GDP is often used to measure an economy’s level of well-being from one time period to another, and to compare one economy’s welfare to another. A proper perspective must be brought to such uses of the GDP measure. Some examples follow.
1. Some things are produced but never sold and so are not included in GDP. A classic example is the work of homemakers, an omission from GDP that has angered women’s rights activists. Another classic example is the case of a lawyer marrying her gardener. Suddenly she does not pay for gardening done on her property, and so this service is no longer counted in GDP. Comparisons between countries with different portions of their economy appearing on formal markets are suspect for this reason. National accounts statisticians impute to homeowners rent implicitly paid to themselves (and include this rent as expenditure on housing), impute to farmers income in the form of home consumption of crops, and impute a value for in-kind wages such as room and board, but clearly many nonmarket activities are missed.
2. Some expenditures are hidden from data gatherers—illegal activities such as selling drugs and prostitution, and underground economic activity such as services provided for unrecorded (and so untaxable) cash transactions. An electrician wiring a plumber’s home in return for which the plumber plumbs the electrician’s home does not find its way into the GDP measure. Some people feel that illegal activities provide considerable benefit to society (as evidenced by the fact that so many people are so eager to participate in them), so that their exclusion causes GDP to understate the benefit society derives from annual economic activity. The size of the U.S. underground economy is thought to be in the order of 15% of its GDP.
3. Some items are included in GDP that do not reflect net benefits to society. The Exxon Valdez oil spill required over $2 billion of cleanup expenditure to bring us back to the pre-spill state. This expenditure is added into GDP, with no offsetting reduction of GDP to reflect the pollution cost to society. A crime-ridden country spends a lot more on police protection, all added into GDP, to obtain the same state of security as that enjoyed by a more law-abiding country.
4. Government expenditure on goods and services is valued at cost, despite the fact that the benefit produced by this expenditure could be valued quite differently by the market forces used to value other components of GDP. On the one hand, if entry fees were charged to the Smithsonian museums, for example, the output thereby measured would probably exceed the museums’ cost. On the other hand, everybody has a favorite example of what he or she considers to be wasteful government spending.
5. GDP does not account for nonrenewable natural resources used up in production processes. In Kuwait, for example, because so much of GDP takes the form of oil exports, the GDP measure is misleading as an indicator of the economy’s sustainable output level.
6. Cross-country comparisons are rendered difficult by several factors: some countries spend a lot on housing to deal with a harsh climate; leisure-loving societies do not have their leisure valued; exchange rates used to express GDP figures in common currencies do not accurately reflect cost-of-living differences; and differences in income distributions are ignored.
Despite these problems in using GDP to measure an economy’s welfare and to compare it to other economies, most economists are comfortable using GDP figures for comparisons over time, such as measuring an economy’s growth rate. So long as the size of the underground economy is stable, there are no dramatic changes in crime and pollution, and the fraction of an economy’s economic activity that appears on markets is relatively constant, growth measures should paint an adequate picture of economic progress.
But economic growth is not the only way of measuring progress, and many believe that the high profile of GDP has served to divert attention from other forms of human progress. One respected alternative measure is the human development index, developed in 1990 by the United Nations Development Programme. It is an index calculated as an equally weighted average of relative performances on measures of life expectancy, educational attainment, and income. Canada and the United States are the top countries by this measure.
Just as a company would be unwise to chart its course by looking at its cash flow without looking at its balance sheet, so would a country be unwise to focus on GDP without looking at its its worth. The World Bank has ranked countries by per capita wealth, calculated by estimating the value of each country’s natural resources, machinery, buildings and other man-made capital, and human resources. By this measure the wealthiest countries are those with few people and lots of oil, like the United Arab Emirates, and countries with few natural resources but substantial human ingenuity, such as Switzerland. Resource-rich Australia and Canada top this ranking; the United States is twelfth, just behind Norway.
One of the most prominent ways in which GDP changes can be misleading is if the effects of overall price changes on this measure are not taken into account. Doing so produces the important distinction between real and nominal GDP.