Section 1: What is GDP?
GDP is really a basic measure of national economic output. What we're really concerned with if we talk just casually—you know, you and I, we kind of ask: Well, gee, how much money do you make, or whatever? And the idea there is, that gives you some idea of what kind of consumption you can anticipate enjoying over whatever the salary period is. So you know if you make a hundred dollars a year, you're doing better than somebody that's making ten dollars a year. The issue is, how do you do that for the country as a whole? It's not okay to just add up everybody's income, although that is one possible approach. A problem with the nation as a whole is one of double-counting…. When we think about the total amount of stuff that an economy makes, both goods and services, you really don't want to count the tires that go into the car and then the finished automobile itself because that would be double-counting the tires. And so what we do is look at final demand, final goods and services sold. We classify these in four dimensions: consumption, investment, government spending and net exports. We don't have to use those classifications, but it's been convenient and it's worked out fairly well and it's pretty broad in its scope. So that's been adopted across all nations, and the nice thing about this is that if you think about cross-national comparisons, you do get a pretty good feel for how different economies are doing.
We realize that GDP has a lot of shortcomings in terms of its measurement of how well an economy is doing. It doesn't consider things like quality-of-life issues. There's no measurement of, for example, negative externalities like pollution, or lifespan issues, or anything like that. And so if you wanted to make the argument that it's not a perfect measure of economic well-being—well, no, it's not. That's kind of not the point. The point is that it's a pretty good gross measure of how an economy is doing. And, in my opinion, a much more important measure is that from one period to the next, it gives you a pretty good indication of how an economy is performing. We might want to argue about whether or not the actual level of GDP is particularly meaningful in any sense. But we do know that if it has grown 4 percent from one period to the next, we're better off than if it had shrunk 4 percent one period to the next. And those sort of comparisons that allow you to judge current economic performance are really important and work really well across countries as well.
Of course, we have to distinguish between nominal and real gross domestic product. The nominal is just adding up all final sales. So you know you have this car that costs $30,000, and you sell 10 of them, and so that's $300,000 in nominal real GDP. The problem is that if you have … inflation, any kind of nonstable prices for the economy as a whole, it can be very misleading to look purely at nominal levels.… Right now, prices are relatively stable. They're growing by some measures at around 2 percent. But that's 2 percent that's occurring just because prices are going up and not because there's actually more stuff being produced. And what we actually care about is the stuff being produced behind this, and that's why we talk about real GDP.
Now, there are an awful lot of different ways to, as we say, deflate nominal GDP to get to the real measures, and there are a lot of different arguments for and against all the different techniques. But the fundamental idea is that you're really concerned about how much more stuff is being produced this period than last. And it's the real quantities, it's the real number of toasters that we care about, not necessarily their price. Of course, there are all kinds of problems associated with this, that if you have a toaster today, it probably is much more reliable and may even do more stuff than toasters did 30 years ago. And then the question is, well, you're paying more for it, but you're getting more for it, too. And so the issue of how you deflate that is tricky and subject to an awful lot of debate. But that shouldn't let us lose sight of the fact that this is fundamentally a pretty good measure. Yeah, you can quibble about things at the margin, but that really sort of misses the point that we do have pretty good comparisons from one period to the next, and watching those numbers move around is really important.
Section 2: Measuring GDP
One way that we calculate GDP is by looking at sources of expenditure—you know, what are people buying? This gives us a standard GDP identity of consumption plus investment plus government spending plus net exports. Consumption is fairly straightforward—it's the largest component in the U.S. It's about 70 percent of our overall economy. That's just the stuff we buy, goods and services. We are becoming a more and more service-oriented economy, but that's not because we are buying less goods. It's just because our income level now on a per capita basis is high enough that a lot of us already have all the toasters that we want…. Now we are buying medical care or dentistry or meals outside the home or some services that we couldn't afford before. And so a transition towards a more service-based economy is not really a bad thing, particularly for high-income countries. It's just a sign of growing income.
On the investment side, this is the stuff that lasts a long time that is not directly consumed by individuals. So real estate is a big component. Software and equipment on the business side is also a major component. This is stuff that lasts a long time, that firms or, in case of housing, individuals make that represents long-term kind of investments. We're really concerned about this in a deep sense because particularly on the business side, it's investment that gives us our productivity, that allows us to enjoy the standards of living that we have.
In government spending, we really only count government consumption of goods and services. So even though the federal government has a much larger budget than state and local governments, state and local governments are actually a larger direct contributor to GDP than the federal government, just because states and local governments employ the teachers and the bus drivers and build the sewers and build the airports. A lot of that is done by the federal government, but a lot of federal spending is in transfer payments, some of which supports other components in GDP. But at the federal level, they're not generally directly consuming stuff unless it's military or infrastructure or employment directly in federal agencies.
The final thing we look at is exports and this gets a little bit—well, interesting. I wouldn't say it's all that tricky. In a conceptual sense, it's straightforward. The rest of the world buys stuff from us. Those are exports, and those are final demand. It doesn't really matter whether the person buying the carton of milk is from your neighborhood or from Europe—it's still being taken out of the grocery store and being purchased. On the other hand, we import stuff, too. And that adds to our consumption, but it's not stuff that's made directly here. So we want to net those two numbers, and that gives us sort of the net consequence to our economy of interacting with the rest of the world.
Section 3: Per capita GDP
In the U.S., per capita GDP, which is the amount of stuff we produce, divided by the number of people is relatively high. We look around at some countries, notably China, where GDP is growing rapidly; it's now the second largest in the world. It's very easy to be misled by really what that means…. When we think about the history of the world, Stephen Roach said this (he's now at Yale): for most of the world's history, three-quarters of the world's GDP was in China and India. And that's because three-quarters of the world's people were in China and India. And if everybody is working at more or less subsistence levels, then everybody's per capita output is going to be more or less the same. And so wherever you have the most people, you're going to have the most GDP.
As industrialization started to occur and productivity started to grow, what happened was various economies grew faster than others, in terms of their individual productivity. As time went on, some economies became relatively rich. And when we think about rich economies, it is on a per capita basis; it's not on an aggregate basis. We think of, I don't know, say , Norway, or a lot of the industrialized European nations as being fairly well off, even though if you just looked at their GDP it's tiny.
On the other hand, they're relatively wealthy because they don't have as many people, and so it's a matter of divvying up the GDP amongst a smaller population. And so we do want to keep very close track of per capita measures of GDP growth as sort of a better measure of economic welfare than just the aggregate amount of stuff that's produced in any one economy because that can be wildly misleading, depending upon populations.
Section 4: The business cycle
Another concept related to measurement of economic performance is the business cycle—the process of expansions and contractions that the economy goes through. We tend to think of these things in purely cyclical terms. I mean, that's how I came to thinking about this, and going in to studying economics. And that just isn't true. The economy does tend to grow over time—that is why we have a higher standard of living now than we had 20 years ago. We are continuously or more or less continuously going forward. There are cases when the economic process and the coordination that is occurring in the economy gets disrupted and the economy contracts. Those are called recessions.
But the issue of what causes business cycles is an issue of enormous importance in macroeconomic theory. Long ago, it started out as almost a theory of waves, where there was this inevitable cycle of seven or 10 years. By and large, that's been discredited, and now the issue is just kind of coordination mistakes … both in terms of the private sector and in terms of policy. Not everyone gets everything right all the time, and problems inevitably will occur. What you want to try and do is get the downturns to be relatively mild.
If you look at a hundred years before the founding of the Fed and you look at the last hundred years where the Fed was in existence, the U.S. has been in recession about half as often as it was prior to the founding of the central bank. Then the question is, well, gee, is that because there was a central bank? Well, maybe—or maybe we just all got better at coordinating our actions with one another. One of the problems with economics is you don't get to do experiments. You can't just poke the economy here and see what happens, because if you get a bad outcome, people get really upset. That's understandable. You can't play around with this stuff.
But as we look over the course of history, the cycles have been getting in general less severe and less frequent than they have before now. Who gets blame or credit for that is not all together clear and subject to an awful lot of debate. But the issue of cyclicality in the economy is something that's going to be with us for a long time.