Gross Domestic Product
Components of GDP
February 12, 2025
In the previous articles, we have discussed the various pitfalls of the GDP system. We have also made the case for an urgent need for a serious and complete overhaul of the GDP system i.e. GDP must be replaced by another metric. However, we have not explained what this other metric should be like.
In this article, we will list down the faults with the GDP system. While enumerating the faults we will also simultaneously list down the requirements from the proposed new metric. The reason behind this is that the new metric is supposed to overcome the faults of the GDP system. The faults inherent in the GDP system therefore form the requirement of the new metric.
The list of faults and requirements is therefore as follows:
Maximize output NOW
The GDP system is completely focused on right now. It does not take into account the future. It does not take into account the past, the amount of resources that are being wasted or anything else. This is opposed to the very nature of the economic science.
Economics is based on conservation of resources and their most appropriate utilization. Hence, GDP system subverts the main purpose for which it was created. It is not an efficient barometer for an economy which can be used for decision making. Instead, it makes the economy act like a stubborn kid who wants anything pleasurable right now.
The new indicator that replaces the GDP system must have a focus on the future as well. The growth perspective should not be time bound i.e. it must not encourage today’s growth at tomorrow’s expense. Today’s growth at tomorrow’s expense is not really “growth”, is it?
Growth over Stability
The second big problem with the GDP system is that it is too focused on growth. This single-minded relentless focus makes the economy behave in irrational ways. Perpetual growth is a myth. It is an even bigger myth in economics because the underlying resources which create this growth are limited. Perpetual growth with limited resources is an absurdity.
The new indicator created should therefore focus on the stability factor more than growth. The impetus should be on ensuring that the economy remains in a steady state wherein it can consistently deliver employment opportunities to its subjects instead of this GDP induced boom and bust cycle.
Disregard Inputs
The GDP system completely disregards all inputs that were utilized to create the output. It is blindly measuring the output. Let’s say that 100 units of electricity were consumed to make a fan work for 100 hours in the previous year. This year, 200 units are consumed to make the same fan work 150 hours.
The GDP system simply measures the output i.e. the fan worked 50% more. However, it fails to mention that the inputs had to be increased by 100% to create this 50% increase, thus making the increase unviable.
The new metric created to replace the GDP must take into account inputs as well. The decision on whether or not an activity adds to the economy must be based upon a favorable input-output trade-off meaning that fewer inputs were consumed to create more output. In short it must be like the capital budgeting exercise which is used in corporate finance.
Depletion Penalty
The current GDP system also simply fails to account for overutilization of resources. Over-utilization simply means that more resources were utilized in a given year than there were created. This leads to shortage of resources in the future from an economic standpoint and degradation of the environment from an environmental standpoint. This should be severely penalized.
The GDP system is flawed because it makes it possible for the economy to grow at the expense of the environment. The newer system which should replace GDP should make such a situation impossible. This can be achieved by ensuring that the economy as a whole faces a penalty in monetary terms for over-utilization of resources. Thus when resources are over-utilized the GDP should fall instead of rising ensuring that corporations and politicians cannot misuse such a system.
Humanitarian Penalty
The current GDP system is perceived to be anti-social. This is because it projects disasters like sickness, war, terrorism and natural disasters in a positive light and goes to the extent of labeling them as economic boons. This is what projects economics as an anti-social science.
The new metric must be created in such a way that there are penalties for increased spending on social evils. An increased spending on national healthcare must not increase the economic growth. Rather it must reduce the economic growth. Such an indicator would ensure that the economy does not benefit at the expense of happiness and well being of its subjects.
Opportunity Cost
The fundamental principle of economics states that economics is a science of ensuring that scare resources which have alternative uses are utilized efficiently. Thus the concept of opportunity cost is literally built into the word economics. It is however strange that GDP which is supposed to be the foremost indicator of an economy’s health does not take into account the concept of opportunity costs. The new indicator must therefore prevent the wastage of scarce resources through the means of suboptimal utilization.
Debt
The GDP system allows for an economy to grow despite it having humungous amounts of debt. The new metric must prevent this from happening. Although it is not possible to completely prevent this from happening since some amount of debt is required by the economy. However, the new metric must set limits, raising debt levels beyond which will attract a penalty. Once again, the growth rate of a country must be negatively affected by excessive debt.
The purpose of creating the new metric is to close all the loopholes in the GDP system. As we can see the GDP system is ridden with inconsistencies and if these inconsistencies are not eradicated they will lead to an implosion of the economy.