Measuring the GDP is difficult; is it even worth coming up with the number? Image: Flickr / michaelreuter / CC-BY

The Gross Domestic Product forecast in the United States has recently been downgraded. In many news reports, the GDP is seen as the biggest indicator for how well the economy is doing. However, the GDP is an outdated and inaccurate way of measuring economic growth.

The basics of GDP

The Gross Domestic Product is a single number that encompasses the entire value of goods and services produced in one country. GDP began as a measurement of the standard of living in various countries, but it is used in several other ways. Gross Domestic Product is usually figured by adding up private consumption, gross investment, government spending and exports (minus the gross amount imported). GDP was first calculated in 1934 for a report given to Congress by economist Simon Kuznets. The Federal Reserve bases many of its monetary decisions, at least partially, on the GDP figure.

Inflation, consumer price and the GDP measure

Since it was first created, the measure of Gross Domestic Product has had limitations. The Bureau of Economic Analysis releases a number referred to as “real” GDP that adjusts the number for inflation. Without that adjustment, the GDP would always appear to be growing with the rate of inflation. The Consumer Price Index, which is a measure of the inflation or deflation of the cost of most household goods, also has no effect on the GDP. So if the cost of household goods goes up by 400 percent, it is seen as a growth of the GDP, despite the fact that the average American has less disposable income.

Why the GDP is like a credit card

The biggest limitation of the GDP measure is that it does not take into account any negative numbers. To translate the GDP in terms of a household budget, it would be as if you measured the health of your household finances based on how much money you spent — both in cash and on your credit cards. The repayment on those cards that would eventually come due, the damage to your budget and the possibility you wouldn’t make your mortgage payment are all left on the cutting room floor. Measuring the economic growth of the United States — or any country — based solely on GDP is too simplistic to be accurate.

Sources

The Money Alert
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Investopedia

It was designed to break your heart. And its falling value has an impact on all our lives. (Photo: flickr.com)

Under both the Bush and Obama administrations, U.S. government spending – financed by government borrowing – has skyrocketed, resulting in a prolonged decline of the value of the dollar. This trend escalated with the Federal Reserve’s reaction to the 2008 subprime mortgage crisis and the dramatic drop in interest rates. Today, with interest rates still low and government borrowing still rising, the dollar continues its steady decline. Recently the dollar has reached new all time lows against the Euro and other major currencies resulting in a lot of concern about the dollar’s viability internationally. It has even been argued in some quarters that the United States may have its national credit rating lowered.

Does it Really Matter to Most Americans?

Economic optimists point out that most Americans do not travel abroad for significant periods of time, meaning that currency conversion rates do not matter to them. They also argue that a weak dollar helps the economy by stimulating American exports. Both of these arguments are valid, but they fail to take into account the ways that a declining dollar does affect the domestic economy. While your average American may not have to worry about converting his cash into euros, your average American does buy a lot of imported goods and though the weak dollar does help exports, exports constitute less than 15 percent of the Gross Domestic Product (GDP), so only a few benefit.

The Weak Dollar and the Cost of Imports

Goods that are imported into the United States, even if the trade is denominated in dollars, are directly affected by the value of the dollar. The weaker the dollar is, the less value it has abroad, so those countries exporting to the United States have to increase the price to compensate for this. Among the most vital of these imports is oil, upon which the United States is largely dependent. A weaker dollar means that oil and all of its derivatives increase in price. The same can be said for all imported goods, from clothing and textiles to components in ostensibly “American-made” products. The lower the dollar, the more expensive all imported goods are to the average American consumer.

Dollar Value and Foreign Investment

The United States has been heavily reliant on foreign investment for decades now. Foreign investment in government debt is what keeps the federal government solvent. Similarly, foreign investment in our financial system – banks, major corporations, securities markets – is also essential to keeping the economy sound and money circulating through the system. However, since virtually all of these investments are denominated in dollars, a declining dollar discourages foreign investment. Since the U.S. requires this foreign investment, the logical answer is to make American investments more attractive by increasing the interest rates, but this significantly hurts domestic debtors.

Yes, the Declining Value of the Dollar Does Matter

Although most Americans do not have to worry about directly converting their dollars to foreign currencies, virtually all Americans do have to deal with the increased price of imported goods, from gasoline to running shoes. The point that the weak dollar helps American exports is also valid, but the export sector amounts to less than 15 percent of the economy, whereas the more expensive imports affect virtually all Americans. Further, since the government and financial industry have to encourage continued foreign investment, it means that interest rates are likely to increase, putting increased pressure on domestic debtors, from mortgage holders to people with large credit card bills.

Is There Anything You Can Do About This?

The factors behind the declining dollar are macroeconomic in nature and the key player, the Federal Reserve, is not directly accountable to the public. Those with large investment portfolios may want to consider diversifying some of their holdings into assets denominated in other currencies to serve as a hedge, but this is only an option for a minority of Americans. There may also be some value in investing your retirement and savings in international mutual funds, those based on foreign assets. Otherwise, there are few options available to your average American. Nevertheless, it is important to understand that the declining dollar does directly impact you.

One of the challenges at the beginning of any economic recovery is reading mixed indicators. One sector of the economy will perk up while another sector takes a downturn. Moreover, most areas of the economy remain stagnant. The average consumer is confused, and investors are reluctant to part with their liquidity.

Last week the jobless rate was reported higher than expected. This week a stronger than expected forecast was given for Gross Domestic Product.  This is confusing for the average person. If we are laying off workers, who is making all the new products?

One Step Forward, Two Steps Back

Another troublesome aspect to a recovering economy is false start indicators.  Sometimes the public, financial sectors and the government are so anxious for the recovery to start they report information too quickly and tout it as a sure sign of better days to come.

For example, indicators in the housing market are watched very closely.  A small rise in new home starts or existing home sales gets a lot of press and attention. However, the next month when the numbers come out these indicators might be lower than they were before. Not only did the growth stop, but the industry actually went backwards.  This oscillating effect makes consumers more likely to wait to make a big move and banks less likely to open up credit access.  Banks still look at the value of homes as a threat because we are not sure exactly where the bottom will be. Most economists and analysts agree that the fall is slowing.

Money In, Money Out

With the economy slow to recover, the federal government has seen fit to drop or at least hold interest rates low. This should be a good thing for borrowers and stimulate some spending and investing. So why hasn’t it worked yet?  There are several factors that diminish the effectiveness of this move, but there are two main factors: restricted credit and return on investment.

Under normal circumstances, lowering interest rates would spur economic activity; however, banks have already cut a good portion of the populous out of the picture with tighter lending criteria. You now have fewer people able to take advantage of the lower rates, thus reducing the effectiveness of the strategy.  Secondly, when interest rates drop on money loaned, the interest rates paid to investors drop, as well.  People with money to invest aren’t going to move ahead earning 1 percent or 2 percent if waiting awhile may double or triple that return.

When Will We Be All Better?

The key to economic recovery is people being convinced that things will get better sooner rather than later.  The individual consumer must see enough positive indicators to have faith in the future and start spending money.  This will drive interest rates up slightly and get investors into the picture. Once this happens, banks will feel secure enough to open up access to credit, and the whole system snowballs to recovery.

Production is on the rise

If you need easy loans just to make it from paycheck to paycheck, and even then you could still use some extra cash, take heart. Recently there have been hopeful signs that the current recession is coming to an end.

At the end of July, the government reported that the real gross domestic product (GDP) fell at an annual rate of only 1% in the second quarter. Manufacturing activity rose to its highest level in the last year. Car sales jumped 15% and manufacturers are ramping up production. Based on the data now available for July, experts are predicting that the GDP will increase by as much as 3% in the second quarter.

Home sales are on the rise

Another encouraging trend is that existing home sales are on the rise. Between April and May, the S&P/Case-Shiller 20-city index of house prices fell just 0.2%, the smallest decline in the past two years. Stabilizing house prices are expected to reduce mortgage-loan defaults, shore up bank balance-sheets and improve the flow of credit.

Oddly, unemployment is also on the rise

Employment, however, is the single most important economic benchmark, and the outlook on that front remains grim. Unemployment rates are still on the rise, which is surprising given that economists generally predict that an increase in the GDP will be accompanied by a decrease in the unemployment rate.

The accuracy of this rule of economics, called Okun’s law, has been disputed, however; and according to Michael Feroli, an economist at JPMorgan Chase, Okun’s law would have predicted a national unemployment rate of only 8.6% during the second quarter of this year, whereas the actual rate averaged 9.3%.

Many factors influence the rising unemployment rate

Several factors may be at work in the discrepancy between the improving GDP and the worsening unemployment rate. Last week, the government revised earlier data to show that the GDP has declined a cumulative 3.7% (rather than 2.5%) since the end of 2007, tying with 1957-58 as the deepest recession since the Great Depression.

Also, expanded unemployment-insurance benefits are encouraging some workers to keep looking for jobs rather than drop out of the workforce altogether, which according to the government, could add as much as a half percentage point to the unemployment rate. Similarly, dissipation of wealth is driving people to look for employment rather than retire or stay at home with the children.

Another factor may be that employers have been quick to slash payrolls. Businesses are budgeting more conservatively because of the credit crunch, and many are pessimistic about an eventual economic recovery.

Whatever the explanation, productivity is rising and so is unemployment. According to a recent article in The Economist, Robert Hall of Stanford University, head of the academic committee that identifies and assigns time frames to recessions, says Okun devised his law in an era when productivity usually fell during recessions: “When productivity rises, the law fails.” Okun’s law, he says, is “obsolete.”

The rise in production may be a false reading

Employers are not likely to do much hiring until it seems reasonably certain that the new growth in production will continue. And some economists are doubtful that what we are seeing is real growth. These experts attribute the recent increase in production to the replenishment of inventory after an extended period of filling new orders from existing inventory in idle factories. They point out that inventory replenishment gives production a temporary boost without a corresponding increase in consumer demand.

The federal cash-for-clunkers program may also have given production an artificial boost. Recent car sales have been strong, in large part because of the program, which offers subsidies of as much as $4,500 to people trading in older, higher-emissions vehicles for newer, more fuel-efficient cars. But the $1 billion set aside for the program, which was supposed to run for several months, was depleted within the first week. The House of Representatives has now voted to spend an additional $2 billion and the Senate is expected to do likewise. But cars bought now will mean fewer cars bought later.

Numbers have a way of changing

And one more qualification: Government figures are notoriously subject to revision. Even the Great Depression is getting worse. According to the latest revisions, the GDP fell 26.7% (rather than 26.6%) between 1929 and 1933. In another 50 or 60 years, or as soon as next week – who can say? — today’s fresh new growth in production may never have happened.