GDP Growth: Why Are We So Obsessed with It?
Economic Growth, GDP, Productivity, Progress
Growth has been one of our main obsessions when thinking about our economy. It has been the headline of many economic publications and discussions, the top priority of government objectives, and the goal of many economic policies. And this is even more true after the COVID-19 pandemic disrupted our economies, resulting in what the International Monetary Fund called the worst economic recession since the Great Depression [2].
So, why are we so obsessed with growth?
In this post, I will tell you all about economic growth.
😋 On the menu:
How is economic growth measured?
What does economic growth capture?
What does economic growth ignore?
KEY TAKEAWAYS
1. How Economic Growth Is Measured?
How Has Economic Growth Become Prevalent Throughout History?
To understand why economic growth has gained considerable weight in economic analysis, political debate, and elsewhere, it is necessary to take a step back in history.
The first thing to know is that rapid and sustained economic growth is a relatively recent experience. Only in the last two centuries has the world experienced significant economic and social change, primarily driven by the industrial revolution. Before, the average person’s income and thus the living standard was pretty constant for centuries.
During the first half of the 1800s, ingenious machines made their first appearance before being used on a large scale. These included the steam engine, the electric loom, and the steam locomotive. This resulted in new jobs that generally offered higher wages and a chance for social mobility. A self-reinforcing cycle thus began: new inventions and investments generated profits, profits provided funds for new investments and inventions, and investments and inventions provided opportunities for new profits.
This has led countries in Europe and North America to shift from centuries of stagnation to a period of rapid growth. They were then joined by other countries such as Japan in the 1960s and 1970s or Latin American countries in the 1960s (Brazil for example), East Asian countries in the 1970s (South Korea, Thailand, and Taiwan), and more recently China and India in the 2000s.
And this spectacular economic growth has led to a striking change in the human condition.
“Most people today are better fed, clothed, and housed than their predecessors two centuries ago. They are healthier, live longer, and are better educated. [...] Although the picture is not one of universal progress, it is the greatest advance in the human condition of the world’s population ever achieved in such a brief span of time.”
— Richard Easterlin, an economist at the University of Southern California, 2000
What Is GDP?
Economic growth is certainly perceptible over a long period of time. But how to precisely evaluate the state of the economy of a whole country? How to estimate its growth from one year to another? How to compare it to another country's economy?
The answer lies in the metric of Gross Domestic Product (GDP) developed by economist Simon Kuznets in 1934 that tracks what the entire economy is producing!
More specifically, GDP measures the value of the final goods and services produced within a country’s borders in a specific time period (without double counting the intermediate goods and services used up to produce them).
It provides a snapshot of the health of an economy and is generally used to estimate its size and growth rate. For instance, Figure 1 shows a strong decrease in the GDP in 2021 This is clearly due to the COVID-19 pandemic which has severely hit the economies around the world. In general, GDP is calculated on an annual basis and sometimes also on a quarterly.
Even a low rate of GDP growth, when sustained and compounded over long periods, can make a huge difference in living standards.
How Is GDP Computed?
There are 3 ways to compute GDP, using expenditures, production, or incomes. Let’s explore them:
The expenditure approach
Also called the spending approach, this approach calculates spending by the different groups that participate in the economy.
GDP = C + G + I + NX
where:
C: consumption
G: government spending
I: investment
NX: Net exports = Exports − Imports
Note that net exports are also called the trade balance. When it is positive, it means that domestic producers are able to sell more to foreign consumers than domestic consumers spend on foreign products. In this case, the country has a trade surplus. If the opposite situation occurs, the country has a trade deficit.
The production approach
Instead of measuring the costs of inputs that contribute to economic activity, this approach estimates the total value of economic output and deducts the cost of intermediate goods that are consumed in the process (such as materials and services).
Since everything that we purchase somebody must first produce, GDP is the same whether measured by what is demanded (expenditure approach) or by what is produced (production approach).
Figure 2 — Breakdown of France's GDP (production approach), 2021, data source: OECD Stat
The income approach
Everything a business produces, when sold, turns into income for the business. Then, firms use the income to pay their bills: wages and salaries for labor, interest, and dividends for capital, rent for land, profit for the entrepreneur, etc.
So, summing up all the income produced in a year is another way of measuring GDP. This is why the terms GDP and national income are sometimes used interchangeably.
What Are the Alternatives to GDP?
Adjustments
A number of adjustments can be made to a country's GDP to improve the meaningfulness of this figure.
Population size:
Comparing China's GDP with Luxembourg's would not make much sense given the difference in population size.
This is why economists generally prefer GDP per capita when comparing the economy of two countries. It is calculated by dividing a country's total GDP by its population. It is also used as a measure of the standard of living of a given country even though it is far from being a precise metric.
Purchasing power parity:
Suppose now that China’s GDP per capita is $1,500, while Luxembourg's is $15,000. Does this mean that the average Luxembourger individual is 10 times better off than the average Chinese person? Absolutely not! It does not take into account the difference in the cost of living in the country.
For this reason, economists generally use real per-capita GDP, adjusted for purchasing power parity (PPP) which measures true income and thus population well-being.
But what is PPP? PPP compares the price of an item, or basket of items, in two countries after adjusting for the exchange rate between the two, in effect. For more information, you can read this article [3].
Inflation:
More generally, it is essential to adjust GDP for inflation in order to distinguish between the increase due to the rise in the general price level and the increase due to the rise in the quantities of goods and services produced. The resulting metric is called real GDP while the former is called nominal GDP.
Variants
Although GDP is widely used, there are alternative ways to measure a country's economic growth.
Gross National Product (GNP) measures the overall production of people or corporations native to a country, including those based abroad. It excludes domestic production by foreigners. It is computed using the production approach.
Gross National Income (GNI) sums up all income earned by citizens or nationals of a country (regardless of whether the underlying economic activity takes place domestically or abroad). It is computed using the income approach.
Note that in the context of a global economy, GNI is better suited than GDP to measure the health of an economy. Some countries, for instance, have most of their income transferred abroad by foreign companies and individuals, resulting in a GDP much higher than their GNI. This is the case of Luxembourg which is very attractive for companies thanks to its favorable tax laws.
BONUS. You can explore the GDP per capita across the world at different periods of time using this interactive map.
2. What Does Economic Growth Capture?
Increased Productivity
To be sustained over the long term, economic growth needs to be driven by an increase in worker productivity, namely the value that each employed person creates per unit of his time. If labor productivity increases, incomes increase. This leads consumers to spend more, resulting in an improvement in the material quality of life or standard of living.
What determines how productive workers are? There are 3 main factors: human capital, physical capital, and technology.
To put it simply, if the quantity or quality of the working-age population increases, if the tools they work with improve, and if the process they follow is enhanced, economic output is likely to increase.
Let's explore the role each component plays in economic growth:
Human capital
It refers to the accumulated knowledge (from education and experience), skills, and expertise of the average worker in an economy possesses.
Increased productivity can therefore be achieved when workers become more competent in their profession and gain experience through training, trial and error, or simply more practice.
Physical capital
It refers to the physical assets that a company uses in the production process to manufacture products and services that consumers will later use. These include buildings, machinery, equipment, vehicles, tools, and infrastructure.
Technology change
It consists of a combination of invention, i.e. advances in knowledge, and innovation. The latter puts those advances to use in a new product or service.
These three factors work together. Workers with higher education and skill levels are often better at coming up with new technological innovations. These technological innovations are often ideas that cannot increase production until they are part of new investment in physical capital. The new machines often require additional training, which further reinforces the skills of workers.
A Healthy Economic Climate
The impact of physical and human capital deepening and better technology is limited without a healthy economic climate.
Two factors contribute strongly to the creation and maintenance of this favorable economic climate:
A robust legal system that governs and sustains property rights and contractual rights.
A market-based system that provides personal and business rewards and incentives for increasing human and physical capital which are the key ingredients of economic growth.
The rapid growth of the late 19th century has largely come from harnessing the power of competitive markets to allocate resources.
However, markets sometimes fail to allocate capital or technology in a manner that provides the greatest benefit for society as a whole. The role of the government is to correct these failures. Here are some of the main areas where government policies are essential:
Education. Providing free and compulsory education for all children for instance.
Taxes. Maintaining low capital gains taxes tends to encourage investment and thus economic growth.
Infrastructure. Ensuring good public infrastructure tends to encourage companies to develop their activities in the country.
Scientific research. Investing in scientific research is essential to ensure technological change. The government can also guarantee a legal environment that protects the ability of inventors to profit from their inventions.
3. What Does Economic Growth Ignore?
If GDP is a great indicator that captures the overall size of an economy and helps track a nation’s evolution, it has been the subject of several criticisms. Understanding its limitations is all the more important as it has increasingly been used as an absolute indicator of a nation's failure or success.
Here are the main criticisms of the GDP:
1. It ignores the value of informal or unrecorded economic activity. As GDP uses recorded transactions and official data, it fails to account for:
Underground economy (or black market): under-the-table employment, trade of illegal goods and services, etc.
Non-market production, i.e. goods and services that are produced for private consumption: for example, some people grow their own food or manufacture their own electricity.
Unremunerated volunteer work
2. It excludes the environmental impact of economic activities. GDP does not take into account the extent to which production harms the environmental health of the country through pollution or deforestation, for example.
3. GDP per capita is a rough estimate of the population's well-being. It fails to account for the distribution of income. It can even be confusing as it focuses on material outputs and ignores other key constituent factors of public welfare such as health, happiness, (in)equality.
In this context, the country of Bhutan came up with a new metric in the 1960s: Gross National Happiness (GNH). This index was used by the country to measure the collective happiness and well-being of a population and guide its decisions and policies. For more information, watch this video. You can find more information on how the GNH is calculated here [4].
KEY TAKEAWAYS
✔️ Economic growth is tracked through Gross Domestic Product (GDP) which measures the value of the final goods and services produced within a country.
✔️ In recent decades, it has been increasingly used as an indicator of a country's development, and this is for multiple reasons:
Historically, the industrial revolution of the first half of the 1800s has led to spectacular economic growth that greatly improved the average standard of living of the population. Today, high-income countries are concerned about whether economic growth will continue to bring the same remarkable gains in living standards.
GDP growth is associated with increased labor productivity which, in turn, reflects a better educated and skilled population, greater capital equipment, and technological changes due to inventions and innovation. Thus, developing countries use GDP to measure the speed at which they are catching up with developed countries.
✔️ GDP is useful in capturing the overall production and indicating when a country is materially better or worse off. However, it has some limitations and provides only a rough estimate of living standards.
✔️ Our obsession with economic growth is dangerous. It prevents us from considering other important indicators of a nation's development such as health, happiness, (in)equality, and environment.
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Cheers,
Lina
References
[1] T. Taylor, S. A. Greenlaw, D. Shapiro, Principles of Macroeconomics 2e, 2011
[2] BBC News, Coronavirus: Worst economic crisis since 1930s depression, IMF says, Avril 2020
[3] Investopedia, What Is Purchasing Power Parity (PPP), March 2022
[4] Investopedia, Gross Domestic Product (GDP), January 2022