What is the point of GDP?20th May 2013

You can’t beat exposure to free-thinkers. My free-thinking week started with the pleasure of a speech and chat with the straight-talking Ruth Lea of Arbuthnot, and ended with the MoneyWeek Conference.

But first, one of those sit bolt-upright moments, as I also bumped into an acquaintance who, in a few short words, encapsulated all that is wrong with our economic system: Soon to retire, he pointed out that after many decades of hard work (as a respected professional in the regions) he has generated no more than if he had simply bought a flat in London a few decades ago. So what does our system do to encourage real wealth-creation? Sadly the answer is very little, with constructive value-added economic activity penalised through heavy taxation whilst monetary inflation rewards simple asset retention.

Probably the favourite economic and political measures of our curious economic system is GDP, which the media also choose to adore but fundamentally misunderstand. You can read my previous thoughts on the nonsensical nature of GDP here, and it was great that both Ruth Lea and the illustrious Bill Bonner took up this topic.

Ruth’s useful breakdown of GDP, and her highlighting of the major subsequent revisions to the numbers demonstrates the immense folly of using GDP statistics as a tool to assess, by margins of 0.1%, whether the country has or has not fallen into a double-dip let alone a triple-dip.

To understand GDP, which as a measure of activity is little more than a measure of turnover, rather than productivity or wealth-creation, it is useful to understand how it is currently made up, which Ruth kindly broke down as follows:

Business & finance services 29.1%,

Services: distribution, transport etc. 24.6%,

Government & other services 23.3%,

Production 15.6%,

Construction 6.8%, and

Agriculture 0.6%

Within these groupings, guess which activity has grown back above the level of five years ago? Yes, Government & other services!

No doubt this has been great for propping up total GDP, but how on earth do you put an accurate economic value on Government activity that people have no choice in? If you want to buy a can of baked beans you have a choice of brand, where to buy it, in what quantity, and even the choice of spaghetti hoops if you fancy a change, all to achieve the best fit of desirability and value to match your specific wishes; in this way the demand and price discovery process is genuine. But Government services aren’t like that, so how on earth do you put a value on them?

Over the past 5 years within the private sector, Construction is down almost 20%, Manufacturing down 10%, and Business & financial 15%. Total GDP is not helped by the fact that Oil & Gas output is down almost 50% over the same period. Only services have crept back up, although modestly if we exclude ‘Government’.

Certainly ‘Government’ is active, as was demonstrated to me by the noisy Unison demonstrators in Westminster on Friday, gathered in their bright yellow and orange jackets to block the pavement, shouting and blowing horns on the subject of … well I have no idea. As demographics evolve we will all see greater pressure on GDP and perhaps start to appreciate the folly of seeking to sustain such large Government “services”.

My trip to Westminster saw the illustrious Bill Bonner issue forth on GDP, pointing out that if he mowed his lawn, as did his neighbour, then despite the fresh stock of grass clippings there was no GDP. Yet if Bill were to mow his neighbour’s lawn, and his neighbour mow Bill’s lawn, and they paid each other for their services, then GDP would miraculously recognise this as economic activity even though nothing had changed.

GDP does nothing to measure the value or quality of the activity, just that “activity” has occurred, and that is a fundamentally flawed approach. In a business you don’t measure turnover alone, you put far more emphasis on profit and cashflow.

Another feature of Bill Bonner’s speech was inflation statistics. You can read my analysis on the official management of inflation statistics here, but his point was how they impact on the published GDP figures.

Lets examine this a little further. However carefully nominal GDP is totted up, it remains an estimate from seasonally adjusted and weighted data from samples, which is then reduced by the inflation figure to arrive at the published “real” GDP numbers. So if inflation is understated, then GDP is overstated, and vice-versa … and this can have an overwhelming impact.

Look at these numbers to see where we may actually be:

• Pre-recession peak GDP in Q1 2008 was £364 billion, and by Q4 2012 had risen to £388 billion, a compound increase of 1.3% pa.

• The “inflation adjusted data” shows that real GDP has actually dropped over the 5 years, a real drop of around 0.6% pa, or 3% over five years.

• Now do this as GDP per person, and we end up with a real drop of 1.3% pa.

• Now adjust to exclude those questionable “Government Services”, and we take the drop to 1.6% pa.

• Now assume that all the inflation adjustments of substituting, weighting and hedonics have understated inflation by just 1% pa, and we now have a GDP reduction of 2.6% pa, leaving real economic activity over 12% lower than 5 years ago, remarkably different to the 3% total fall.

So could inflation be 1% out? Well GDP isn’t adjusted by either CPI or RPI, but by the “GDP deflator”, a different measure of the prices of all new, domestically produced, final goods and services in the economy. Over the period the GDP deflator has averaged 2.2% pa compared to both CPI and RPI being around of 3.2% pa. Now that may well make sense, as the pound has fallen driving up the price of imported versus domestic goods (and thus CPI and RPI, but not the deflator), but given all the assumptions and adjustments that go into these figures we need to allow a decent margin for the errors and statistical interpretation that goes on, and the 1% distinction between the difference measures seems a reasonable place to start

So if over 5 years we can end up with such diverging possibilities, from a 3% drop to maybe a 12% drop, does this not demonstrate that playing with figures and persuading the country that all is good – or bad – based on miniscule adjustments of high-profile statistics really doesn’t deserve wasting so much of our attention? What is worse, these statistics risk greatly distorting our individual and collective economic behaviour as we jump between optimism, pessimism and uncertainty.

The ray of hope is that whatever the economists and politicians and media claim about the state of GDP, there is always business opportunity. The potential for businesses that run themselves for the long-term, reinvesting effectively in their own future, and focusing on delivering for their customers and all stakeholders is strong … in the short-term it may be affected by economic cycles, but we need to see through them with constructive plans and effective delivery.

Driving the nation’s real economic activity forward involves businesses taking risks. Taking a leaf out of the wisdom of a couple of centuries ago, Napoleon said ” … if one is not prepared to take risks when the time is ripe, one ends up doing nothing – and, of course, one should never take a risk without being sure that one will be lucky.”

So in my words, don’t just be lucky, make your own luck by planning for it!