Limitations of using GDP statistics
GDP statistics are widely used for comparing economic performance of developing countries, but they can be criticised for several reasons.
Differences in the distribution of income
Although two countries may have similar GDP per capita, the distribution of income in each country may be very different.
Differences in hours worked
As when comparing a country over time, the number of hours worked to generate a given level of income may be quite different. For example, workers in the UK tend to work longer hours than those in France, and this would falsely inflate the GDP figures in the UK relative to France. Wider measures of economic welfare usually include an adjustment of GDP to take into account the value derived from leisure.
International price differences
International prices will also vary, which is significant because purchasing power is based on price in relation to income. To solve this problem, GDP statistics can be re-calculated in terms of purchasing power. The purchasing power of a currency refers to the quantity of the currency needed to purchase a given unit of a good or common basket of goods and services. Purchasing power is determined by the relative cost of living and inflation rates in different countries. Purchasing power parity means equalising the purchasing power of two currencies by taking into account cost of living differences.
For example, if we simply convert GDP in Japan to US dollars using market exchange rates, relative purchasing power is not taken into account, and the validity of the comparison is weakened. By adjusting rates to take into account local purchasing power differences, known as PPP adjusted exchange rates, international comparisons are more valid.
Difficulty of assessing true values
The true value of public goods such as defence and transport infrastructure and, and merit goods, such as healthcare and education, is largely unknown. This means it is difficult to compare two countries with very different spending on these goods and assets.
Hidden economies
Similarly, the existence of a large hidden economy may make comparisons based on GDP very misleading. For example, comparing the official GDP of the UK and Russia may be misleading because of the size of the hidden economy in Russia. To avoid tax, transactions may go unrecorded and excluded from official statistics.
Currency conversion
GDP figures for different countries must be converted to a common currency, such as the US dollar, and this may give misleading figures. Exchange rates against the US dollar may not be accurate for countries whose international trade is relatively small. In such cases converting to US dollars may significantly under-value national output. This is why converting to purchasing power parity is preferable to converting to US dollars.
See: Measures of Economic Welfare
GDP was not designed to assess welfare or the well being of citizens. It was designed to measure production capacity and economic growth. Yet policymakers and economists often treat GDP as an all-encompassing unit to signify a nation’s development, combining its economic prosperity and societal well-being. It’s time to acknowledge the limitations of GDP and expand our view of development to include welfare. A number of countries, including India, are paving the way.
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Economic growth has raised living standards around the world. However, modern economies have lost sight of the fact that the standard metric of economic growth, gross domestic product [GDP], merely measures the size of a nation’s economy and doesn’t reflect a nation’s welfare. Yet policymakers and economists often treat GDP, or GDP per capita in some cases, as an all-encompassing unit to signify a nation’s development, combining its economic prosperity and societal well-being. As a result, policies that result in economic growth are seen to be beneficial for society.
We know now that the story is not so simple – that focusing exclusively on GDP and economic gain to measure development ignores the negative effects of economic growth on society, such as climate change and income inequality. It’s time to acknowledge the limitations of GDP and expand our measure development so that it takes into account a society’s quality of life.
A number of countries are starting to do this. India, for instance, where we both work advising the government, is developing an Ease of Living Index, which measures quality of life, economic ability and sustainability.
When our measures of development go beyond an inimical fixation towards higher production, our policy interventions will become more aligned with the aspects of life that citizens truly value, and society will be better served. But before we attempt to improve upon the concept of GDP, it is instructive to understand its roots.
The origins of GDP
Like many of the ubiquitous inventions that surround us, the modern conception of GDP was a product of war. While Simon Kuznets is often credited with the invention of GDP [since he attempted to estimate the national income of the United States in 1932 to understand the full extent of the Great Depression], the modern definition of GDP was developed by John Maynard Keynes during the second world war.
In 1940, one year into the war with Germany, Keynes, who was working in the UK Treasury, published an essay complaining about the inadequacy of economic statistics to calculate what the British economy could produce with the available resources. He argued that such data paucity made it difficult to estimate Britain’s capacity for mobilization and conflict.
According to him, the estimate of national income should be the sum of private consumption, investment and government spending. He rejected Kuznets’ version, which included government income, but not spending, in his calculation. Keynes realized that if the government’s wartime procurement was not considered as demand in calculating national income, GDP would fall despite actual economic growth taking place. His method of calculating GDP, including government spending into a country’s income, which was driven by wartime necessities, soon found acceptance around the world even after the war was over. It continues to this day.
How GDP falls short
But a measure created to assess wartime production capabilities of a nation has obvious drawbacks in peacetime. For one, GDP by definition is an aggregate measure that includes the value of goods and services produced in an economy over a certain period of time. There is no scope for the positive or negative effects created in the process of production and development.
For example, GDP takes a positive count of the cars we produce but does not account for the emissions they generate; it adds the value of the sugar-laced beverages we sell but fails to subtract the health problems they cause; it includes the value of building new cities but does not discount for the vital forests they replace. As Robert Kennedy put it in his famous election speech in 1968, “it [GDP] measures everything in short, except that which makes life worthwhile.”
Environmental degradation is a significant externality that the measure of GDP has failed to reflect. The production of more goods adds to an economy’s GDP irrespective of the environmental damage suffered because of it. So, according to GDP, a country like India is considered to be on the growth path, even though Delhi’s winters are increasingly filled with smog and Bengaluru’s lakes are more prone to fires. Modern economies need a better measure of welfare that takes these externalities into account to obtain a truer reflection of development. Broadening the scope of assessment to include externalities would help in creating a policy focus on addressing them.
GDP also fails to capture the distribution of income across society – something that is becoming more pertinent in today’s world with rising inequality levels in the developed and developing world alike. It cannot differentiate between an unequal and an egalitarian society if they have similar economic sizes. As rising inequality is resulting in a rise in societal discontentment and increased polarization, policymakers will need to account for these issues when assessing development.
Another aspect of modern economies that makes GDP anachronistic is its disproportionate focus on what is produced. Today’s societies are increasingly driven by the growing service economy – from the grocery shopping on Amazon to the cabs booked on Uber. As the quality of experience is superseding relentless production, the notion of GDP is quickly falling out of place. We live in a world where social media delivers troves of information and entertainment at no price at all, the value for which cannot be encapsulated by simplistic figures. Our measure of economic growth and development also needs to adapt to these changes in order to give a more accurate picture of the modern economy.
How we’re redefining development in India
We need alternative metrics to complement GDP in order to get a more comprehensive view of development and ensure informed policy making that doesn’t exclusively prioritize economic growth. We’re seeing some efforts already, such as Bhutan’s attempt to measure Gross National Happiness, which considers factors like equitable socio-economic development and good governance, and UNDP’s Human Development Index [HDI], which encapsulates health and knowledge apart from economic prosperity.
As a step in this direction, India is also beginning to focus on the ease of living of its citizens. Ease of living is the next step in the development strategy for India, following the push towards ease of doing business that the country has achieved over the last few years. The Ministry of Housing and Urban Affairs has developed the Ease of Living Index to measuring quality of life of its citizens across Indian cities, as well as economic ability and sustainability. It is as well expected to evolve into a measurement tool to be adopted across districts. We believe that this more holistic measure will provide more accurate insights into the state of development of the Indian economy.
The end goal is to have a more just and equitable society that is economically thriving and offering citizens a meaningful quality of life. With a change in what we measure and perceive as a barometer of development, how we frame our policies will also catch up. In an economy with well-being at its heart, economic growth will simply be another tool to guide it in the direction that the society chooses. In such an economy, the percentage points of GDP, which are rarely connected with the lives of average citizens, will cease to take the center stage. The focus would instead shift towards more desirable and actual determinants of welfare.