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All posts by Dan Whalen,
Providence, RI (resume)

Thursday, January 12, 2012


             How do you measure something that has no physical dimensions?  Can a child tell you he has 3 more units of love per hour for this toy than he does for that one?  Can I tell you that today's customer service clerk is exactly twice as helpful as the one I spoke with yesterday?  Does it even make sense to use the word “measure” when talking about something intangible?

            So how would you go about quantifying an economy

            It’s definitely not a simple thing to do.  But it's certainly worth it to try.  Without a set of hard measurements for an economy's size, we can't tell if one is growing or shrinking, or if another nation's economy is larger or smaller than its neighbors.  Without one, studying economies would be a bit too subjective for most people's taste.

            So in an economic sense, what is a "big" country?  When we describe a nation’s economy as "small," what are we saying?

            Does a "big" economy have a lot of physical size?  For example, is it sensible to say Russia’s economy is larger than Japan’s, since it just looks bigger on a map? 

            Well, no.  When thinking about the "economic size" of a country, geographical dimensions don't really matter directly - there are nations with little land or resources that are still major players in the world economy, such as Hong Kong, Taiwan or Singapore.

            Ok, so how about population?  Sure, population can be an important factor in some economic issues, but not always.  Some of the world's most populated nations are pretty quiet when it comes to economic activity or power, like Nigeria or Bangladesh.

            What we’re truly looking for is a measure of economic activity itself, not a measure of size of the country in which that activity takes place, or the number of participants in it.  How big or small is this economy when compared to that one?  How big or small is this economy compared to itself last year?  Lucky for us, we have exactly such a metric.  It's called Gross Domestic Product (GDP).

            GDP, is "the total dollar value of all final goods and services produced over a specific time period."  I know that definition sounds simple enough, but there's some subtle (and a few not so subtle) important little points in there that you should understand before you go round town quoting GDP factoids - if your into that sort of thing, of course…ya weirdo.

            There's a couple different ways that GDP can measured, but the most common ways are the "income approach" or the "expenditure approach."  Using either method will yield the same result.

            The income approach just involves adding up the income received by economic agents contributing to production - citizens, businesses government bodies, EVERYONE – in a given country, in a given year.  So that's the sum of all after-tax salaries and wages, profits from firms, and the taxes the government collects (remember, government income by definition is just tax revenue).

            The expenditure approach is basically the same equation in reverse.  It's the sum of all the consumer spending, business investment, government spending and net exports (exports minus imports, that is) that occurred in a given country, in a given year.  Or in other words, the amount spent on final goods/services by all agents in the economy.

            The difference lies in whether or not you view GDP as a measure of how many dollars were "received" in exchange for a good or service (income approach), or how many dollars were "spent" to pay for goods or services (expenditure approach).  Every income is at someone else’s expenditure, every expenditure gives income to someone else.

            Either way, GDP can be viewed just as a count of how many dollars circulated in a country to facilitate the exchange of goods and services in a year.  Or looking it another way, how many dollars worth of goods and services was produced, created, sold, or transacted in a year.  Same same.

            You notice that I used the qualifier "goods or services" a bunch above?  That’s because GDP does not include any straight-up transfers of cash when there’s no corresponding production involved.  If Congress passes a law stating that every American has to stand in a circle and pass a buck to whoever is immediately to their left, we don't magically create $309 million worth of GDP (there’s 309 million Americans, each one would “transact” $1, you get what I’m saying).  We only want to count money that changes hands in exchange for something else.

            So the $700 billion worth of Social Security payments the Fed will make this year adds nothing to GDP.  Its just a reshuffling of it. The money is just being transferred from working Americans to retired Americans, via taxes, and therefore doesn't represent any newly generated wealth for America as a country.  GDP is a measure of the wealth a country produces, not how much wealth it already has, or who has a claim to it. 

            For a cool little visual tutorial on GDP, check out moneychip.com's graphic guide to GDPThe solid arrows are counted as part of GDP, the open ones are money movement not part of GDP.  Click on an arrow or picture in the system to get a more detailed description.

(I've actually just recently learned about this page. They give a lot of simple, effective lessons about economics and finance on there.  Scroll down to the bottom of the page that the above hyperlink sends you to and hit the "NEXT PAGE"  to see some more, or skip through the lessons in the "Article" box toward the top right.)

What’s NOT included in GDP:

            GDP is a measure of economic activity, and so “non-transacted” assets - things that are just being held on to and not used for production - are not part of it.  For example, the US government holds millions of acres land (the national and state parks), oil reserves, and property.  But that’s not part of our GDP. 

            If we charged people to camp in those park, or drilled up and sold that oil, or auctioned off the Washington Monument, we could claim that as part of our GDP.  But just to have it doesn’t make a lick of difference.

            We don’t count assets held as part of GDP, because, we really don’t have any idea what they are worth.  This is because things don’t have a price until they are sold.  If a house is appraised for $50,000, all this means that the appraiser thinks, in their professional judgment, that if the house was to be sold, it would fetch $50,000.  That doesn't mean that the house is "worth" $50k. Until it's sold, it’s not really “worth” any amount of money. 

            Just having something may increase our nation’s Net Worth.”  But it won't affect its GDP.  A country might have tons of assets in terms of resources or land.  But only what they do with those assets matters when  they calculate their GDP. 

            I know this is all a little bit “the sound of one hand clapping,” but if you think on it for a minute, it will make sense.  For more on how prices come into existence, check out my previous post on the topic
            Either way, this leaves nations that are resource rich, but productivity poor, showing a smallish GDP.  Similarly, those with limited resources, but a great deal of cleverness or innovation, are more likely to post very high GDPs.  Just keep in mind, GDP is about current economic activity.  It’s not what you’ve got that matters, it’s what you can do with it.

            Another value that GDP misses is all the non-monetary transactions of services that a country might produce, ie “non-market” activity.  These services provide value for the citizens.  And they would have value in other places.  But when no money changes hands, there’s no record, and no price tag, so it’s impossible to count as part of GDP.

            I’ll give you one interesting example.  A few years back, I spent half a year in the country of Nicaragua.  There’s kind of an unspoken cultural attitude in most parts of Nicaragua that if you are fortunate to own a car or truck, you almost owe it to the public to provide rides to anyone who might be walking along the side of the road.  This norm holds true no matter how many people are already in the car, whether or not you even put up your thumb in the first place, or how unlikely it would appear the car could make it over the next hill.

            I’ve never done so much hitchhiking in my life!  It’s so engrained in the culture, drivers are expected to pick up riders.  I learned more cuss words from listening to hitchers blow out the motorists that passed them by than I did hanging out in any bar.

[One bizarre Nicaragua hitching story: I was walking down a country road, when a police pick-up truck came up behind me, and the passenger cop yelled “Subase, chele!” out the window at me.  I hadn’t even signaled for a ride, in fact, I hadn’t even noticed the police car until they stopped, but here they were, demanding I jump in the back.  I gave them a “Gracias” and obliged.  In the back were bunch of school kids, still in their uniforms, each about 10, on their way home.  I asked them what it was they had done at school that the police had to come and take them home.  They didn’t get the tease.  “Sometimes the police drive us home.  School is far,” one girl told me.  My statement didn’t make sense to them as a joke at all.  The police giving kids a ride home from school, just because they could fit a lot of little ones in their car, was normal as anything there.  Its a cultural norm, a societal expectation.]

            ANYWAY!!  Nicaragua “produces” this transportation through cultural activity, not market activity.  Sure, transportation is a service worth money in any other place or situation.  The profits of a bus company in Managua contributes to Nicaraguan GDP, just as a cabbie’s business in NYC would contribute to the US's. 

            But, because there’s no real practical way of measuring this informal production, and we don’t know what the prices of those rides would have been anyway, that transportation Nicaraguan’s enjoy just can’t be measured.  So there’s another item left off their GDP tally.

            Can you think of other goods and services your country produces, but is not counted as part of its GDP, since it’s not market production?  How about baby-sitting grandparents?  Helpful friends/suckers who show up to lend a hand on moving day?  Think about the billions of stay at home moms there are in the world, who spend 6 or 8 hours a day cleaning, cooking, and caring for kids? 

            All that activity gets left off the GDP counter, since it’s not really economic activity.

Some GDP caveats:

            Back to Nicaragua for a sec.  While I was there, I rented a small, but nice room in the back wing of a larger home for $80 a month.  My rent here in the US, for a room a bit nicer and bigger (but honestly not all that different) is $230 a month. 

            So here's my question:  if we were comparing economic production in the US to production in Nicaragua, is it fair to compare straight-up dollar amounts?  If the same good or service is created in both places, but is cheaper in one place than it is in the other in terms of one currency, should it contribute equal amounts to both GDPs?  Or a different one?

            For me, Nicaragua "produced" a rental room comparable to the one “produced” for me here in the US, but due to larger macroeconomic issues, the room goes for almost 1/3rd the price that it would here.  Or put another way, if that apartment could be magically teleported to the US, its value would triple, even if its quality and size remained unchanged.

            Does that mean that the US economy produced 3 time more "rental room" than the Nicaraguan economy with that one room?  Of course not!  The price difference has only to do with the location of the transaction, not the transaction or item itself.

            This conundrum has led economists to create a type of adjustment to GDP figures, called Purchasing Power Parity (PPP).  When ever you see "GDP by PPP," the indication is that adjustments have been made to account for things like local supply and demand, exchange rates, etc.  It does more than just counts not how many dollars exist in a GDP, but accounts for how far do those dollars went.

            Whenever you are comparing two different countries’ GDP, you really should only use GDP by PPP.  The opposite of PPP is "Nominal GDP" - GDP calculated just by looking at the absolute dollar (or Euro or Pound or whatever) amount of expenditures or income, not what that country’s GDP feels like for its citizens.

            Nominal GDP is fine when comparing, say, the same nation's economy this year to its economy last year (although you shouldn't use Nominal when comparing the same country's GDP over many years, since Nominal GDP doesn't account for inflation).  But using Nominal GDP to compare two different nation's economies will always distort the picture by making the poor look very poor and the rich look very rich.

            Earn a $20,000/year income in the US, and you're broke.  A $20,000/year income in Haiti, however, puts you decently well-off.  Similarly, $20,000 of economic activity in Port-Au-Prince would get some decent attention, but $20,000 circulating in the Buffalo, NY would go largely unnoticed.

            PPP compares not just the raw dollars moving in an economy, but the power of those dollars.  It calculates GDP by the movement of goods and services themselves, not the movement of currency, giving it a more "universal" type function.

            I have one last GDP caveat, and that’s the difference between GDP and GNI (Gross National Income).

            If a Canadian factory, owned by an American parent company, makes a $1 million profit in Canada a year, that $1 million is part of Canada's GDP, even thought that economic activity was technically generated by America, and remains in American control.

            So how do we account for it?  Well, that profit is counted as part of Canada's GDP.  But the same profit is added to America's GNI.

            GDP is about the economic activity within a countries borders, independent of whether or not another country is driving that activity.  And domestically owned production that happens abroad is not counted in GDP.

            If you want to know how much total economic activity involves or is generated by Americans (as opposed to in America), you'll want to look at our GNI – not our GDP.

            At one point, in the not too distant past, the two terms were virtually interchangeable.  But in the globalized world, they can differ by quite a bit.

            For example, in 2010, China's GDP was somewhere around $5.9 trillion.  In the same year however, its GNI was $10.1 trillion, almost double.  For every dollar of goods and services produced in China that year, a Chinese entity created another dollar worth of economic activity abroad.

            Of course, what makes a country interesting, or note-worthy, is not just its economy.  The true nature of a place cannot be summed up in just figures and sums.  Culture, history, strategic influence, ability, and people are all components of a nation’s identity that’s just as important, if not more so, than economy, commerce or production.  Absolutely.

            But it’s still worthwhile to understand GDP.  It’s a rare little metric in that it can be applied near-universally (we can measure the GDP of any place, in any year), and it’s an effective way of putting a numerical value on something pretty ephemeral.  It’s really a great tool to have in your mental tool box - though it shouldn’t be the only economic one you’ve got.

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