Nearly 80 years ago — during the height of the Great Depression — economist Simon Kuznets envisioned a system capable of measuring productivity and economic activity. In a report to Congress, Kuznets proposed charting all economic production with a single measurement that would decrease when the economy struggled and increase when it thrived. He called it gross domestic product, or GDP.
Nations throughout the world embraced GDP as the standard for measuring economic activity; Kuznets eventually won the Nobel Prize for his creation. The popularity of GDP belies its effectiveness, however, as the measure systematically under-reports the significance of production.
The most recent data from the U.S. Bureau of Economic Analysis showed that the country’s GDP increased by about 1.4 percent in the second quarter of this year, which was encouraging news to some. GDP in the U.S. had increased by about 0.8 percent in the first quarter of the year. While this seems like positive news, it’s difficult to say exactly what it means for the average consumer.
GDP was the only available option for a long time, but it has always been flawed because it assumes a net contribution to consumer value through production. A business that produces a certain good is believed to add only the difference between the product’s monetary value and the cost of all inputs combined.
GDP also mistakenly places too much emphasis on business-to-consumer activity compared to business-to-business transactions, which account for a significant amount of investment and opportunity. In fact, money invested in B2B startups through the end of March increased by about 40 percent compared to 2015 figures.
Moreover, GDP is useless because it measures official statistics rather than actual value. Dollar amounts measured in statistics don’t capture the actual satisfaction — or real value — being produced. It also fails to accurately measure innovations until after the fact, meaning investments are considered a loss until they pan out. An economy investing for future production might, therefore, appear to be contracting.
By only measuring monetary values — primarily consumption data under the guise of “produced” goods — GDP ignores the fact that value is added in each step along the production chain. It also specifically tracks expenditure and income rather than well-being.
What truly matters in economic growth is how our well-being has improved: how our lives become more convenient, how we get more time for leisure, and how we can afford everything. This is a matter of perception and ability to consume.
It can be argued that we experience economic growth when prices fall but wages are steady. Those same incomes can buy more goods and services, consequently making us wealthier.
When we talk about inequality, we’re almost always speaking of income rather than well-being. But what does it matter if one person earns $1,000 and another earns $1 million if the goods they both consume are identical? If we’re unable to satisfy more wants by earning significantly more money, income becomes irrelevant.
This is often the case in Western nations, where income inequality is on the rise. The U.S. has seen income inequality increase since the 1970s, with the top 1 percent of U.S. families earning about 25 times as much as the remaining 99 percent. While income inequality is growing, well-being inequality is actually shrinking.
The price difference between a Mercedes-Benz and a Toyota is greater than the gap between having a car and not having one, but the well-being differential is reversed. A Mercedes-Benz doesn’t offer more transportation than a Toyota, but having any car is tremendously better than not having one in terms of well-being.
A Better Indicator
While GDP ultimately fails to track the size of an economy, a different measure offers a much broader view of economic activity.
Economist Mark Skousen has long advocated for gross output as a viable alternative to GDP. Gross output goes beyond finished goods and services that don’t necessarily have a final “value.”
For instance, a business breaking even without any profits still contributes to the economy through production — it consumes inputs to produce outputs, pays suppliers and employees, and provides goods, services, and capital to other businesses. A lack of profit doesn’t mean the economy is smaller or that this business isn’t contributing to the economy. Instead, consumers of its products have added to their well-being.
It’s a matter of perspective. The GDP is based on a faulty theory of the economy as consumption-driven when it’s actually more production-driven. Consumption happens where production facilitates it, through goods and services produced as well as income generated by selling those goods and services.
In a market society, we produce for market needs rather than our own benefit. This allows us to generate income to satisfy our own needs and wants by consuming the goods and services others produce. This allows us to specialize and develop expertise to innovate and simplify our own production, which eventually helps us increase our output, serve more consumers, and generate more money to spend on goods.
GDP effectively ignores all attempts to improve production because they don’t result in increased consumption. It falsely assumes that consumption drives production; therefore, it’s pointless to map out and measure the latter. In other words, GDP adopts a backward economic perspective.
In reality, entrepreneurs produce what they believe consumers want to buy. The fact that they undertake uncertain production projects helps contribute to our common prosperity and standard of living.
Whereas gross output takes a broader view of economic activity, GDP misunderstands economics by simply counting what statistics capture: net consumption, net profits, net this, and net that. After almost eight decades of flawed logic, we’re due for an economic paradigm shift.
Per Bylund is Assistant Professor of Entrepreneurship and Records-Johnston Professor of Free Enterprise in the School of Entrepreneurship at Oklahoma State University. His areas of research are entrepreneurship, management, and economic organization. Connect with him on Twitter.