Get to grips with the true value of GDP

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Gross domestic product - GDP - is taken by the general public and most economic commentators to be a synonym for the overall size of the economy. So, growth in GDP is a proxy for economic growth.

But so much attention is paid to GDP that this flawed calculation risks becoming a misleading 'magic number', quoted by the many but understood by the few.

GDP can be calculated by statisticians in one of at least two ways.

One is to add up all of the items of spending in an economy: consumption, investment, government spending, spending by overseas buyers on goods produced for export (minus spending on imports of course).

The alternate way of calculating it is to add up the income earned by anything and anyone (that's to say capital and labour) producing all of the goods and services in the economy. So this means wages and salaries, the income of the self-employed, rent, company profits and the surpluses generated by publicly-owned businesses. However, interest and dividends are not included, nor are welfare benefits. That's because these represent transfers from one part of the economy to another and therefore cancel out.

It's not surprising therefore, given the laborious process of arriving at a final number, that it's often incorrect.

Or, that's to say, it is frequently revised at a later date. Market commentators and traders alike therefore face a dilemma: do they comment on the original 'flash' number, knowing that it is almost certain to be revised either up or down, or do they wait for the definitive one.

This is one of the factors that limit the usefulness of GDP data for those who want to get at the truth of what is going on in an economy. Another problem is that even the 'flash'' GDP numbers are not exactly current by the time they are published. Data on UK GDP is published quarterly, but not until seven weeks after the end of the quarter.

In the US, GDP figures are also published quarterly, but then estimated over two successive months. The data is thus known as the 'advance estimate', 'preliminary estimate' and 'final estimate' - none of which sobriquets exactly conveys the precision with which observers are wont to ascribe to the data.

Read what Ken Fisher has to say on GDP in: The GDP change game and Don't be thrown off course by volatile GDP.

The other problem with GDP is not so much what the numbers include, but what they don't.

One big omission is any sort of work that is unpaid or any assets that are intangible. So if you pay a cook, cleaner, gardener, handyman or childminder it shows up in GDP, but if you or your partner do this work for free it doesn't. Similarly, transactions in second hand goods are excluded from GDP, as are transactions that take the form of any sort of barter or payment in kind.

One of the biggest problems with GDP numbers is that they exclude the 'black economy', or as statisticians coyly term them, 'unrecorded cash transactions'. One important issue with this is that it distorts comparisons between countries, since different countries have varying levels of 'black economy' involvement, the problem being greatest in those countries where tax levels are high or politicians seen as profligate and corrupt.

Despite what you might think, black economy levels among European countries are lowest in the UK, Germany and Switzerland. In the US, attempts have been made to adjust for black economy factors, which is clearly a problem in large states like California that have an acknowledged major issue with widespread employment of illegal immigrants outside of the mainstream economy.

The bottom line is that in GDP we have a statistic that is calculated with varying degrees of accuracy, doesn't include everything it might do, is published late and frequently revised. Nonetheless it is widely used as a proxy for economic size and growth. That makes it important in its own right. Occasionally there are debates about whether other data might stand in better for GDP and GDP growth, but none has so far been found.

The obvious answer is that it is in itself a mistake to rely on a single number for ones viewpoint on the whole economy. Other data, such as job creation, retail sales, advertising spending, and vehicle sales can also point us in the right direction.