Possible causes explaining why GDP has become a prevalent economic indicator, and some of the impacts its prevalence has on development as a whole:
In an article posted not too long ago about GDP as an economic illusion, we argued that GDP is not a good enough indicator to measure the welfare of a nation, particularly, its people. We explained the idea from the development perspective; we talked about how GDP does not account for inequality, corruption, discrimination, human rights abuses, social or political instability, environmental damage, and so forth. As far as I am concerned, none of these are included in GDP and GDP per Capita (at least, not at the moment).
However, the misconception about GDP and its effectiveness as an indicator comes mostly, not from economists (who, we can safely assume, have clear understanding of the issues), but from people untrained in the discipline (who make up the majority of the world population). This is problematic because the economy is driven by the 99%. So what? Well...
...You see, GDP is used as an indicator of economic performance of a country, not because they consider it the best and most inclusive indicator, but because GDP serves as a practical means of measuring aggregate production of goods and services of an entire nation during a period of time, which is great.
GDP = C + I + G + NX
GDP for gross domestic product, C for consumption, I for investment, G for government spending, NX for net export. Simple. Clear. Intuitive.
Furthermore, the fact that it has become a common measurement method adopted by almost every nation is the result of what we call "Network Effect". The more countries use GDP as its economic indicator, the more GDP is valued and used by other late adopters. This is no different from how things like phone, email, and QWERTY keyboard layout were brought into popularity. Their value rose significantly as their user base got larger and larger. Imagine a world with only you using phone. Who are you going to call anyway? Not to forget, the more people adopt and accept something, the harder and more costly it is to change/switch to another option even though the long-term prospect for such changes to happen is actually a lot better than sticking to the status quo. I mean, this might sound a bit counter-intuitive and stupid, but it really happens in real-world. For the same reason, I believe, GDP has become so popular, and people have become so accustomed to thinking in terms of GDP (using it as their frame of reference) that they unconsciously resist the transition from GDP to a new indicator (which cause the transition like this to be quite costly). Time is, of course, required for the change to occur. Regardless, I have to admit that we need to start somewhere (Maybe there are people who have already been working hard on the transition process).
Another cause of the proliferation of GDP as an indicator is the "bandwagon effect" which basically states that the more people do/believe in something, the more likely everyone else do/believe in that same thing despite their own belief or the initial skepticism they had. Another term to describe this psychological phenomenon is "herd mentality". Individuals are predisposed to follow the crowd by ignoring their own reasoning. Globalization and localization of foreign knowledge (esp, through the media) might play a role in spreading this economic fallacy concerning GDP, from the misguided few to the entire global population.
One must never ignore the fact that decisions are always made at individual level, and thus, they are further constrained and rendered less effective if the individual's rationality is bounded by his/her limited information and cognitive capacity (we call this "bounded rationality"). In our case, the lack of knowledge about GDP acts as a constraint that renders individual decisions and the following collective outcomes less effective and favorable.
Therefore, the universal employment of GDP as an economic indicator is, on the one hand, good because GDP has become a common language/term used by everyone despite their different native languages. It reduces the cost during encoding and decoding processes, which would have been incurred had we use different languages/terms when referring to a single idea. Thus, GDP as a universal indicator of productivity allows for comparison, mutual understanding, and convenience when attempting to establish a common ground where all nations can begin their engagement in cross-border development, in the globalization process.
However, the herd mentality and the limited information available (bounded rationality) can have a profound impact on the knowledge and understanding of the population, their rationale and the outcomes of their decisions.
I have, hundreds of times, heard people talking about GDP and GDP per capita as if these are divine tools for measuring growth. This is a serious misconception, and if the majority of the global population continues to hold on to such fallacy, they will be more prone to manipulation and misguided behaviors towards states and development itself.
GDP can be a double-edged sword in development as it has the ability to mislead a nation and its population into either underestimating or overestimating (because, for instance, GDP does not factor in informal sector which is huge in many developing nations) their own growth rate, their physical and soft development rate, and the level of welfare they achieved. Overuse of GDP can harm a society by masking reality and clouding the judgment for both state and non-state actors. Why should it be a concern? Because not being able to analyse the situation one is in will incapacitate one's ability to determine the remedies necessary to enable proper recovery and improvement.
That is exactly why countries who are proud of its 7% or 10% GDP growth rate are too complacent. First of all, you have to think in terms of the base used to measure the growth rate. A country with $1 million in GDP can easily grow 10% more by increasing their output to $1.1 million ($0.1 million increase). However, a country with an annual GDP of $100 million will have to increase its output by $10 million to maintain the same 10% growth rate. Thus, growth rate, while it is useful, does not tell you everything about growth.
In addition, by overlooking their shortcomings in other dimensions of development, they will not be able to achieve a sustainable and equitable inclusive growth. Our previous article on Poverty has provided substantial reasons to justify the claim made in this article. A $30 increase in income (which contributes to growth shown in the calculation of GDP) does not necessarily imply better well-being of an individual. A sick person might not be able to eat the food or absorb all the nutrients in the food bought with the $30 increase in income. An uneducated person might not wisely put the $30 increase in his/her earning into good use (ex: the person might end up spending all on gambling). GDP has the power to hide such facts from the public eyes, and governments who want to increase their popularity and credibility might resort to using GDP as an expedient to manipulate and sway the public opinion in their favor.
Globalization: What does it tell us about GDP?
In the context of globalization, GDP is losing its effectiveness as a universal indicator of growth, especially in the long run. Basing one's understanding about the world economy on GDP is exactly the reason why some people start to talk about the so-called post-american world with China hegemony on the rise. It is the idea that the United States will soon decline from its position as the global powerhouse, the leader of nations and that China will soon surpass the United States simply because its GDP is growing larger than that of the US. This sounds promising, but is it really happening? No, or at least, not anytime soon.
By making such a statement, many variables are unaccounted for. China's aggregate GDP, first of all, is only growing larger than the US due to the 1.3 billion+ population (cheap labour) it has, the influx of FDI, and the mass export to developed regions it enjoys since the implementation of the open door policy initiated by Deng Xiaoping (one of the most prominent leaders in the entire history of China, best known for the economic revolution he brought forth for the country) in 1978, which set into motion the economic transformation into the current modern China. Of course, it simply means that China is heavily reliant on the west for its growth, socially and economically (while incurring substantial environmental cost... just a side note). Inter-dependence is probably a better term to describe the real world situation, in which all countries are increasingly depending on each other economically due to the world economic integration, or in a broad term, globalization.
Notwithstanding this tremendous achievement, GDP per capita wise, China is still behind the US by a long shot. According to the online data published by the World Bank, as of recently, the Chinese, on average, earns about US$6,800 a year, while the American is earning US$53,143/year. Of course, you might argue that goods and services offered by the Chinese market are cheaper, but even if this allows the Chinese to buy more goods and services compared to the American given both having the same amount of money, you cannot deny the fact that the American is still several times better off. Moreover, you have to take into consideration the quality of goods and services offered that ultimately constitutes the quality of life itself... which is how it is in contract-intensive economies (please google the term "contract-intensive economy"). And don't forget the different social and political environments encompassing the two populations (democracy vs communism, etc).
Furthermore, since globalization gives rise to stronger inter-connectedness/interdependence between states, it also leads to high capital and labour mobility across countries. This means that capital is actively seeking places with higher potential return, the selling point of developing nations. Consequently, more capital, especially in the form of FDI (long-term investment), from the first-world countries are flowing into the thirds. This can be witnessed in the activities of multinational corporations are expanding their operations and outsourcing strategies in many countries across the globe.
What does this tell you about GDP? I think what it, once again, implies is that a new indicator should be adopted, or GDP (the traditional indicator) should be adjusted/improved to the changing real-world conditions. Why? Because GDP only measures the total output (value of all goods and services) produced within a country (literally, within a country) at a specific period of time. If capital and labour mobility increases as a result of globalization (ex: in the form of economic integration), this implies that factors of productions (inputs) and outputs happen elsewhere outside of the nation where they come from (in our case, outside of the US). In that sense, GDP is losing its accuracy and potency as an economic indicator.
For less-developed and least-developed nations, GDP might overstate the nation's well-being as its labour and capital might be exploited by the multinational giants, taking advantage of the nation's inclination towards corruption and weak rule of law.
When talking about globalization, we have to also consider the previously discussed mini-concept related to self-fulfilling prophecy. When people misinterpret GDP as an accurate predictor of growth, they tend to also believe that falling GDP foretells impending crises, and as a consequence, they react accordingly in response to the warning siren. The strangest thing is that most of the time, by conforming to the popular belief about GDP, people end up saving themselves in the very short-run but aggravating the situation for themselves and everyone else later on. How? For example, upon hearing the news about the imminent global economic crisis, they couldn't help but withdrawing money from banks and start saving to prepare for the heavy rain ahead. Just in the bank sector alone, two things end up happening.
First, the fear of bank run compels more people to withdraw their deposits, which make it more likely for the bank to really become insolvent, a prophecy self-realized by the mass panic. Since banks are the financial intermediaries, the link between producers & consumers and between lenders & borrowers, their bankruptcy is a real apocalypse for our modern society.
Second, paradox of thrift comes into play. The fear of economic downturn and the subsequent effects force people to start saving more and more, to buy more precious metals (considered as safe haven for investment), and to hoard money and goods; all of which drain away capital supply from the economy. The aftermath? Less money spent, less money received (earned). Less money earned, less tax. Less tax, less potent fiscal policy. Government resorts to printing money, but that increases the risk of inflation if overdone.
The thing is... as bad as it might sound on a national scale, globalization can make things a lot worse. To reiterate, globalization implies strong links or interdependence between countries, and thus, when the majority blindly relies on a single indicator as a predictor of economic health, a national or regional crisis has the potential to escalate even further into a global crisis. In other words, countries are gravitating towards the core of the global network, which most of the time, lessens the day-to-day economic volatility, but worsens the impact of a shock occurring in the central network. Remember that misconception can lead to a level of panic disproportionate to the actual problems at hand, and this can lead to self-fulfilling prophecy, giving rise to the most unlikely event (that would most probably not have happened had people been better informed).
Still, GDP as an indicator, per se, is not detrimental to the development of any nation (not that bad of an indicator either), but the fact that most people are confused about what GDP really is, the fact that people (esp, the media) hold a strong belief in GDP as an indicator of their countries' economic performance without considering the flaws of this indicator, are what really make this traditional indicator, GDP, a less desirable economic measurement tool. We need to find a new and better indicator, either a brand new one or a combination/improvement of the old ones. At the very least, what we should do is get people to understand more about GDP, particularly its strengths and weaknesses.
Don't get me wrong though. I am not saying that GDP is a failure. No. Whoever came up with the idea is a genius. GDP has served us well, but we are living in a dynamic world, meaning that things change all the time. We are able to survive because we win in the natural selection competition (survival of the fittest). How did we win? How did we overcome constant changes? Because we evolve, we adapt, we improve. We, humans, have come a long way, and globalization is a new milestone for us. As we get closer and closer to globalization, there is a demand for changes in the way we do things so that we can realize the true potential of the "one earth, one country" concept (I completely made it up).
Adapt and evolve. This is the bottom line of this article.
--------------------------------------------------------------------------------------------------------
Sources used:
http://data.worldbank.org/indicator/NY.GDP.PCAP.CD
Another cause of the proliferation of GDP as an indicator is the "bandwagon effect" which basically states that the more people do/believe in something, the more likely everyone else do/believe in that same thing despite their own belief or the initial skepticism they had. Another term to describe this psychological phenomenon is "herd mentality". Individuals are predisposed to follow the crowd by ignoring their own reasoning. Globalization and localization of foreign knowledge (esp, through the media) might play a role in spreading this economic fallacy concerning GDP, from the misguided few to the entire global population.
One must never ignore the fact that decisions are always made at individual level, and thus, they are further constrained and rendered less effective if the individual's rationality is bounded by his/her limited information and cognitive capacity (we call this "bounded rationality"). In our case, the lack of knowledge about GDP acts as a constraint that renders individual decisions and the following collective outcomes less effective and favorable.
Therefore, the universal employment of GDP as an economic indicator is, on the one hand, good because GDP has become a common language/term used by everyone despite their different native languages. It reduces the cost during encoding and decoding processes, which would have been incurred had we use different languages/terms when referring to a single idea. Thus, GDP as a universal indicator of productivity allows for comparison, mutual understanding, and convenience when attempting to establish a common ground where all nations can begin their engagement in cross-border development, in the globalization process.
However, the herd mentality and the limited information available (bounded rationality) can have a profound impact on the knowledge and understanding of the population, their rationale and the outcomes of their decisions.
I have, hundreds of times, heard people talking about GDP and GDP per capita as if these are divine tools for measuring growth. This is a serious misconception, and if the majority of the global population continues to hold on to such fallacy, they will be more prone to manipulation and misguided behaviors towards states and development itself.
GDP can be a double-edged sword in development as it has the ability to mislead a nation and its population into either underestimating or overestimating (because, for instance, GDP does not factor in informal sector which is huge in many developing nations) their own growth rate, their physical and soft development rate, and the level of welfare they achieved. Overuse of GDP can harm a society by masking reality and clouding the judgment for both state and non-state actors. Why should it be a concern? Because not being able to analyse the situation one is in will incapacitate one's ability to determine the remedies necessary to enable proper recovery and improvement.
That is exactly why countries who are proud of its 7% or 10% GDP growth rate are too complacent. First of all, you have to think in terms of the base used to measure the growth rate. A country with $1 million in GDP can easily grow 10% more by increasing their output to $1.1 million ($0.1 million increase). However, a country with an annual GDP of $100 million will have to increase its output by $10 million to maintain the same 10% growth rate. Thus, growth rate, while it is useful, does not tell you everything about growth.
In addition, by overlooking their shortcomings in other dimensions of development, they will not be able to achieve a sustainable and equitable inclusive growth. Our previous article on Poverty has provided substantial reasons to justify the claim made in this article. A $30 increase in income (which contributes to growth shown in the calculation of GDP) does not necessarily imply better well-being of an individual. A sick person might not be able to eat the food or absorb all the nutrients in the food bought with the $30 increase in income. An uneducated person might not wisely put the $30 increase in his/her earning into good use (ex: the person might end up spending all on gambling). GDP has the power to hide such facts from the public eyes, and governments who want to increase their popularity and credibility might resort to using GDP as an expedient to manipulate and sway the public opinion in their favor.
Globalization: What does it tell us about GDP?
 |
| "Globalization: We all play a part in it" Image source: http://imgarcade.com/1/globalization-and-cultural-diversity/ |
In the context of globalization, GDP is losing its effectiveness as a universal indicator of growth, especially in the long run. Basing one's understanding about the world economy on GDP is exactly the reason why some people start to talk about the so-called post-american world with China hegemony on the rise. It is the idea that the United States will soon decline from its position as the global powerhouse, the leader of nations and that China will soon surpass the United States simply because its GDP is growing larger than that of the US. This sounds promising, but is it really happening? No, or at least, not anytime soon.
By making such a statement, many variables are unaccounted for. China's aggregate GDP, first of all, is only growing larger than the US due to the 1.3 billion+ population (cheap labour) it has, the influx of FDI, and the mass export to developed regions it enjoys since the implementation of the open door policy initiated by Deng Xiaoping (one of the most prominent leaders in the entire history of China, best known for the economic revolution he brought forth for the country) in 1978, which set into motion the economic transformation into the current modern China. Of course, it simply means that China is heavily reliant on the west for its growth, socially and economically (while incurring substantial environmental cost... just a side note). Inter-dependence is probably a better term to describe the real world situation, in which all countries are increasingly depending on each other economically due to the world economic integration, or in a broad term, globalization.
Notwithstanding this tremendous achievement, GDP per capita wise, China is still behind the US by a long shot. According to the online data published by the World Bank, as of recently, the Chinese, on average, earns about US$6,800 a year, while the American is earning US$53,143/year. Of course, you might argue that goods and services offered by the Chinese market are cheaper, but even if this allows the Chinese to buy more goods and services compared to the American given both having the same amount of money, you cannot deny the fact that the American is still several times better off. Moreover, you have to take into consideration the quality of goods and services offered that ultimately constitutes the quality of life itself... which is how it is in contract-intensive economies (please google the term "contract-intensive economy"). And don't forget the different social and political environments encompassing the two populations (democracy vs communism, etc).
Furthermore, since globalization gives rise to stronger inter-connectedness/interdependence between states, it also leads to high capital and labour mobility across countries. This means that capital is actively seeking places with higher potential return, the selling point of developing nations. Consequently, more capital, especially in the form of FDI (long-term investment), from the first-world countries are flowing into the thirds. This can be witnessed in the activities of multinational corporations are expanding their operations and outsourcing strategies in many countries across the globe.
What does this tell you about GDP? I think what it, once again, implies is that a new indicator should be adopted, or GDP (the traditional indicator) should be adjusted/improved to the changing real-world conditions. Why? Because GDP only measures the total output (value of all goods and services) produced within a country (literally, within a country) at a specific period of time. If capital and labour mobility increases as a result of globalization (ex: in the form of economic integration), this implies that factors of productions (inputs) and outputs happen elsewhere outside of the nation where they come from (in our case, outside of the US). In that sense, GDP is losing its accuracy and potency as an economic indicator.
For less-developed and least-developed nations, GDP might overstate the nation's well-being as its labour and capital might be exploited by the multinational giants, taking advantage of the nation's inclination towards corruption and weak rule of law.
When talking about globalization, we have to also consider the previously discussed mini-concept related to self-fulfilling prophecy. When people misinterpret GDP as an accurate predictor of growth, they tend to also believe that falling GDP foretells impending crises, and as a consequence, they react accordingly in response to the warning siren. The strangest thing is that most of the time, by conforming to the popular belief about GDP, people end up saving themselves in the very short-run but aggravating the situation for themselves and everyone else later on. How? For example, upon hearing the news about the imminent global economic crisis, they couldn't help but withdrawing money from banks and start saving to prepare for the heavy rain ahead. Just in the bank sector alone, two things end up happening.
First, the fear of bank run compels more people to withdraw their deposits, which make it more likely for the bank to really become insolvent, a prophecy self-realized by the mass panic. Since banks are the financial intermediaries, the link between producers & consumers and between lenders & borrowers, their bankruptcy is a real apocalypse for our modern society.
Second, paradox of thrift comes into play. The fear of economic downturn and the subsequent effects force people to start saving more and more, to buy more precious metals (considered as safe haven for investment), and to hoard money and goods; all of which drain away capital supply from the economy. The aftermath? Less money spent, less money received (earned). Less money earned, less tax. Less tax, less potent fiscal policy. Government resorts to printing money, but that increases the risk of inflation if overdone.
The thing is... as bad as it might sound on a national scale, globalization can make things a lot worse. To reiterate, globalization implies strong links or interdependence between countries, and thus, when the majority blindly relies on a single indicator as a predictor of economic health, a national or regional crisis has the potential to escalate even further into a global crisis. In other words, countries are gravitating towards the core of the global network, which most of the time, lessens the day-to-day economic volatility, but worsens the impact of a shock occurring in the central network. Remember that misconception can lead to a level of panic disproportionate to the actual problems at hand, and this can lead to self-fulfilling prophecy, giving rise to the most unlikely event (that would most probably not have happened had people been better informed).
Still, GDP as an indicator, per se, is not detrimental to the development of any nation (not that bad of an indicator either), but the fact that most people are confused about what GDP really is, the fact that people (esp, the media) hold a strong belief in GDP as an indicator of their countries' economic performance without considering the flaws of this indicator, are what really make this traditional indicator, GDP, a less desirable economic measurement tool. We need to find a new and better indicator, either a brand new one or a combination/improvement of the old ones. At the very least, what we should do is get people to understand more about GDP, particularly its strengths and weaknesses.
Don't get me wrong though. I am not saying that GDP is a failure. No. Whoever came up with the idea is a genius. GDP has served us well, but we are living in a dynamic world, meaning that things change all the time. We are able to survive because we win in the natural selection competition (survival of the fittest). How did we win? How did we overcome constant changes? Because we evolve, we adapt, we improve. We, humans, have come a long way, and globalization is a new milestone for us. As we get closer and closer to globalization, there is a demand for changes in the way we do things so that we can realize the true potential of the "one earth, one country" concept (I completely made it up).
Adapt and evolve. This is the bottom line of this article.
--------------------------------------------------------------------------------------------------------
Sources used:
http://data.worldbank.org/indicator/NY.GDP.PCAP.CD
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