This article was originally published by J.R. MacLeod at The Mises Institute. 

Gross domestic product (GDP) is the most common measure of national wealth and economic growth. Yet the layman—and even many businessmen and economists—is taken aback when mainstream commentators and professionals get very excited about changes to GDP, which seem to have little to no impact on real economic conditions.

While GDP can sometimes reflect real economic conditions, this is often when conditions are very favorable or unfavorable and where other techniques would still give a better indication of economic conditions, how those conditions developed, and how they could be changed.

The fundamentals of calculating GDP are C + I + G + (X − M) = GDP, where

• C = personal consumption expenditures
• I = gross private domestic investment
• G = government consumption expenditures and gross investment
• X = exports
• M = imports

First, GDP focuses exclusively on final consumption, ignoring Say’s law—one of the best concise English language statements I can think of—which states that production must occur before consumption. An economy can suffer from serious structural problems, yet GDP won’t provide any information about these issues since it only focuses on the final part of economic activity.

Government “investment” receives a prominent role in GDP, yet government intervention is by nature noneconomic. Money is not willingly handed over to the government, meaning the first choice for that money’s use goes unfulfilled. From the perspective of economic value, government intervention only destroys value, redistributes value, or produces added value less efficiently than is otherwise the case. Yet, in the GDP framework, government intervention will always make a positive contribution.

Nor does GDP adequately reflect the effects of inflation. Focusing entirely on numerical monetary value actually goes beyond ignoring inflation to providing a rationale for it. The creation of additional fiat money does not add to wealth if we define wealth properly in terms of goods and services. Yet the more money the government creates and injects into the economy, the more the GDP increases. The money is viewed as spurring further activity, meaning it has a multiplying effect. Therefore, under the GDP framework, each person can make an argument for being handed large sums of money, as Murray Rothbard famously detailed.

The fortunes of the GDP inevitably follow fluctuations in the money supply. As artificial credit is injected into the economy, GDP increases. However, the Austrian business cycle theory explains how, rather than creating true and stable growth, the boom induced by artificial credit leads inevitably to bust. When the bust occurs, the GDP framework views it as a fall in consumption, government expenditures, and other components that make up aggregate demand. So, the answer under this framework is to create more artificial credit to boost aggregate demand, boost GDP, and supposedly turn the business cycle around.

However, it is artificial credit expansion that causes the boom-bust cycle in the first place. GDP has no room for concepts that explain the cycle, such as malinvestment, the structure of production, the heterogeneous nature of capital, or even any capital theories at all. Rather, GDP sees capital as an undifferentiated, homogeneous fund.

GDP is a Keynesian metric, and we should ask why we rely so heavily on a tool of a body of work that was proven to be substantially false quite a long time ago. It is also intrinsically linked with a Keynesian view of political economy that stresses heavy government intervention in the macroeconomy.

While GDP ignores the effects of inflation, the framework recognizes in theory the deleterious effects of price inflation. Yet the track record of the GDP shows it doesn’t take this threat seriously enough. It only recognizes runaway price inflation as meaning higher consumer prices, but it doesn’t imply that there is anything inherently problematic about inflation itself.

There are logical flaws in the way GDP calculates total output as well as the price deflator it uses to take account of inflation. Prices are exchange ratios between money and units of different goods and services. These different goods and services cannot be mathematically mixed together. As Frank Shostak explains:

Suppose two transactions were conducted. In the first transaction, one TV set is exchanged for $1,000. In the second transaction, one shirt is exchanged for $40. The price or the rate of exchange in the first transaction is $1000/1TV set. The price in the second transaction is $40/1 shirt. In order to calculate the average price, we must add these two ratios and divide them by 2. However, a $1000/1TV set cannot be added to a $40/1 shirt, implying that it is not possible to establish an average price.

It is interesting to note that in commodity markets, prices are quoted as Dollars per barrel of oil, Dollars per ounce of gold, Dollars per tonne of copper, etc. Obviously, it wouldn’t make much sense to establish an average of these prices.

Mark Skousen’s gross output statistic provides a superior metric for national income accounting. It takes proper account of business-to-business spending and the production economy. It also integrates with Austrian capital theory and the model first referred to as Hayek’s triangles. Skousen’s work seeks to develop and quantify a model that runs through the work of Carl Menger, Friedrich von Hayek, Murray Rothbard, and Roger Garrison. It also integrates with mainstream measurements, which in many ways is an advantage, though perhaps it means that it has not fully escaped flaws associated with GDP.

The general sense is that Western economies are not strong, even if interpretations differ about how these problems developed and their future solutions. Studies that praise present conditions rely heavily on GDP. They also rely on people failing to understand trajectory through time. Yes, we have iPhones now that we didn’t have in 1950, but the structure of the economy, as well as the rate at which it was improving, was better then than it is now. We could be doing better today than we are; talking at length about conditions from half a century, or even hundreds of years, ago in what are meant to be studies of economies today only obfuscates this fact.

The commonly used GDP per capita doesn’t give useful information about the average standard of living. Equatorial Guinea has a high GDP per capita but virtually no middle class. San Francisco has a high GDP per capita, but the widespread presence of drug-addled homeless people on the streets severely impacts the quality of life.

A survey should instead attempt to determine the economic condition of the average citizen of today and should include his assessment of the state. It should take a holistic view of the economy, based on a sound understanding of economic theory, and measure factors that drive real economic growth, such as savings.

Unfortunately, GDP measures regard savings as a “leakage” from the system and a drag on economic growth. Thus, Keynesians believe that the real value of capital spending is not the creation of capital itself but rather the spending that goes with it. This is not a prescription for a strong, growing economy but rather an economy feeding upon itself.