# How Is GDP Calculated?

Updated on

#### How Is GDP Calculated?

GDP: A Brief But Affectionate History
By John Mauldin | Jul 20, 2014

“Measurement theory shows that strong assumptions are required for certain statistics to provide meaningful information about reality. Measurement theory encourages people to think about the meaning of their data. It encourages critical assessment of the assumptions behind the analysis.

“In ‘pure’ science, we can form a better, more coherent, and objective picture of the world, based on the information measurement provides. The information allows us to create models of (parts of) the world and formulate laws and theorems. We must then determine (again) by measuring whether these models, hypotheses, theorems, and laws are a valid representation of the world.”

“In science, the term observer effect refers to changes that the act of observation will make on a phenomenon being observed. This is often the result of instruments that, by necessity, alter the state of what they measure in some manner.

“It was, perhaps, the most unusual episode in the long running duel between the two giants of twentieth century economic thought. During World War Two, John Maynard Keynes and Friedrich Hayek spent all night together, alone, on the roof of the chapel of King’s College, Cambridge. Their task was to gaze at the skies and watch for German bombers aiming to pour incendiary bombs upon the picturesque small cities of England….

“Night after night the faculty and students of King’s, armed with shovels, took it in turns to man the roof of the ornate Gothic chapel, whose foundation stone was laid by Henry VI in 1441. The fire watchmen of St. Paul’s Cathedral in London had discovered that there was no recourse against an exploding bomb, but if an incendiary could be tipped over the edge of the parapet before it set fire to the roof, damage could be kept to a minimum. And so Keynes, just short of sixty years old, and Hayek, aged forty-one, sat and waited for the impending German onslaught, their shovels propped against the limestone balustrade. They were joined by a common fear that they would not emerge brave nor nimble enough to save their venerable stone charge.”

– Nicholas Wapshot in Keynes Hayek: The Clash That Defined Modern Economics

The problem we have today in economics is that many people, and not a few economists, seem to regard economics as “pure science,” as described above by Gauri Shankar Shrestha. If you delve deep into measurement theory, you find that all too often the way in which you measure something determines the results obtained from your experimental model. How you measure the effectiveness of a drug can sometimes determine whether it gets approved – apart from whether it actually does any good. The FDA actually works rather hard at measurement theory.

And if you’re using models, as we do in economics, to determine policies that govern nations, your efforts can result in economic misdirection that seems for a time to work but that all too often can lead to a disastrous Endgame. A short-sighted economic policy is not unlike a drug that makes one feel good for a period of time but ultimately leads to further weakness or collapse.

In this week’s letter we look at the construction of gross domestic product (GDP). As we will see, GDP is a relatively late-to-the-party statistic, thoroughly malleable in its construction and often quite contentious in its application. Yet the mainstream media regularly releases GDP numbers with the implicit assumption that they are in fact an accurate reflection of the general economy. We shall soon see that GDP is instead a fuzzy reflection of the economy, derived from a model that is continually readjusted in a well-intentioned effort to understand the scope of the economy.

GDP is one economic model among several that could serve the purpose, but its use conveniently leads to policies that reflect the thinking of a particular school of economic monetary and fiscal policy advocates.

We all know that in operating a business we need to be able to measure the profits of our company and then adjust our prices and production to make sure that there are enough profits to adequately fund the company. That is a relatively straightforward process, since the amount of money in the bank at the end of the month is a real number.

#### How GDP Is Calculated? Hayek Versus Keynes

When most people see the release of the GDP number, they equate the precision of that statistic with the bottom right-hand number in their bank accounts. And news anchors and journalists rarely acknowledge the rather significant caveats that the Bureau of Labor Statistics publishes along with that data.

What we are going to find is that developing the concept of gross domestic product was more than a dry economic and accounting undertaking. At its very core, GDP is John Keynes versus Friedrich Hayek writ large. And their debate explains a great deal of the current tension between those who would make final consumption – or what we call consumer spending – the be-all and end-all of economic policy, and those who feel that productivity and income should instead be the focus. The very act of measuring GDP as we do gives the high and easy intellectual ground to those of the Keynesian persuasion.

Let me hasten to note that I have no problem with the concept or the calculation of GDP in general. It is absolutely a number that we need to have in order to understand the workings of a part of the economy. But it is just one tool in the economic toolbox. If the only tool you use to affect (determine, guide – choose your word) economic growth and the creation of jobs is the hammer of GDP, the world ends up being a very strange-looking, rather deformed nail, bent time and time again by the imprecise blows of those wielding the hammer.

GDP is an important concept, perhaps one of the more important that we have looked at in quite a few years. I urge you not to roll your eyes at the attempt to understand yet another dry economic statistic, but instead to look deeply at how the attempt to measure GDP affects everything in our lives.

But before we jump deeper into our topic, let me call your attention to a Mauldin Circle Member Exclusive. We have now made the Newt Gingrich and Niall Ferguson Strategic Investment Conference videos available. Two weeks ago we made select presentations from the Strategic Investment Conference, including those of Kyle Bass and David Rosenberg, available to Mauldin Circle members. This week, we are happy to provide even more material from this incredibly informative event. Newt Gingrich and Niall Ferguson were the two highest rated presenters at a conference packed with some of the finest economic and investment minds in the world. Both Newt’s insights into the opportunities offered by the remarkable technological evolution underway (and the roadblocks to progress thrown up by our bureaucracies) and Niall’s analysis of the monetary and geopolitical “tapering” currently in progress are well worth a watch.

You can access both videos, absolutely free, just by becoming a Mauldin Circle member. In addition to these select videos, you’ll get access to summaries and presentations of many more speakers from the conference. In order to join, you must be an accredited investor. Register here to be qualified by my partners at Altegris and added to the subscriber roster. Once you register, an Altegris representative will call you to provide access to the videos, presentations, and summaries from selected speakers at our 2014 conference.

If you are already a Mauldin Circle member, simply log in to the “members only” area of the Altegris website at http://www.altegris.com. Click on the “SIC 2014” link in the upper left corner to view the videos and more. If you have forgotten your login information, simply click “Forgot Login?” and your information will be sent to you. And now back to our letter.

GDP: A Brief But Affectionate History

The title of this week’s letter is taken from the title of a recent book by Diane Coyle. (For economic wonks, she writes an interesting blog at http://www.enlightenmenteconomics.com.)

GDP: A Brief But Affectionate History is a fascinating 140-page book that I cannot recommend highly enough. This is simply the best book on GDP that I’ve ever seen. You can read it on a few hours’ plane ride or a lazy Sunday afternoon. And Ms. Coyle actually makes a relatively dry subject interesting and at times a page-turner. She has a true gift. (Now that she has conquered the GDP mountain, might I suggest she move on to CPI?)

Ms. Coyle starts with the predecessors to Adam Smith and takes us through the 17thcentury right up until today with the development of GDP, so we see the ebb and flow of ideas through time. Who knew the early developers of the model did not want to include defense spending, as they saw it as a wasteful, nonproductive activity? Or that Adam Smith thought