The Fallacies of GDP

Many people see Gross Domestic Product (GDP) as an accurate measure of the health of an economy, when in reality it’s not. While it might seem to correlate with metrics of well-being, there are certain things it gets pretty wrong, even to the point that it can be entirely misleading. For readers who are unaware of what the GDP is, it’s the sum of all spending on final goods in an economy¹. This spending is usually divided into three categories: consumption spending, investment spending, and government spending. Because it’s supposed to be a measure of domestic production, the prices of goods produced domestically that get exported are added to the GDP while the prices of goods produced internationally that get imported are subtracted from GDP².

In this section, we’ll go over a few major problems that can make GDP very unreliable. Understanding these drawbacks and looking at the disaggregated data can therefore lead to a more accurate understanding of the health of an economy.

The most glaringly obvious problem with trying to measure how socially beneficial the economy is is that in any voluntary transaction, there is a double inequality of wants, but the psychic profits themselves are never actually quantified. We can know that someone who exchanges $7 for a dozen pasture-raised eggs values the eggs more than he values his $7, but we can’t know by how much. If he only valued the eggs at $7.01, then after the transaction, he is only a single penny better off than he was before; in contrast, if for whatever reason he would have been willing to pay $107 for the carton of eggs, then he is $100 better off than he was before³. If we were trying to construct some kind of measure of how much better off people are as a result of this transaction, it doesn’t really make sense to just mark down $7 and then stop thinking. The man who buys the eggs is better off by the difference in utility he perceives between the eggs and the dollars, but this is information that no one has access to and very well might not even be rigorously quantifiable. As our examples show, he might benefit by an amount much less than $7 or by an amount much more than $7 and there would be no way to know. His experiences are subjective, and there’s no way to measure them except by observing his actions. All we can say is we know he was willing to pay at least $7 for the dozen eggs. So while GDP might be a measure of something, and while it might seem to correlate with qualitative standards of living over certain time periods or over certain geographic regions, we have to keep in mind this crucial deficiency. GDP is not the end-all and be-all of prosperity. It’s just a measure of spending.

The reader might think, “Well GDP is supposed to be a metric of production, not a metric of well-being.” Sure, in that case maybe it makes sense to simply write down $7 and call it a day. We can do that—but as soon as we do, we have to admit that we’re no longer concerned about a metric of well-being, but a metric of production, which isn’t the same thing.

But even if we choose to look past this more obvious inadequacy of GDP, there is still another critique that is much more relevant to many topics in economics: GDP gives equal weight to the voluntary spending of private individuals (which is almost necessarily beneficial, at least according to those individuals, unless they were defrauded or had wrong expectations) and also to government spending (which is not necessarily socially beneficial, and very frequently even detrimental).

Voluntary spending is known to be socially beneficial precisely because it’s voluntary; both parties to a voluntary transaction are better off and no one else is worse off. If this weren’t the case, they wouldn’t engage in the voluntary trade. It’s consentual. All parties are respected. The case of government spending is different though, since it involves theft and coërcion. When the government steals from Alice, whether directly through taxation or indirectly through inflation, and spends that money to Bob, it is not certain that the benefit to Bob outweighs the harm done to Alice^{4, 5}. Therefore it is not the case that government spending is necessarily socially beneficial in the same way that private spending is. So yes, government spending can make certain people better off, but by making others almost certainly worse off. It therefore doesn’t make any sense to give the same weight to voluntary spending and government spending.

Just to give a more concrete example, let’s say that Bob is an industrialist who greased the palms of the politicians so that government controlled water supplies will be buying Bob’s toxic industrial waste and dumping it into the drinking water. This is something that has actually been happening in North America since the mid-twentieth century⁶. If Alice doesn’t want the industrial waste added to her water, then too bad for her: The government just extorts her money anyway to buy up Bob’s industrial waste, poisoning her drinking water and enriching Bob. Even though Alice has only been made worse off by being violently coërced into paying for poisoned water, this government spending nevertheless still counts positively towards the GDP. So it’s obvious that government spending isn’t necessarily socially beneficial, and can even be extremely harmful. And this insight applies to all corruption: Every single time the government spends money to benefit special interest groups at the expense of the society as a whole, the spending counts toward GDP even though everyone save a few have been impoverished.

Another point can be made against something called “real GDP.” This term, “real GDP” refers to price-inflation-adjusted GDP. This is supposed to take into account when the GDP goes up only because the cost of living went up. For example, if a dozen pasture-raised eggs costs $7 one year and $9 the next, neither production nor general well-being could be said to have increased; it’s just that the same carton of eggs is more expensive, and so it would count more towards GDP. If GDP is supposed to be a measure of economic well-being, it obviously wouldn’t make sense to cheer on increases in GDP that are only actually the result of a general increase in prices and not the result of real increases in productivity. Therefore if the cost of living increases by, for example, 3 percent, but the GDP increases by 5 percent, then the “real” growth in GDP would only be 2 percent, since 3 out of the 5 percentage points would just be due to the general increase in prices.

To the extent that we entertain that GDP is a measure of productivity, and to the extent that we entertain that price-inflation can be measured in a non-arbitrary way by measuring the changes in prices for some generic “basket” of goods, this all makes sense. But if we admit that price-inflation isn’t necessarily accurately measured, then that’s a big problem because “real GDP” has an extreme sensitivity to the rate of price-inflation. In particular, if price inflation is understated, then the growth of “real GDP” will be overstated.

Let’s go back to our previous example, where the GDP growth was listed at 5 percent and the government figure for price-inflation was listed at 3 percent, and let’s just say that the actual price-inflation is 6 percent. Instead of the economy growing by 2 percent (i.e., 5 percent minus 3 percent), it will have actually shrunk by 1 percent (i.e. –1 percent growth, which is 5 percent minus 6 percent). So “real GDP” is extremely sensitive to the rate of price-inflation, and a misstatement of the price-flation could even result in the appearance of growth where there’s actually contraction. In other words, even if the economy is in a recession⁷, the “real GDP” could be growing due to a misstatement of price-inflation. If price-inflation is understated by even one or two percent, then GDP growth will be overstated by one or two percent.

The reader might be wondering why the government would want to manipulate their price-inflation data, but, in fact, there are motives. Most obviously, as already explained, this would result in larger “real GDP” figures, as already reasoned. In our previous example, by stating a price-inflation rate of 3 percent instead of 6 percent, it gave the illusion of growth where there was actually contraction. This can be used to gaslight the public when the economy isn’t great: If real people are struggling because the economy is in a recession, the talking heads can just say, “You fools just don’t understand how good this economy is! Real GDP grew by X percent this quarter!” Moreover, to everyone except for economists, it’s not a good thing that prices perpetually increase, and so high-price inflation can lead to political unrest. Therefore when people are complaining about how fast prices have doubled, the people on the “news” can just say something like, “Well prices obviously haven’t doubled because inflation is only 9 percent.” The policians never want the economy to look bad when they’re in charge, and so by having the bureaucrats under report price-inflation, the politicians can preside over an economy that’s fictionally fantastic, or at least not as bad. This goes for politicians of all political parties.

But it’s not just price-inflation-adjusted GDP and price-inflation itself that end up looking better; price-inflation-adjusted returns on stocks and bonds will also be inaccurate, and for the exact same reason. Bonds are particularly important for government finance, since so many of the bonds people buy these days are issued by the government. But when people buy bonds, they want a real return. So, to use the same numbers as before, if the people expect price-inflation to be 3 percent, then they probably won’t be very happy about buying a bond with less than a 3 percent yield. Maybe they’d like a bond to have a 5 percent yield instead, which would result in a 2 percent real yield. But if the real price-inflation is 6 percent, then a 5 percent bond yield actually results in a 1 percent decrease in purchasing power. It could still be argued though that buying a bond with a –1 percent real yield is still preferable to just holding cash whose purchasing power is depreciating at a rate of 6 percent per year. The fact remains that, if inflation had been accurately reported at 6 percent, then maybe people wouldn’t be willing to buy bonds with only a 5 percent yield, so it’s still kind of scammy. The higher people believe price-inflation to be, the higher yields they’ll demand when paying for bonds. Therefore, by understating price-inflation, governments can trick people into over-paying for bonds, and that allows the govermental interests to pay out less in interest on the government debt. The issuing of government debt therefore becomes a skimming operation.

On top of inaccurate price-inflation figures being able to make recessions disappear and allow the government to lower the interest cost of its debt, another reason to misstate price-inflation is because some government programs have to make payments that are tied to the cost of living. For example, in the US, the government retirement scheme known as Social Security makes payments to the elderly and the disabled, and those payments increase each year with increases in the government’s consumer price index. So if the cost of living actually went up by 6 percent from one year to the next, but if the government asserts that the cost of living only went up by 3 percent, then they were effectively able to reduce the real Social Security benefits paid out by 3 percent. The government can get away with reducing its obligations to the elderly and the disabled just by saying price-inflation is lower than it really is. This is the secret Social Security cut that few people know about.

The point is that there are three big problems with using GDP as a measure of economic well-being. First of all, the psychological well-being that every person derives from his transactions can’t be measured, and just recording the total amount of money that changes hands isn’t obviously a measure of each person’s psychological profits. Therefore this isn’t a measure of how good the people are generally feeling. Second of all, there’s the fact that government spending is counted the same as voluntary spending, even though it’s fundamentally different from voluntary spending, and even though it can often lead to people being coërced to pay for things they don’t actually want, or even things that are harmful for them. Third of all, “real GDP” is supposed to be price-inflation-adjusted, but it’s extremely sensitive to the reported price-inflation, and by reporting price-inflation as lower than it really is (and there are incentives to understate it), the political class can pretend that the economy is doing fine, even when it’s not.

In the appendix of his book America’s Great Depression, Rothbard suggested two alternatives to GDP that would much better represent people’s standards of living because of the difference between voluntary and government spending⁸. The first of which is the Gross Private Product (GPP), which only tallies up voluntary spending on final goods on the part of private individuals, excluding all government spending because it’s not clear that this is socially beneficial. But Rothbard’s second metric is probably an even better one: Since government spending represents the state bidding against the private sector for resources, it’s more realistic that government spending is positively harmful to people’s standards of living, rather than just neutral as the GPP would suggest. He therefore suggested taking the GPP and then subtracting all of the government spending from it in order to account for the losses that result from land, labor, and capital being directed away from more productive private uses. Rothbard called this the Private Product Remaining (PPR). Rothbard pointed out that, if a person even believes that as much as 51% of government spending is wasted, then it’s already more realistic to be subtracting government spending than adding it, making PPR superior to GDP.

To consider why the PPR is significantly more accurate, consider the case of the government building tanks with steel. It should be obvious that if government bids up the price of steel for the production of tanks, so that there’s less steel to go around for private individuals to use, this might seem to be a boost to the economy, as this might increase GDP, and it might even be beneficial to the steel industry (considered in isolation), but the result is that the private individuals who wanted to use steel or wanted to use products made with steel will have to pay higher prices. As a result of this kind of intervention against the natural economy, for private individuals steel is artificially scarcer than it otherwise would be, i.e. they’re poorer than they otherwise would be. This boost to GDP does not come simultaneously with leaving the people generally better off; the people are generally worse off. So by the government extorting the people’s money and then spending it on resources that could have been employed in more useful projects that actually better people’s lives, the people are made worse off both when the money is stolen from them and again when the money is spent. (Of course, special interests will enjoy that the government spends this stolen money on them. In this particular example, the steel smelters and the military-industrial complex will get a boost, but their gains will be at the expense of making everyone who’s not a part of these special interest groups poorer.)

It might be countered that the extra business given to the steel industry will help to expand the steel industry so that steel prices might come back down in the future, and with increased capacity for production. Are we getting a free lunch here? Are we just getting lower priced steel without any downsides? Unfortunately, no, and the reason is clear as soon as we don’t myopically focus on the steel industry; we have to remember the effects on other industries as well. Having accepted a subsidy from the military, the steel industry will expand at the expense of other industries, since there’s more spending on steel and less spending on other goods. There are only so many resources to go around, and so diverting resources towards steel production necessarily means diverting resources away from other industries that could have made use of those resources. This makes profits artificially larger in the steel industry and artificially smaller in other sectors. Land, labor, and capital that would have been used to produce things in those other industries instead become employed in the production of steel. So yes, it really is the case that government spending on steel will cause there to be more steel production, even into the future, but this will come at the expense of less of everything else—even into the future. Any artificial increase steel-making capacity will be at the expense of having artificially less capacity in other sectors. This actually means that even the people who weren’t interested in buying steel or things made with steel will be worse off: Since, resources having been drained away from other sectors for making steel, whatever they planned on buying will come from industries that are artificially less productive than they otherwise would be, as a direct result of government interference against the economy. Therefore, to the extent that we care about tallying up spending, it makes more sense to subtract government spending rather than add it.

So when one is simple-mindedly accepting of whatever mainstream economists say about GDP, all these details just get buried. Not even mentioned. But from the perspective of the PPR, we can see how buying up steel on the part of the state would be harmful to people’s standards of living. As a result of the state taxing its people and then spending it on steel, private spending is lowered and government spending – with all its waste and corruption – is raised, making the general fall in standards of living rather obvious. Both the act of taxation and the act of spending on steel distort the economy in ways that only make people generally poorer than they otherwise would be. The PPR captures both of these effects, the GPP captures only the former effect, and the GDP is completely and utterly incapable of capturing either of these effects. Therefore PPR is strictly superior to GDP as a metric of the health of an economy—at least as long as we understand that the purpose of the economy is to raise the people’s standards of living.

Rothbard’s PPR metric is actually a little bit more complicated than presented here. So far, the formula has only been to take private spending on final goods and to subtract off government spending, but the amount that the government spends and the amount it confiscates in in taxes typically isn’t the same number. If the government is spending more money than it receives in taxes, which is often the case, then it makes sense to simply subtract government spending as spending is the major drain on the economy. On the other hand, if the government is stealing more than it’s spending, then it’s said to be running a budget surplus. The word “surplus” might sound like a good thing, but it has to be remembered that this is all extorted money—having a “surplus” means the government stole more money than it needed to to pay its bills in a given period. In that case, since the theft is the bigger problem, Rothbard advocating subtracting not the government spending, but the total government tax receipts. If the government is running a budget surplus, it’s because it’s confiscating its people’s money, and so lowering people’s standards of living by direct confiscation. Therefore the true calculation of the PPR is the total private spending on final goods minus either the government spending or the total tax receipts, whichever is higher. Moreover, Rothbard handles interest payments to and from the government differently than mainstream economists. The reader is encouraged to pick up a copy of America’s Great Depression and flip to the back to learn more about Rothbard’s perspective on PPR, and the details about calculating it.

For all these reasons, it will make sense to be very cautious about GDP numbers. When the GDP goes up, is it going up only because of government spending? Is it going up only as a result of persistently high yet understated inflation? In the end, it doesn’t make a whole lot of sense to care about GDP as a metric because of how distorted it is.