Sometimes a self-appointed economist gets it so wrong that their statement fails the laugh-out-loud test. Today’s subject is the fascinating world of national income accounting and the most recent NPR fail. Along the way we’ll learn how gross domestic product is measured. Even if you’re a real economist, I suspect you can learn a thing or two from this.
Why is this important? Because gross domestic product is equal to national income.[1] When GDP rises, so does national income. Even if you don’t think GDP is important, I’m pretty sure national income matters to you.
Writer Dave Barry once famously said, “gross domestic product would be an excellent name for a band.” While that may be true, we’re going in a different direction today.
Background: NPR Strikes Again
Today’s egregious error is from Public Radio International’s The World. The segment was titled “How Should We Judge Our Economy.” And the guest clown pseudo-economist was “Eric Zencey, a political economist with the Gund Institute for Ecological Economics at the University of Vermont.” Forthwith, Mr. Zencey’s argument (lifted straight from the PRI page for this story).
“I think GDP should re-named, so that we don’t mistake it for a measure of well-being. I think we should call it gross domestic transactions,” said Zencey. “That’s all it is, it totes up the monetary value of all the transactions. And if it had that name that would help break the association people have with the idea that more GDP is better. It’s like hmmm, more transactions are better? Well it depends on what you’re transacting.” [All quotation marks and other punctuation unchanged from original story.]
The easy criticism is that, even if GDP equaled spending, it would not equal the total volume of transactions in the economy. For starters, GDP excludes transactions involving assets. If you buy or sell shares in a mutual fund, that is not included in GDP. Also excluded are transactions involving previously-owned items. That antique pepper mill you bought at a garage sale? Not in GDP. That car you bought from a soon-to-be-ex-friend? Also not included. So the total volume of transactions in any economy would be a huge multiple of GDP.
The more subtle issue is a complete misunderstanding of what GDP measures. Most principles of economics texts get this pretty much: gross domestic product is the market value of all goods and services produced in a country during a calendar year. Read that again and see if you can find the words “spending” or “transactions.” You can’t because GDP measures neither of those. GDP measures production, not spending.
“Wait,” says the knowledgeable reader. “In macroeconomics I learned that GDP was the sum of consumption spending, investment spending, and government spending. Why isn’t GDP the same as total spending? What about C + I + G?”
Read on. The answer is far simpler than you can imagine.
GDP and Spending
Think carefully about what you learned in that economics course. In the definition of GDP wasn’t there something about exports and imports? And if you memory is better than mine, you may recall something about the net change in business inventories being part of gross private domestic investment (“investment spending”). Each of these three items is important in its own way. Let’s begin with a basic fact: C + I + G measures total domestic spending on newly-produced goods and services. Asset transactions and purchases of previously-owned goods are still excluded.[2]
GDP, Domestic Spending, and Domestic Production
Let’s first discuss a country that operates in complete autarky. This lovely word autarky describes a country that does not interact economically with the rest of the world.[3] In such a country, total domestic spending on domestically produced goods is, in fact, total spending.[4] What happens if there is a difference between spending and production in such an economy?
This is actually pretty simple. John Maynard Keynes discussed it at length in his General Theory of Employment, Interest, and Money. When spending is less than production, business inventories rise. The unsold goods flow into inventories. And when spending is greater than production, business inventories fall. The only way businesses can sell goods they have not produced is to draw them from inventory.
A simple example may help. Consider a company that makes ordinary wooden pencils. They try to produce to meet demand. When thinking about how many pencils to produce in July (for example), they consult their economist who assures them that there will be demand for 5 million pencils in July. The company produces 5 million pencils in July. But the forecast was incorrect. Only 4.8 million pencils were actually sold. What happens to the remaining 200,000 pencils? They end up in inventory for the beginning of August.
Note the relationship here: output – sales = inventory change. We can rewrite this simply as output = sales + inventory change.
But wait – we’re trying to measure output (GDP). We start by adding up total spending: consumption plus government plus business fixed investment. We then correct for any output that was not sold by adding the net change in business inventories. Adding inventory change converts total spending into total output.
That was pretty easy. Believe it or not, the next section is even easier.
GDP, Domestic Spending, and Domestic Production in an Open Economy
Now let’s open our economy to international trade. Our GDP equation now becomes C + I + G + (X − M). Exports are X, imports are M. Together, X − M is called net exports.
If you read several principles textbooks you will find many convoluted explanations of why exports are added and imports are subtracted. That’s unfortunate because the explanation is very easy. Exports are goods and services produced in our country and sold elsewhere. We add exports to domestic spending because those goods and services are not included in domestic spending but they are included in domestic production. Workers producing those exports earn income even though the products they are producing are not sold within the country where they are produced.
What about imports? Goods and services that are produced in other countries but sold in our country fall into this category. Therefore, those goods and services are part of domestic spending. But they are not part of domestic production. Imports are subtracted to correct domestic spending into domestic production.
Consider a couple of examples. Suppose you buy a new BMW for $50,000. The car was produced in Germany. But it’s sold here, which means domestic spending rises by $50,000. But domestic production has not changed. We need to subtract that $50,000 from domestic spending to move the total in the direction of domestic production.
Similarly, consider German tourists visiting the U.S. They are buying tourism services from the U.S. which count as exports. The services are produced here but sold (in effect) in another country. Therefore we must add the value of those exported services to total spending to move the total in the direction of domestic production.
Conclusion
So here’s the story. We begin with domestic spending (roughly C + I + G ignoring the fact that inventory change is included in I). We then add the net change in business inventories to this total to correct for any difference between domestic spending on domestically produced goods and domestically produced goods sold within the country. Next we add exports, products that are produced here but sold in other countries. Finally we subtract imports, products that are produced in other countries but sold here. Remember, the central idea is to convert domestic spending into domestic production.
At its most basic, this stuff is not difficult. It’s always been a mystery to me why economists insist on making it difficult. I hope this explanation has been helpful. Please feel free to ask questions in the comments.
[1] Please don’t quibble. I know there are differences between GDP and national income. This is a blog, not the American Economic Review.
[2] No one has yet figured out how to sell previously-owned services, so we don’t have to worry about that.
[3] From the ancient Greek autarkeia: self-sufficiency, or nonattachment. See this page from Britannica online for more details.
[4] Consistent with national income accounting assumptions, I continue to exclude spending on assets and previously-owned goods.
