What is GDP, and how are we misusing it?

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People pass the skyline of the central business district in Singapore January 4, 2016.

You shouldn’t judge a country by its GDP.
Gross Domestic Product (GDP), and growth thereof, has been widely used over the years to measure economic progress. But what is GDP, and why does it matter?

Mathematically it is the sum of consumption, investment and government spending (plus exports, minus imports). It is regularly cited in discussions related to the economic health and wellbeing of countries and regions, with some governments such as China going so far as to set specific targets for GDP growth (placed between 6.5 and 7% at the recent National People’s Congress in the new Five Year Plan).

And even without specific targets, the evolution of GDP remains a fixation for governments around the world and is also a regular topic on the agenda of global and regional groupings such as the G20 and the European Union.

What does GDP miss out?

Amid this GDP obsession, it is easy to forget that it was not initially intended for this purpose – it merely provides a measure of the final goods and services produced in an economy over a given period, without any attention to what is produced, how it’s produced or who is producing it.

Simon Kuznets, who defined the modern version of GDP in the 1930s, specifically cautioned against using it as a measure of welfare. Yet its relatively straightforward measurability has led it to be used widely over the decades for precisely that purpose.

Of course, GDP is highly correlated with a lot of the things that we prize in a society: good education, quality infrastructure, functioning markets.

And yet, as has been long recognised, as a concept it is missing critical parts of the puzzle. Indeed over the past decade a number of commissions and research projects have been set up to explore how we would think about measuring welfare “beyond GDP”, led by luminaries and Nobel Prize winners such as Joseph Stiglitz, Michael Spence and Amartya Sen.

The shortcomings of GDP as a measure of welfare have become even more striking in today’s much more complex world of rapidly evolving technologies, demographic shifts, rising income inequalities and the urgent need to reduce pressure on the physical environment.

Three areas provide particularly good examples of why a more nuanced approach to the discussion is needed: the inclusiveness of the economic process, the extent to which economic development respects the natural environment and a need to measure the improvements in living standards ushered in by new technologies, which can help drive greener and more inclusive growth, but which are not captured in traditional statistics.

Three questions that GDP overlooks

Is growth fair?

First, inclusive growth. Recent years have seen a significant rise in inequality across most OECD economies and it remains high in many developing countries.

What are needed are good jobs, education and opportunities for improved living standards more generally. Researchers at the IMF and the OECD, among others, have started to measure the extent to which inequality slows growth through channels such as lower consumption.

At an extreme, economies that are not inclusive risk societal unrest and breakdown, as we saw during the Arab Spring and elsewhere.

In other words, it is not just how much is produced that matters but how the gains are distributed and the extent to which growth translates into broad-based improvements in living standards, touching all citizens rather than the lucky few.

This is true at a particular point in time but also has a temporal aspect related to intergenerational equity. For example, are we building up debts that we will simply leave to future generations? Are we living at the expense of tomorrow?

With public pension systems around the world on the verge of bankruptcy, will retirement even be possible for the average citizen in future decades as funds dry up?

Is growth green?

Another way to ensure that we don’t live at the expense of tomorrow is through responsible environmental stewardship and ensuring that growth is as “green” as possible. It is not just about how much we produce and grow but how we do it and how much pressure this puts on our natural environment.

This is important in areas ranging from energy to agriculture to manufacturing of consumer goods and requires a focus on the how of production and also the life cycle of what we produce.

Efforts towards developing a more “circular economy” where manufacturing pays attention to how inputs will be reused in future production (in a sense “recycling 2.0”) are an important part of this story.

Environmental accounting can play a critical role, making sure that companies pay attention to and are held accountable for their environmental as well as financial impacts. The fundamental question here is – in what state will we leave the planet for ourselves and for future generations?

Is growth improving our lives?

And then there are the new business models that are both adding more value as well as holding the promise of a greener future. Consumers around the world increasingly derive great value from new “sharing economy” business models such as Airbnb and Uber, where we make more use of what already exists rather than simply producing more “stuff”.

It is a question of adding economic and consumer value rather than quantity. And yet the shortcomings of GDP are also clear here since much of this value derived from new technologies is not picked up in GDP and productivity numbers.

Robert Solow famously quipped in 1987 that, “You can see the computer age everywhere but in the productivity statistics.” This has been dubbed the “productivity paradox” and is somewhat analogous to the way that unpaid household work and childcare – clearly critical activities for the functioning of the economy and society – are not taken into account in the GDP statistics. Something is clearly missing and we need to move beyond GDP to get there.

Many developing countries have learned from the experience of advanced economies that simply focusing on GDP growth is not the way forward. Indeed, the considerations outlined above are in some ways even more acute for those countries that are still in the process of raising living standards, and it very much matters how they go about the “catch-up” process.

For example, the African Development Bank, and many of its regional member countries, emphasizes the importance of fostering growth that is both inclusive and green, not merely high.

There is also an understanding in developing economies that it is important to focus on particular sectors in the development process – for example improving productivity in agriculture is widely seen to be of particular importance.

In sum, while instructive in many ways, GDP is a partial, short-term measure, whereas the world needs more wide-ranging and responsible instruments to inform the way we build the economies of the future.

The World Economic Forum is working in each of these areas to foster a better understanding of what is needed to ensure sustainable progress, and our hope is that these efforts will lead to the widespread use of more relevant targets for measuring economic progress.

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