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Behind the numbers: what does GDP measure and is it useful?

15 Dec 2017
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In a season which saw the Autumn Budget and the long-awaited Industrial Strategy, the news has been awash with data forecasts. Productivity growth – how much more we can produce per hour – has been the focus, given its decade-long flat lining since the financial crisis, but also because it feeds into our overall economic growth.  

The Office for Budget Responsibility (OBR) revised down the UK economy’s growth rate – measured by gross domestic product (GDP) – alongside the Chancellor’s Autumn Budget. GDP growth is now projected to reach 1.5% this year, dip to around 1.3% in 2019, and pickup to 1.6% by the end of this Parliament. Meanwhile, average growth across other developed nations is expected to be closer to 2%.

Newspapers, academics and politicians fret over GDP, but what does it measure exactly, and is it useful? Put simply, it aims to capture the value of all goods and services produced within the country over a specific period of time, aka ‘economic activity’. This is essentially the sum of all consumption, government spending, investment and net trade in the economy. And right now, with the UK’s uncertain investment climate, penchant for imports, and constrained government spending, inflation-squeezed consumers have been picking up the slack in economic growth.

As such, supporting firms – particularly small and medium-sized businesses, which comprise 99.9% of all businesses and 60% of employment – is even more pivotal while other sources of short-term growth are waning. Managers are facing higher costs – including from the higher national living wage, pensions auto-enrolment and the apprenticeship levy – as well as productivity challenges, combined with unpredictability around EU workers, trade, and supply chains.

The low interest rate environment has offered some respite. But the Autumn Budget fell short on fiscal policy, just as the UK enters a pivotal period in the Brexit negotiations. Measures including the doubling of the Enterprise Investment Scheme annual allowance, unchanged VAT threshold, and adjustment to the up-rating of business rates were welcome, but ultimately missed the mark on the reliefs and incentives the IoD recommend to lift business confidence to invest -- and hence quarterly economic growth.

Economic indicators, such as the Purchasing Managers Indices which measure activity across sectors in areas including order books, inventories, and recruitment, point ahead to slightly higher quarterly economic growth (0.4% in Q3). But for the time being it’s still an uphill slog: the IoD’s survey of members’ economic confidence remains in the red, as the economy battles against weak real wage growth, political uncertainty, and now falling net immigration.

That partly explains the OBR’s weakened 5-year growth forecasts. But the other component – which is straining developed economies around the world – is structural. Long-term economic growth is doomed if the country’s skills, education, and infrastructure system cannot keep apace with technological and global developments. For example, if workers are not trained to move into higher value-added professions, as some roles are made obsolete by technology, underlying economic growth is at risk.

The Industrial Strategy went some way to acknowledging this. The extension to the National Productivity Investment Fund, to overturn a legacy of underinvestment in infrastructure, support for developing STEM education and retraining, and new capacity being built into the British Business Bank, are all steps in the right direction. But its implementation is another issue.

Businesses will need clarity around how the government’s funding will be allocated and sequenced, in order to anchor their own revenue, investment and employment expectations. A key approach would be to clarify the role, and powers, of the much-needed independent Industrial Strategy Council – slated as a long-term growth oversight institution.

Reflecting this, 6 in 10 business leaders say the Industrial Strategy must be protected from myopic political pressures to work effectively.  Limited skillsets, poor investment in technology, and regional inequality –which constrain the economy’s output potential – are all long-term issues that span Parliaments, but that have often been subordinated for near-term measures by successive governments.    

Of course there are also wider questions on the accuracy, and value, of GDP. It’s harder to measure intangibles such as services, compared to physical products in manufacturing for which the measure was originally designed. And disentangling the impact of technological innovation on output is also difficult to capture. Meanwhile, some question its outright focus on the level of production – which does not necessarily correlate with the quality of living.

Many have argued for measures of economic growth that incorporate a range of factors which impact human welfare – including citizen’s health and happiness – and adjust for things like income inequalities and environmental damage. Indeed, the IoD’s Good Governance report highlights the important role corporate social responsibility plays in forging a sustainable growth path for business.  

Nevertheless, GDP remains an important gauge for an economy’s health. But evolving our measures of economic activity, and developing institutions to foster long-term growth, is vital in meeting the challenges of the future.

A single- and short- sighted focus on the numbers can detract from the wider issues that impact the longevity of economic growth. And, to echo Goodhart’s Law  - named after economist Charles Goodhart - ‘when a measure becomes a target, it ceases to be a good measure.’

Check out the first blog from Tej - Behind the Numbers: Productivity


Tej Parikh, Senior Economist, IoDTej Parikh

Tej holds a Bachelor’s degree in Economics from University College London, and a Master’s degree in International and Development Economics from Yale University. Prior to joining the IoD, he worked as an economic analyst at the Bank of England in roles across monetary and financial policy. Subsequently, he moved to Cambodia where he was a journalist focusing on economic and private sector development for a national newspaper. He has since been a freelance political risk consultant and journalist, covering Europe and Asia in particular. He has published for numerous international media outlets including Foreign Affairs, the Guardian, and The Diplomat, and is currently an active member of London’s Great Debaters Club.

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