The only industrial countries that adjust their GDP figures for the shadow economy are Italy and America and they may well underestimate its size.
World GDP
The Great Recession is receding, according to our measure of global GDP, based on data from 52 countries. World output fell by 1.2% in the year to the third quarter, around half the rate of decline recorded in the year to the second quarter. In most of the countries that have published third-quarter figures, GDP was lower than a year earlier. The exceptions were mostly in Asia: China and India recorded the fastest growth, followed by Indonesia. Only one European country, Poland, reported higher GDP in the third quarter than a year earlier. But some of the world’s most troubled economies are in eastern Europe. The three Baltic countries – Estonia, Latvia and Lithuania – suffered the biggest falls in GDP.
Output, expenditure and income
Output
The output measure of GDP is obtained by combining value added (value of production less cost of inputs) by all businesses: agriculture, mining, manufacturing and services. Output data are usually presented in index form (that is, with a base year such as 2005 = 100).
Sectors
In general countries have larger agricultural sectors in the early stages of economic development. The manufacturing sector’s share of output increases as the economy develops and services take the largest share of output in mature economies.
3.1 GDP per sector
Source: World Bank
Highly detailed data are often available. The production of tens or hundreds of goods and services industries may be recorded separately. For example, there will probably be an appropriate index in the GDP output breakdown to allow you to compare the performance of, say, a furniture manufacturing company with that of the industry as a whole. The industrialised countries generally publish more detailed (and more up-to-date) statistics than less developed countries.
Classifications
Economic information has to be categorised, but the correct classification is not always self-evident. For example, should the production of man-made fibres from petroleum be recorded under textiles (as they generally used to be) or chemicals (as they are now)?
Standards have been introduced to deal with these problems and provide consistency. Industrial production, retail trade, imports and exports are classified according to standard themes. Many countries now follow the United Nations’ international standard industrial classification (ISIC), while European countries tend to use the similar EU Nomenclature statistique des Activités économiques dans les Communautés Européennes (NACE). These are fairly detailed and they need revision from time to time.
For example, if the standard industrial classification (SIC), which was introduced in the UK in 1948, had not been revised several times, computer manufacturing would be classified under office equipment, which is part of non-electrical engineering.
When making sectoral comparisons between two or more countries, try to find out if the sectors are made up of the same industries, otherwise there may be inconsistencies in the comparison.
Expenditure
The expenditure measure of GDP is obtained by adding up all spending:
Government consumption
The level of government spending reflects the role of the state. Government consumption is generally 10–20% of GDP, although it is higher in countries such as Denmark and Sweden where the state provides many services. Changes in government spending tend to reflect political decisions rather than market forces.
Private consumption
This is also called personal consumption or consumer expenditure. It is generally the largest individual category of spending (but see exports, page 36). In the industrialised countries consumption is around 60% of GDP. The ratio is higher in poor countries which invest less and consume more.
Investment
Investment is perhaps the key structural component of spending since it lays down the basis for future production. It covers spending on factories, machinery, equipment, dwellings and inventories of raw materials and other items. Investment averages about 20% of GDP in the industrialised countries (see Chart 3.2), but is over 30% of GDP in East Asian countries, and over 40% in China.
3.2 Domestic spending
Note: Negative net trade as % of GDP indicates that the country is a net importer.
Source: World Bank
Consumption or investment?
There are some anomalies in the identification of consumption and investment. Government spending on roads, defence and education is generally scored as consumption rather than investment. Consumer spending on cars and other durable goods (items with a life of over one year) is considered to be consumption. Capital goods purchased by a financial institution and leased to an industrial company are also usually classified as consumption. Thus consumption tends to be overstated and investment under-recorded.
Total domestic expenditure (TDE)
Consumption plus investment is known as total domestic expenditure. This is a useful concept because it measures domestic spending, some of which goes on imported goods and services. It under-records sales because it does not include those goods and services sold abroad (exports).
Total final expenditure/output (TFE/TFO)
Consumption and investment plus exports of goods and services is known as total final expenditure. This takes account of the fact that some consumer and investment goods and services are purchased by foreigners.
Another way of looking at this is as total final output: the value of home-produced and imported goods and services available for consumption, investment or export.
TFE and TFO are identical in coverage. The difference is in the terminology, which depends on whether the emphasis is on output or spending. Since some expenditure goes on goods and services originating overseas, TFE/TFO has to be reduced by the amount of imports of goods and services to give total output.
Exports and imports
Exports generate foreign currency income, while imports are a leakage of domestic spending into another country’s production. These external transactions can have an important effect on GDP.
Some countries have a low dependence on external trade. American imports are about 17% of GDP and exports over 11%. Other countries, especially those on the Pacific rim, are heavily dependent on external flows. Hong Kong and Singapore, both trading economies, have imports and exports each of which are around 200% of GDP (many imports are re-exported). These are open economies, while America and Japan are relatively closed (see Chart 3.3). Open economies have greater opportunity for export-led growth but are also more vulnerable to external shocks.
3.3 Trade in goods and services
Source: World Bank
Income
The income measure of GDP is based on total incomes from production. It is essentially the total of:
wages and salaries of employees;
income from self-employment;
trading profits of companies;
trading surpluses of government corporations and enterprises; and
income from rents.
These are known as factor incomes. GDP does not include transfer payments such as interest and dividends, pensions, or other social security benefits. The breakdown of incomes sheds additional light on economic behaviour because it is the counterpart to expenditure in what economists call the circular flow of money. It also provides a useful basis for forecasting inflation.
Accounting conventions
Incomes data are collected from figures which are based on common accounting conventions, rather than the principles of national accounting. One result is that reported company profits include any increase or decrease in the value of inventories. A value (as opposed to a volume) change does not represent any real economic activity, so this stock appreciation is deducted from total domestic income to arrive at GDP. Britain’s Office for National Statistics uses a definition of profits that excludes the change in the value of stocks, so no stock-appreciation a
djustment is shown in national accounts.
Discrepancies
In a perfect world, the output, expenditure and income measures would be identical. In practice there are discrepancies owing to inevitable shortcomings in data collection, differences in the reported timing of transactions and the shadow economy. The discrepancy between any pair of measures is typically up to 1–2% of GDP. It can be much larger than this, as it was in many countries in the mid-1970s when data collection was complicated by sharp oil price increases and rapid inflation.
Since output, expenditure and income data are, by and large, collected independently, the safest approach is to take the average of the three as indicative of overall economic trends. Not many governments, however, publish such averages and it may not be practical to calculate them. Consequently it is usually necessary to focus on one.
The output measure is usually the most reliable indicator of short-term developments (that is, up to one year) as the survey data are fairly concrete. For longer periods the expenditure measure is probably better, mainly because the weights used to aggregate the output indicators are updated at infrequent intervals and they become out of date. The income measure is usually the last available and least reliable.
Prices
Market prices, factor cost and basic prices
Many transactions are subject to taxes and subsidies. Sales tax or value-added tax (VAT) and subsidised housing are obvious examples. The expenditure measure of GDP records market prices, which includes these taxes and subsidies. The income and output measures are generally reported at factor cost (that is, they exclude taxes and subsidies). The relationship is simple:
The factor cost adjustment
The factor cost adjustment (the net total of taxes and subsidies) enables the income, expenditure and output measures to be converted freely between factor cost and market prices. This allows consistent comparisons and highlights the effect of government intervention.
Basic prices
Britain’s official statisticians now call the basic output measure of GDP “gross value added (GVA) at basic prices”. This includes subsidies and excludes taxes (such as VAT) on products only. GVA or GDP at factor cost also excludes taxes on production, such as business property taxes. The statisticians consider GVA at basic prices to be a better measure of short-term movements in the economy than the old factor-cost measure.
National conventions
Americans tend to measure economic activity at market prices right through to the net national product stage. They then adjust for taxes and subsidies to reach national income at factor cost. Thus a reference to American GDP probably means GDP at market prices. In Britain, the “headline” measure of GDP is at market prices. However, GVA at basic prices is also reported. The only way to be sure is to check the basis of the figures in question.
Current and constant prices
GDP figures are reported in current and constant prices.
Output data are generally collected in both current and constant prices. The constant price figures for each industry are obtained by valuing current output in the prices applicable in a given base year; say, 2000 or 2005.
Expenditure data are mostly collected in current prices. They are converted into constant prices by the same adjustment process used with output data, or – slightly differently – by deflating each component by an estimated price indicator. Once the current and constant price versions of the expenditure measure are available, they are used to calculate an overall deflator (that is, the price index) which is used with the income measure.
Income data are collected in current prices and converted into constant prices using deflators derived from the expenditure measure.
The deflator
The GDP deflator calculated from expenditure data at factor cost is also known as the implicit price deflator. This is a handy measure of economy-wide inflation trends, but it is affected by changes in the composition of GDP (see page 226).
Adjusting for inflation is less reliable at times when prices are changing rapidly. Small errors in the measurements of current values and prices can combine to create large errors in the constant price series. Make it a rule to question the accuracy of price deflators. For example, 12% nominal GDP growth with inflation of 10% results in approximately 2% real growth in GDP. If inflation is actually slightly higher, at 11%, real GDP growth is halved to a mere 1%.
Putting it in context
Population
The notes on omissions (pages 30–32) suggest that output figures are a dubious guide to the quality of life. Nevertheless, total output per head (that is, GDP divided by the size of the population) is used as a broad indicator of living standards. A rise in real GDP that is greater than any increase in population is taken to indicate an improvement in economic well-being. However, if, for example, real GDP increases by 3% while the population expands by 5%, the economy is “worse off” (that is, real GDP per head has declined).
Purchasing power
Output per head in current prices is a useful guide to levels of economic activity when making snapshot comparisons between countries. Since it is necessary, however, to convert the figures into a common currency, the underlying message can be distorted by exchange-rate effects.
The best solution is to use output per head on a purchasing power parity (PPP) basis, which adjusts for national variations in the prices paid for goods and services. This is not easy to calculate accurately, but some intergovernmental agencies such as the World Bank, IMF and OECD produce estimates. Their figures show, for example, that although Finland’s GDP per head is higher than that of Canada if converted into dollars at current exchange rates, after adjusting for variations in prices the spending power of the Finnish is below that of Canadians (see Table 4.2).
Employment
Another way of measuring relative activity is with output per person employed. This is an important measure of productivity which is discussed extensively in Chapter 4.
Reliability
Some problems of obtaining information by surveys and samples are outlined above. In addition, the rush to publish information often means that figures are revised several times as new information comes to hand, perhaps causing major changes in interpretation. For example, industrial production figures may be based initially on sales and output data and adjusted later to take account of changes in inventories not caught in the sales figures.
Statisticians go to great lengths to account for these and other problems. The techniques employed are reasonably reliable, at least in the more developed countries. It is important to remember, however, that published figures for GDP, average earnings, prices, and so on are only estimates.
Moreover, the basis on which some figures are calculated by less scrupulous governments does not stand up to close examination. Consumer-price indices are particularly vulnerable. They may include only selected subsidised goods and services and omit those which increase in price too rapidly.
Chapter 4
Growth: trends and cycles
When your neighbour loses his job, it’s a slowdown; when you lose your job, it’s a recession; when an economist loses his job, it’s a depression.
Anon
Chapter 3 focused on national income as a snapshot of economic activity. This chapter considers the changes in economic activity over time. The introduction outlines the basic issues which affect growth. The GDP briefs explain how to interpret indicators of overall activity. The productivity brief shows how employment and investment lay down the basis for long-term growth. Finally the brief on cyclical indicators indicates the way that many economic series fluctuate around the trend.
Trends and cycles
Economic developments should be judged in the context of trends and cycles.
Trends.
The trend is the long-term rate of economic expansion. The industrial economies have enjoyed a growth trend for decades or even centuries. Since the second world war the volume of goods and services that they
produce has grown by 3–4% a year in general. Chart 4.1 shows the 1990–2009 trend for the American economy.
4.1 US trends and cycles
Source: US Bureau of Economic Analysis
Cycles
The cycle reflects short-term fluctuations around the trend. There are always a few months or years when growth is above trend, followed by a period when the economy contracts or grows below trend (see Chart 4.1).
Sources of growth
Long-term growth
In the long term the growth in economic output depends on the number of people working and output per worker (productivity).
Clearly there are limits to changes in the size of the population and the number of people in employment. But only an extreme pessimist can see an end to long-term productivity improvements. Output per worker grows through technical progress and investment in new plant, machinery and equipment. Investment and productivity are therefore the basis for continued and sustained economic expansion.
The Productivity brief (page 52) quantifies the relationship between employment, investment and growth. It is important to distinguish between economic growth, which may reflect nothing more than an expanding population, and overall economic welfare which, if measured by the volume of goods and services produced per person, improves only if output grows faster than the population.
See GDP and GDP per head, pages 43–52.
Short-term cycles
The brief on Cyclical indicators (page 55) explains the way that economic growth fluctuates around the trend. The brief is important because it lays the basis for interpreting many economic indicators. For example, a downturn in housing starts or an increase in inventories may signal a recession perhaps 12 months hence.
The circular flow of incomes
Firms and households are the backbone of an economy. Firms employ people to make goods and provide services. This gives households their incomes. Household spending provides the rationale for the existence of firms. Thus the circular flow continues; in short, output = income = expenditure.
Guide to Economic Indicators Page 4
