Many readers of The Agenda were vexed when I argued that it was no surprise that ARRA led to an uptick in GDP. But I wasn’t arguing that ARRA was thus a good idea — far from it, as I believe that we need stable monetary and fiscal policies and ARRA represented a continuation of the extreme macroeconomic policy swings that have defined the Greenspan-Bernanke era. Rather, I was suggesting that economic policy shouldn’t focus exclusively on “GDP management.” Better than we improve the environment for long-term job and wage growth. That could mean a slightly lower GDP now and a slightly higher GDP in the future.

It helps to understand that, as David Henderson has argued, GDP has serious limitations for understanding the shape of the economy, in no small part because of the way that public spending is counted. Henderson writes:

One of the most careful definitions is in The Economic Way of Thinking, 10th edition, by Paul Heyne, Peter Boettke, and David Prychitko. They write: “The gross domestic product is the market value of all the final goods produced in the entire country in the course of a year.”1 Most economists would agree with this definition. It turns out, though, as Heyne et al. point out, that even this careful definition does not accurately characterize GDP, let alone wellbeing. It is inaccurate in two ways. First, because there is usually no market for the things that government produces (the U.S. Postal Service being one of the exceptions), government spending on goods and services is valued at cost rather than at market prices. Second, because many goods and services are not bought or sold, even though they would have a market value if they were, these goods and services are not counted in GDP. In early editions of his best-selling textbook, Economics, the late Paul Samuelson gave his favorite example of this pitfall in GDP accounting. Samuelson pointed out that if a man married his maid, then, all else equal, GDP would fall.
These two inaccuracies in themselves mean that actual GDP is not a good measure of wellbeing. Take the first inaccuracy—the valuing of government-provided goods and services at cost rather than at market prices. Many government programs actually destroy value rather than create it.

This quirk of GDP — the fact that we don’t use mark-to-market accounting to evaluate the value of public spending — matters more as public spending increases as a share of GDP. Let’s make the reasonable assumption that northern European democracies do a better job of running certain public services than we do, i.e., they destroy less value than our public services. This would, as Will Wilkinson has argued, make the U.S. look better than it should relative to some of the social democracies. We could work to improve the effectiveness of our public services, and we should. But my point is that GDP proves to be a very unreliable guide here. If anything, a heavy emphasis on GDP might actually prove highly misleading.

Keith Hennessey has written a short essay defending the use of GDP for measuring living standards, and I understand his reasoning. It’s a heck of a lot better than vague, contested “happiness” measures, as Hennessey suggests.

Mr Oswald argues that we should measure well-being and include both subjective surveys and sustainability as components of that measurement. I have no quarrel with measuring well-being, but there is no reason to foul up a useful statistic in doing so. GDP is but one indicator that policymakers can and should use to analyse the economic health of a nation, and it is foolish either to use it for a purpose for which it was not intended, or to attempt to change it to suit one’s policy goals. A doctor who monitors only a patient’s pulse is not doing his job, but one who argues we should ask the patient how he feels and call that his “pulse” is outright dangerous.
A patient’s pulse is useful in part because it is an easily measurable and objective metric that is comparable over time and across patients. GDP is quantifiable—it is simply an accounting measure. GDP is objective—we can rely on the data even when personnel in the statistics office change or the party in power flips. GDP is, within limits, roughly comparable across nations and over time, allowing us to make imperfect but still useful policy comparisons and judgments. And since wealthier societies generally devote some of their increased resources to improving non-market attributes like clean air and water, GDP is only partially incomplete as a measure of the non-tradable aspects of improved living standards.

But as a cautionary note, GDP is more useful for long-term comparisons than short-term comparisons. Year-to-year or, for that matter, quarter-to-quarter, GDP can prove highly misleading as it takes us a long time to understand how living standards really change at the ground level — how should we value various consumer innovations, etc.

It is, however, the best we can. My main hope is that we can do a better job of determining whether or not public spending is creating value or destroying it. Henderson strikes the right note in his conclusion:

If, instead of seeking GDP, we ask of each government policy, “What will it cost and how much value will it create?” we will come up with better policies. The concept of GDP, handled carefully, can be useful. But for many people, and even many good economists, GDP has been used to judge wellbeing even when using it that way leads to highly misleading conclusions.

Unfortunately, the GDP framework is the only conceptual tool most of us have for understanding the economy.