Real gross domestic product (GDP) is the market value of all goods and services produced by a nation within a certain span of time, adjusted for inflation. It includes both the goods and services sold in the marketplace, such as a can of tuna at the grocery or server space leased from a website host, as well as those that are not, such as disaster relief provided by the Red Cross. Because this calculation is for what’s produced, it doesn’t include existing goods (re-sold homes, used cars) or those in transition (empty aluminum cans purchased by Coca-Cola to fill at a bottling facility). Nor does it include the value of stocks or bonds outstanding (although the sales commissions count), which is why the Dow Jones meltdown currently underway has not affected GDP estimates.
The adjustment for inflation is of primary importance. If an economy grew by 2.8% and inflation also rose by 2.8%, then the economy didn’t really grow. The same amount of goods and services were produced as before; only the prices increased. Economist Charles Wheelan calls it the equivalent of exchanging a $10 bill for ten $1 bills; your wallet feels fatter but there’s really no difference.
In the United States, the Bureau of Economic Analysis, a division of the Department of Commerce, keeps an index of inflation adjustments dating back to 1929, giving economists a stable means of comparison for U.S. economic performance across the years.
Nominal GDP has not been adjusted for inflation and is therefore merely raw data, which is why you don’t hear about it all that often.
Measuring GDP
GDP is measured in two ways: the raw figure, and the percent change from the previous time period. The U.S. real, inflation-adjusted GDP for the third quarter of 2008 reached $14,420,500,000,000.00, even if the economy is currently contracting rather than expanding. The sheer size of that number makes working with the raw figures rather cumbersome and also makes people’s eyes glaze over. It’s more easily understood if we simply say the U.S. economy contracted by 0.5% in the third quarter as compared to the second quarter of 2008, when it expanded by 2.8% over the first quarter.
Taking the real GDP figure and dividing it by that nation’s current population gives per capita GDP, another favorite economic scorecard, this one designed to compare economies by their average (not median) incomes and therefore standards of living. For example, Ireland’s 2007 GDP of $191,600,000,000.00, when divided by its population of 4,156,119, equals its per capita GDP of $46,600—higher than the $45,800 of the U.S.
If a nation’s population is growing, then its GDP must grow at least as quickly just to provide jobs for the new arrivals. An economic rule of thumb called Okun’s Law states that, in the U.S., GDP growth of 3% is required to prevent unemployment from rising. For every gain of 1% above that figure, the unemployment rate should fall by 0.5%. Although this pattern isn’t cast in stone, it’s been fairly consistent since the end of World War II, which unfortunately doesn’t bode well for job seekers through at least the end of this year, considering the current and expected fall in GDP worldwide.
Downsides to GDP
On average, GDP makes for a workable scorecard across economic borders; however, it does have its shortcomings. It doesn’t count values that aren’t easily transcribed into monetary figures, such as cultural, environmental, or historical values. An old-growth forest, in GDP terms, is worth no more than one planted for harvest by a forestry company (and it also doesn’t care what sort of owls call it home), while a building remains the total of its construction materials plus labor no matter who slept there.
GDP also doesn’t count work performed in the home unless it requires the purchase of cleaning materials or new siding. Nor does it count raising children as an investment for the future beyond braces and educational materials.
GDP also doesn’t include the “shadow economy,” constructed to avoid paying a tax or to bypass governmental regulations. The classic example is the waiter who doesn’t report his tips as income. Although it’s obviously difficult to calculate such things with any exactitude, a serious study performed by Friedrich Schneider of the Johannes Keppler Institute Linz claims that this shadow economy in the U.S. is approximately 7.9% the size of the official one, or around $1.14 trillion in 2007—larger than the official GDP of Australia.
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Professor Schneider’s Shadow economy
WARNING
Before taking Professor Schneider’s estimates of the Shadow economy too seriously, be aware of an important footnote in a recently published paper in the Journal of Comparative Economics June 2008.
“We have consciously refrained from including MIMIC estimates of the “shadow economy” as presented by Friedrich Schneider and several of his co-authors. Not only is the “shadow economy” poorly defined, but a careful econometric review (Breusch, 2005) demonstrates that “The literature applying this model to the underground economy abounds with alarming Procrustean tendencies.
Various sliding and scaling of the results are carried out in the name of ‘benchmarking’, although these operations are not always clearly documented. The data are typically transformed in ways that are not only undeclared but have the unfortunate effect of making the results of the study sensitive to the units in which the variables are measured. The complexity of the estimation procedure, together with its deficient documentation, leaves the reader unaware of how the results have been stretched or shortened
to fit the bed of prior belief.” He concludes that “the MIMIC model is unfit for the purpose” of estimating the size of the underground economy. Breusch (2006) also reviews a book edited by Bajada and Schneider (2005) and comments on a chapter written by the editors which purports to show the size of the shadow economy in 145 countries. Breusch concludes that “it is impossible to reconstruct these results from the documentation that is provided here or in other Schneider papers on which this chapter
is based. Neither the data nor the model details were forthcoming from Schneider when I asked for them”. The authors of this paper have had similar experiences in various attempts to obtain data and model specifications from Schneider in order to attempt to replicate his results. We therefore concur with Breusch’s (2005) assessment that “There are many other results in circulation for various countries, for which the data cannot be identified and which are given no more documentation than ‘own calculations by MIMIC method.’ Readers are advised to adjust their valuation of these estimates accordingly.”
Cheryl – Congratulations on a clear, concise statement of GDP.
Even though the “shadow economy” may be over or understated in a specific instance, it simply shows that particular expenditures for a country can or cannot be justified in terms of actual purchasing power.
Tracking a nation’s real GDP can provide a true guide to the state of a economy, devoid of particular partisan or philosophic issues.
That is precisely why a national sales tax to replace the onerous and complicated income tax would provide a simpler and more measurable indicator of the ability of a country to afford (or not) its various political choices regarding consumption or spending.
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