Greatly Dubious Premise I - GDP is an artificial construct with shifting parameters

A triple blessing was nestling under The Value Perspective’s Christmas tree this year in the shape of Diana Coyle’s GDP.


Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

A triple blessing was nestling under The Value Perspective’s Christmas tree this year in the shape of Diana Coyle’s GDP: A Brief but Affectionate History – first, because it makes a potentially dull topic so interesting; second, because it is short enough to have been consumed before the last of the turkey; and, finally, because it should lead nicely into our now-traditional anti-forecast for the year ahead.

A country’s economic growth is hardly worth measuring if there is none and so gross domestic product (GDP) only really became an issue around the time of the Industrial Revolution in the second half of the 18th Century. It was at this point people began to discuss in earnest how one might gauge what is essentially an invisible, intangible and indeed wholly artificial construct – the financial and non-financial wealth of a society.

As if to prove that the more things change the more they stay the same, the first serious attempts to put a value on a country’s GDP aimed to determine whether the UK could afford to go to war. The calculations focused on the economy’s various assets – people, land, capital and so on – as well as the income these assets produced.

What was not included in the size of the economy was anything related to government services and spending, which was seen as an unproductive, albeit necessary, cost to society and as such was deducted from GDP. This all changed as a result of the Second World War, however, when politicians baulked at the idea of increased government spending on the war effort leading to a drop in the country’s GDP.

The consequent decision to extend the boundaries of what constituted GDP to encompass the spending of the State changed economics as we know it today. After all, Keynesianism involves increasing or decreasing government spending in order to grow or shrink the economy. Without including government spending within  GDP, one of the pre-eminent economic theories of the 20th Century cannot work.

Complex calculation

Add government spending into the mix, however, and an already hugely complex calculation becomes even more so. Indeed, it is hard to think of anything that illustrates this more starkly than that it now takes teams of people to work out national and global GDP numbers – and that no single individual on this planet understands exactly the whole process of how GDP is measured.

And yet GDP’s mind-boggling complexity is only one of a wide arrays of issues, whose surface this article and its two sequels will barely scratch. Take, for example, the question of just what should be included in the definition of GDP – yes, government spending is now an integral part but what about a country’s ‘black’ economy, say, or domestic work?

Keen followers of The Value Perspective will know that one of those two is actually now on a par with government spending. In High jinks, we noted the instructions from the European Union’s statistical office, Eurostat, a couple of years back that illegal activity such as drug-trafficking and prostitution should henceforth be included in member states’ GDP calculations.

Well … OK – different countries are naturally going to excel in different areas, some of which are more legal that others – but why stop at the black economy? Why not also include the rather more worthy domestic activities such as housework and childcare? As things stand, anyone deciding to elope and marry their baby-sitter is effectively taking a small amount away from their country’s GDP.

Aside from the inconsistencies of where the line is drawn on what is included in GDP – and the fact that line keeps moving – there is the fundamental question of how the inclusions are actually valued. Ostensibly, every element of a GDP calculation is given a market price but of course not everything has a market price, especially when it comes to the aforementioned government spending.

Ducking the issue

What, for example, is the market price for a teacher and how would you measure their productivity? Do you assign a higher value to a teacher who educates one child very well or 500 children quite poorly? It is all a very difficult judgement to make so the statisticians instead duck the issue, with the productivity of the government workforce simply held to be its cost – in other words, the workforce’s wages.

The problem here, of course, is this means a government can never become more productive. If you ever wanted to prove governments are inefficient and unproductive, you have plenty of ammunition with GDP because its very make-up makes it impossible for government to be otherwise. It is also another inconsistency of GDP because government spending is not included at a true market price.

Yet further inconsistencies are introduced because those calculating GDP must, by necessity, use a wide variety of data sources. Measuring the productivity of a widget manufacturer – or indeed the whole widget sector – may be straightforward enough but, when you are aggregating that idea across thousands of businesses and millions of people, measuring economic output becomes hugely difficult.

It means melding a whole hodgepodge of different statistical sources – production surveys for different sectors, tax revenue data, employment data and so on – into a single idea of GDP. It also means that single idea of GDP becomes subject not only to a host of errors but also to a series of recalculations to the extent that, over time, annual GDP revisions can be material.

That could be an article in its own right – indeed, in Gross misconduct, it recently was. Suffice to say, the only economy whose GDP number is never revised is China but everyone else’s data undergoes numerous and often quite significant revisions. To take a UK example, GDP growth for 2005 was initially held to be 1.8% but, over the last 10 years, it has been revised materially. It stands at 2.8% – for now.

All of which means, if you choose to base decisions on a GDP number the day it is published – as the stockmarket is inclined to do – you are exposing yourself not only to an artificial construct with arbitrary definitions and significant statistical errors, but also to the simple fact that, whatever number is announced on day one is almost certainly wrong. We will consider further GDP inconsistencies – and why investors should care – over the next couple of articles.


Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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