The big economic news reported by the media yesterday was that the gross domestic product (GDP) for the U.S. only increased at a 2.6% year-over-year rate in the second quarter, rather than the previously predicted 2.9%. The media always makes a big hullabaloo whenever quarterly GDP numbers are released, but the bigger question is, do these economic numbers matter?
Yesterday, fellow Fool Dan Caplinger did a nice job explaining what GDP is composed of and how it is used to measure economic activity. But today I'd like to expand on his explanation of GDP and argue that the big fuss over quarterly GDP numbers is much ado about nothing.
Why do economists calculate GDP?
The main goal of most macroeconomists is to ensure that people are as well-off and happy as possible (economists call this "utility"). Unfortunately, since happiness and other emotional traits are numerically impossible to gauge, we economists have to use the closest computable substitute we can for these positive feelings. To that end, economists brilliantly came up with the idea of using the level of goods and services being produced and consumed in an economy as the most accurate monetary way to calculate happiness.
The failings of GDP
As Dan pointed out so well, GDP is the easiest way to calculate the real value of all goods and services in an economy -- which, as I've just mentioned, is simply a proxy for how well-off a country's citizenry is. Unfortunately, GDP fails in many ways to capture many of the variables besides physical goods that are involved in a person's level of utility. Things like political freedom, environmental quality, health, and quality of life, for example, are all major components of anyone's utility, but since they cannot be quantified numerically, economists usually don't bother trying to estimate them.
Even accepting that GDP can't fully capture changes in the utility of individuals, there are problems with using it as a proxy for the economic well-being of a society. As the constant revising of quarterly numbers shows us, this statistic is at best an imprecise measure of all the activity that goes on in an economy. Furthermore, many types of economic activity, such as drug dealing or household production (i.e., cleaning one's house or making a dinner at home), do have real economic impacts on a society, but measuring these values is very difficult. Who would have known that drug dealers don't like to report their sales to economists?
Also, GDP is calculated using what is called a GDP deflator, which takes prices and inflation into account. For a variety of reasons, many economists believe that inflation is inaccurately calculated, which would mean GDP must be inaccurately calculated as well.
Is GDP even the best way to calculate economic well-being?
Even if we have to accept that it is a valid measure of the well-being of a country, GDP is not what the media should be reporting. Instead, the focus should be on the economic statistic called GDP per person.
To calculate GDP per person, you simply take GDP and divide it by the population of a country. Using GDP per person is a much better way of determining the health of an economy, because it tells us the average income of everyone in that economy.
The best way to understand why this is a better measure of economic health than GDP is with an example: Suppose GDP growth is stagnant for several years, yet during this time the population is declining until it is half its original size. If someone reading the newspaper every quarter saw only the stagnant overall GDP numbers, they might conclude that the economy was stuck in a rut. A more savvy reader, though, would see that even with GDP not growing, the fact that the population had declined by half would mean GDP per person had doubled over that period! I don't know about you, but if my income doubled over several years, I'd consider myself much better off even if the overall economy was not growing.
Why, then, does the media care so much about overall GDP numbers?
Overall GDP numbers do matter a lot to one group: corporations. Obviously, shares of most companies go up when their sales and profits increase. Many corporations like Wal-Mart (NYSE:WMT), General Mills, or Best Buy (NYSE:BBY) are so large that they cannot expand any further and depend on growth in the economy as a way to increase sales.
Companies like the above, which primarily sell commodity goods, can only grow sales via an expanding economy because they don't produce unique and differentiated products like Apple's (NASDAQ:AAPL) iPod or Medtronic's (NYSE:MDT) ingenious diabetes pumps. So for them, GDP is a very telling statistic about their future prospects.
This connection between overall GDP and the financial fortunes of these stock-market behemoths is primarily what gives this economic statistic its stature.
Final thoughts
Most macroeconomists care more about the long-term health of the economy than the short-term fluctuations of the GDP. There are a variety of variables like the state of education, population growth, debt levels, and savings that are more important than GDP growth rates in determining the success of an economy in the long run. Because of all this, and because GDP is such an inaccurate measure of individual economic well-being, it is too bad that such attention is focused on these quarterly numbers.
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Fool contributor Brian Lawler wouldn't mind if his employer doubled his GDP per person. He does not own shares of any company mentioned in this article. The Fool has a disclosure policy .
