Arms, Politics and the Economy: Historical and Contemporary Perspectives. New York: Holmes & Meyer.
Kutznets S. (1937). National Income and Capital Formation. NBER.
Kutznets, S. (1951). Income and Wealth. Cambridge.
Lequiller F. (2006). Understanding National Accounts. Paris.
Neumayer E. (1999). “Not an Index of Sustainable Economic Welfare”, Social Indicator Research, No. 48.
Stiglitz J., Amartya S. and Fitoussi J. (2015). La misura sbagliata delle nostre vite. Parma.