Is GDP all it's cracked up to be?

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It seems we live and die by the latest reading on gross domestic product, purported to be the final market value of all the goods and services produced within our borders over a certain period of time. When GDP came in at an annualized rate of 3.5 percent last week -- the first rise in a year and ahead of economists' expectations -- the Dow Jones Industrial Average ($INDU) soared 200 points on the news.

Then, the next day, the nay-saying, nitpicking and deconstruction of the data commenced, helping the Dow cough up 250 points in a session.
It's no secret that the way GDP is calculated is flawed. Economists have taken issue with the various cogs, springs, levers, slides and chutes that comprise this most Rube Golbergian of measures pretty much since its inception.

Lately the mainstream press has gotten in on the act, offering some cogent and credible illustrations of the limitations of GDP. In this month's The Atlantic magazine, Megan McArdle story's "Misleading Indicator" shows that GDP and economic well-being are hardly the same thing. Meanwhile, Michael Mandel writes in BusinessWeek that GDP, as currently constructed, is not up to the task of measuring a 21st century economy -- and greatly overstates its current strength.

McArdle's main criticism of GDP is that is doesn't measure quality of life. For example, if a stay-at-home mom goes back to work, that adds to GDP, even if it causes a decrease in overall satisfaction (because of commuting costs, child care, prepared foods for dinner versus home-made meals, that sort of thing.)

Fair enough. We're all for something that measures well being, but as Robert Brusca, chief economist of Fact & Opinion Economics in New York, says, GDP was never designed to measure such things. Blaming GDP for failing to capture happiness is like criticizing a thermometer for not being able to guess your weight.

As for Mandel, he's got a beef with the way GDP fails to pick up cutbacks in "intangible investments," such as business spending on research and development, product design, and worker training.

"There's ample evidence to suggest that companies, to reduce costs and boost short-term profits, are slashing this kind of spending, which is essential for innovation," Mandel writes. "Without investment in intangibles, the U.S. can't compete in a knowledge-based global economy. Yet you won't see that plunge reflected in the GDP and productivity statistics, which are still too focused on more traditional sectors, such as motor vehicles and construction."

Okay, fine. But Brusca's says he doesn't know how economists would even begin to measure that. "That's pretty flaky," he says. "An intangible is an intangible. You don't value it on the way up and you don't value it on the way down. If you have R&D spending, it gets capitalized when it comes to fruition. And if you put a lot of money into R&D and you never get anything for it, then arguably you did waste that money."

No doubt GDP has its weaknesses, but Brusca thinks economists, market participants and the media have become unreasonably cynical about the metric. It does reasonably good job of measuring what it's supposed to -- with the best information economists have at the time, he says.

"GDP is like any number you measure," Brusca says. "The most important number is always your most recent observation. And your least reliable number is always your most recent observation."

That's why these things get revised, he says. There are too many missing variables that need to be estimated or left out entirely.

"You'll have firms no longer reporting because they went out of business," Brusca says, "That's a hit. But then there are new firms coming into existence that don't get reported because we don't know about them yet."

Most important is to look at the totality of data available to us, Brusca says. GDP isn't all that useful interpreted in a vacuum. After all, there's a reason economists -- and the market -- pour over the seemingly constant stream of data, from housing to manufacturing to unemployment to ad nauseum.

"I'm not defending everything about the way GDP is measured," Brusca says. "There are a lot of nuances, but there is nothing intrinsically wrong with it."
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