What does GDP measure?

Is gross domestic product a good indicator of the size of the economy? Does it measure growth? What are its shortcomings?

Gross domestic product (GDP) is perhaps the most widely used macroeconomic indicator today. It is generally accepted that GDP measures the well-being of an economy and that the higher its value (in real terms), the richer we are. This makes the indicator a target for politicians, many of whom try to do everything (often without realizing the cost of their actions) to increase it so that they can proudly claim that their policies are driving the economy forward. But does GDP accurately measure the well-being of a country?

How is GDP measured?

Let's recall the familiar GDP equation, studied in the first macroeconomics classes and known as GDP by the expenditure method:

Y = C + G + I + NX

Where,

Y = GDP

C = Household consumption

G = Government Consumption

I = Investments

NX = Net exports, i.e. exports – imports

According to this equation, GDP increases if one of its components increases. The problem with the accuracy of GDP as a measure of well-being lies in the letter “G”. There is no direct relationship between how much a country spends on goods and services and the well-being of the people living within its borders. On the contrary, there are many studies that show that the large size of the state stifles the economy through higher taxes, heavier administration, higher corruption, and so on. Large government spending can only be associated with the degree of “sociality” of a country, because every lev spent by the government is seized or is expected to be seized in the future by another economic unit. That is, if we accept the statement that most government spending increases our well-being as true, this implicitly means that we assume that the state spends money more efficiently than the private sector. Returning to our example of measuring GDP, it becomes clear where the main drawback of this indicator lies. A government can increase GDP by spending more, which in most cases will lead to people becoming poorer in the long run. Austrian economist Frank Szostak gives a good summary of GDP as a macroeconomic indicator. According to Szostak, the way GDP is measured cannot tell us whether, over the period under consideration, the goods and services produced in an economy are the result of an increase in wealth or are simply the consumption of capital. For example, if a government decides to invest all its resources in building a pyramid (in both the figurative and literal sense of the word), then GDP will increase due to the growth of government spending. In reality, however, this massive project will divert real savings in the economy from activities that generate wealth, i.e. the government will “crowding out” all private initiatives, and in the end this pyramid will do nothing to improve the lifestyle of the country’s residents.

In response to this shortcoming, some economists have proposed that the government expenditure component be removed from the calculation of GDP, but this only partially solves the problem because all government transfers are recorded as household consumption, i.e. they enter the letter “C” in the GDP equation. The reason for this lies in the expenditure method of recording GDP, which seeks to record the expenditures made by economic units for final consumption. That is, transfers such as social transfers, state pensions, unemployment benefits, etc. are recorded as consumption by private individuals at the time they are received by the respective beneficiaries. This further distorts the accuracy of GDP as an indicator of well-being, especially in more socially oriented economies.

There are many other shortcomings of GDP as an indicator of economic well-being. GDP is often underestimated because it does not include the shadow economy, non-market transactions (for example, an individual cleaning his apartment or growing tomatoes for personal consumption), barter transactions, etc. From this it can be concluded that GDP is relatively more underestimated for countries like Bulgaria, compared to countries in Scandinavia, for example. In addition, GDP does not distinguish between sustainable and unsustainable growth, the latter of which may be the result of a large accumulation of debt, as is the case in many countries in the Western world at the moment.

What GDP certainly tells us is the structure of an economy – how much of it is export-led, how much is household consumption-led, etc. The problem is not that this indicator does not accurately reflect the state of the economy (everyone is free to choose whether to believe a statistic or not), but rather that it is used by politicians to make decisions. There is an incentive for governments to increase public spending when GDP is expected to decline, and this will inevitably lead to more redistribution, higher taxes, less economic freedom, and more power in the hands of politicians – all things we must avoid if we want to achieve long-term prosperity.

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