GDP Is a Flawed Measure – but It Matters

This is the 26th installment of The Rationalist, my column for the Times of India.

A group of statesmen sat around a table 100 years ago to hammer out an agreement. World War 1 had just ended, and the Treaty of Versailles, signed in June 1919, was meant to make the loser pay for starting the war. Germany would have to disarm, give up territory and pay reparations to the winners. The amount came to 132 billion marks – which would be US$442 billion today.

Germany did not have anywhere close to that kind of money. Their only way out was to print the money. Printing money, of course, leads to inflation. Germany printed so much of it that it led to hyperinflation: a loaf of bread that cost the equivalent of 26 cents in 1919 rose to US$100 billion by the end of 1923. This was not just a tax on the poor, as inflation always is, but a war on the citizens of Germany. Out of the resultant  bitterness and anger rose Nazism, Adolf Hitler and the Second World War: the unintended consequences of a poor treaty and bad economics.

Some people saw it coming. John Maynard Keynes wrote a book called The Economic Consequences of the Peace in 1919, in which he explained why those clauses of the treaty would lead to disaster. He also pointed out one problem that economists of that time faced: they did not have a measure for national income. The concept of the Gross Domestic Product – or GDP as we know it – did not then exist.

There are two points I want to make in telling you this story. One, economics has humanitarian consequences. Two, metrics matter.

The original impetus behind measuring national income was a statist one. The state needed to know how much money it could extract from its subjects, often for the purpose of fighting a war. There had been efforts made to calculate nation income from the 17th century, but this task gathered momentum during the Great Depression of the 1930s. President Franklin Roosevelt planned to revive the economy through increased government spending – but there needed to be a way to measure it first. A group of economists led by Simon Kuznets got to work, and the metric was formalised just as the Second World War approached. Keynes approved, as the title of his 1940 pamphlet indicated: ‘How to Pay for the War.’

The creation of the GDP has been described as “The Manhattan Project of economics,” but its utility extended beyond the war, for reasons beyond economics. It became important in geopolitics, where the optics of the Cold War led the two sides to fight over whose was bigger. (The Soviets used a different measure, and the CIA had a team dedicated to poking holes in it.) Any metric can be gamed, and there were ample geopolitical incentives to game the GDP: a high GDP could get you entry into exclusive groups like G8 and G20, and a low GDP could get you more foreign aid.

As far as domestic politics was concerned, how does one measure the economic performance of a government? The GDP is the obvious measure, which explains why arguing over the GDP has become, as the Greek economist Andreas Georgiou pointed out, “a combat sport.”

There are many things wrong with the measure. Its pioneer, Kuznets, felt that any measure of national income should measure welfare and not just output. He was opposed to government spending being counted in GDP, but was over-ruled by the US administration. That meant that bombs and biscuits are both counted in the GDP, even though one often leads to destruction of wealth. The predatory state can divert money from productive uses in its citizens hands to unproductive ones in its own. Government spending, even if it leads to a net loss for society, will still be counted in the only metric we use, creating an illusion of progress.

Besides this, there is the question of what GDP cannot measure, summed up so well by the Widower Paradox: If a widower marries his domestic help, and thus stops paying her, the nation’s GDP goes down. GDP also cannot measure many of the intangible ways in which our lives are better: I might buy a cheaper mobile phone today than I did 20 years ago, but the value I derive from it is so much more because of technology.

There have been recent efforts to come up with alternatives to GDP, such as the Human Development Index, introduced by the UNDP. The GDP more or less correlates with these. Even if it is not an accurate measure of human welfare, it is a good indicator of it. For that, though, it needs to be measured accurately.

In India, GDP measurement has been shady. Firstly, the informal sector is most of our economy, and measuring this is hard. Secondly, the methodology the government uses is opaque, even arbitrary, and cannot be independently verified. We have to take the government’s word for it – and all governments in a democracy have an incentive to lie. If, despite all this, our GDP growth rate has dipped so much recently, that is a cause for alarm.

Economics has consequences. Bad economics kept millions in our country poor for decades. The liberalisation of 1991, partial and incomplete though it was, showed us the power of GDP growth. Today, we know that every one percent of GDP growth takes over two million people out of poverty. Thus, a falling growth rate is not just an economic problem but a moral failure.

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Also check out:
Demystifying GDP — Episode 130 of The Seen and the Unseen