Thursday, March 22, 2007

China The 2nd Richest Country In The World? An Explanation of GDP

Hardly a week passes by that we do not read articles in the newspapers, or hear on news broadcasts, the word "Gross Domestic Product" [GDP] when the subject is economic growth or comparison of living standards among countries. While statistics can be enlightening, statistics can also lie if you are not really clear about what GDP means and how it is calculated.

Here is an article abstracted from my weekly newsletter for , which attempts to illustrate what is, and what is NOT GDP and some of the problems associated with any attempt to compare GDP across countries.
A nation is like a corporation. Its production, income, and expenditure can be measured according to accounting principles, and a figure arrived at, that hopefully gives some information on the 'well-being' of the nation/corporation. This is the subject of National Accounts, and Gross Domestic Product is one of the measures in National Accounts. GDP measures the size of the U.S. Economy, and is the dollar value of all final goods and services produced in the USA during a certain period of time. Other countries also measure their GDP, and if we want to compare them with the U.S., we would need to convert their GDP figures to U.S. Dollars at the current exchange rate. However such comparisons are not totally valid since it does not take into account how much a similar basket of goods costs in each country. Therefore, another way that economists compare GDP internationally is in terms of Purchasing Power Parity where the cost of a similar basket of goods in both countries is used to calculate the exchange rate that should be used instead of the spot rate in the FOREX market. The PPP rate makes a big difference when GDPs of countries are compared. For example, China's GDP in US Dollars is $2.4 trillion, but in purchasing power parity dollars is $9.4 trillion because a 'typical' basket of goods cost much less in China.
GDP is by no means an infallible metric for measuring the wealth of a country [note that we use the word 'country' instead of 'nation' for reasons that will be clear as you read on] Indeed, it has many flaws. GDP per capita fails to reflect the distribution of income, since a small proportion of people with very high income can skew the average to be much higher. But GDP is still a useful indicator. For example, if you know that the US GDP is $12 trillion, and the next top country is Japan with $4 billion, with China, and Germany bunched up around the $2 trillion mark, then you have a better sense of the predominance of the U.S. economy. And that [2] despite 15 years of very slow growth, Japan is still second in the list, which shows you that accumulated wealth takes a long time to run down. On the other hand it also shows you how starting from scratch after the Second World War, Japan can grow to become the second largest world economy in a very short time, because wealth grows at a compounded rate. You would also be enlightened to know that [3] California has a State GDP of $1.2 trillion, and if it were a country, would rank 10th in the world. [4] Warren Buffett and Bill Gates if they were countries would have assets equivalent to the GDP of countries like Ecuador, Luxembourg, Oman or the Dominican Republic. Change in GDP [growth] is also important. If in comparing two countries, one with a growth in GDP of 2 %, and the other with a growth rate of 10 %, the 10 % country would very quickly catch up with the 2 % country because growth like interest on money is accumulative and compounded. That is how China surpassed France in GDP, growing at 10 % or more for the last decade while France grew by 2 %. But if you are starting from a very low base, all that heady growth besides meaning nothing much, will also lead to problems of inflation. Azerbaijan's growth rate was 34 % last year due to its oil industry, but its GDP still stands at $12.5 billion, though $12.5 billion can buy a lot more things in Azerbaijan than in the USA. The former Soviet States of Latvia, Estonia and Lithuania, since joining the European Union have enjoyed phenomenal rates of over 10 % growth in GDP resulting in inflation, a current account deficit equivalent to 25 % of GDP in the case of Latvia, and hotel room rates more expensive than in New York or London.
GDP is also different from GNP or Gross National Product, a concept less used by the US government, but important for small countries with large investments overseas. GDP measures production within the geographical boundary of the United States. GNP is the value of a country's goods and services not only within its geographical boundaries, but as a nation. It includes income from investment that its residents or government owns overseas, minus the income that it must pay to foreigners for the output of those factors of production owned by them. Thus GNP is a more useful measure for small rich countries like Singapore, Kuwait, Brunei and Switzerland whose government and citizens own significant productive assets [businesses] overseas.
Before we talk about the components of GDP, it is important to remember that GDP is counted at each stage of production only on the value- added part of it. This is to avoid double-counting. Double-counting seldom occurs in the accounts of a corporation, since expenditures and incomes are clearly defined. But when calculating the GDP at country level, double-counting can be a very real problem. This is because at the country level, in a closed loop, the income of somebody is the expenditure of another, and the input of one is the output of another. Thus although Wal-Mart's revenue is $300 billion, it contributes much less to the GDP figure because the value-added of the inputs that made the products, have been accounted for at each stage of their own production. This is also the same reason why Exports for a country can be more than 100 % of the GDP figure. There are certain principles laid down for the definition and calculation of final value-added by the agencies responsible for the national accounts for the avoidance of double-counting.
The Components of GDP
GDP = Consumption + Investment + Government Expenditure + Net Exports ( Exports-Imports]
Shortened to C + I + G + Net X
C is the same as G except that G is done by the government. In large economies with sizeable populations, e.g. the U.S and China, domestic demand via C is crucial to the economy. In the U.S.A., C accounts for 70 % of the Economy, and monitoring changes in the mood of Consumers becomes an obsession with the media. In tiny Singapore, on the other hand, with a population of 4 million and exports equivalent to 300 % of GDP, monitoring the situation in the big economies, and how it affects Singapore's exports is more important.
Investment is defined as investment by a business for the purpose of enabling it to operate, expand its business or otherwise contributing to the business capital. Investment in GDP does not include investments in financial products and papers contrary to the usual definition of Investment. In GDP, such paper investments are regarded merely as transfer in the deed or property of the productive asset. Thus the estimated $150 trillion that is the value of derivatives traded on U.S. Exchanges and over the counter is not included in GDP.
G is the sum of government spending and includes the salaries of public servants, the purchase of military equipment, the building of roads and bridges etc. Government expenditure can also be used a tool for economic management. In Keynesian economics, the role of the government was to use its expenditure as one of the tools for regulating the economy. If the government paid people to dig holes in the road and then fill them up again, it is G in the GDP.
Net X is the value of Exports minus the value of Imports. The value of Imports must be subtracted from the value of Exports because Imports are already included in C, G and I. The value of U.S. Exports is about $1 trillion, while the value of U.S. Imports is about $1.9 trillion.
* GDP can also be measured by the total income payable method where GDP is the sum paid to factors of production. Here GDP= Rents + Interest + Profits + Wages + Statistical Adjustments [corporate income taxes, dividends, undistributed corporate profits] But we won't go further into this suffice to say that the figures for GDP by the Expenditure method and the Income method should be the same.

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