Understanding GDP: What it does and does not tell us about the economy
By Nia Bradley and Shannon Halbrook
Each quarter, a flurry of data tells us about the state of the U.S. economy. One of the most frequently cited statistics is the country’s gross domestic product (GDP). The U.S. Bureau of Economic Analysis (BEA), which publishes the official U.S. GDP figure (PDF), calls it the “most comprehensive measure of U.S. economic activity” and “the most popular indicator of the nation’s overall economic health.”
On Jan. 1, 2022, the U.S. GDP was approximately $23.99 trillion, with an annualized increase of 14.3 percent over the fourth quarter of 2021 (Exhibit 1). But what does GDP really tell us (or not tell us) about the economy, incomes, spending, and quality of life? And what other measures can be used to determine the health of the U.S. economy?
EXHIBIT 1: U.S. REAL AND NOMINAL GDP, 1929-2021 (ANNUAL)
GDP is a monetary measure of all the goods and services produced within a country during a certain period. Intermediate goods such as automobile parts are not counted. This is the main difference between GDP and total economic output.
Simon Kuznets first introduced this measure in 1937 while writing a report on the Great Depression. At the time, gross national product (GNP), which measured overall worldwide production of a country’s citizens and corporations, was the standard measure. It was replaced by GDP in 1991.
Each quarter, the BEA calculates several estimates of GDP (PDF): an advance release three weeks after a quarter ends, followed by second and third releases. Each release contains increasingly complete data and therefore higher accuracy. The bureau also provides GDP per capita, with and without seasonal adjustments, and estimates it at the state, county, metropolitan area, and industry levels, which are useful for making comparisons.
The BEA additionally produces nominal and real estimates of GDP. Nominal calculations are based on current prices and do not adjust for inflation, so they may be misleading when used for comparisons over time. To compensate for the omission, calculations for real GDP adjust for inflation by incorporating a base year as a reference point to compare output over time.
Similarly, the World Bank issues annual estimates of every country’s GDP. In 2020, the total global GDP was around $84.7 trillion. The United States had the fifth-largest real GDP per capita that year, with 28 percent of the world total (Exhibit 2).
EXHIBIT 2: REAL GDP PER CAPITA, TOP 5 COUNTRIES, 2010-2020
Calculating GDP can take three different approaches. When calculated correctly, all approaches yield the same GDP value.
- The Expenditure Approach adds all spending by the various groups that participate in the economy: consumer spending, business investment, government transfers and other spending and net exports.
- The Production Approach adds up the total economic output of a country and subtracts all the intermediate costs accumulated during the process.
- The Income Approach calculates income earned by all factors of production (e.g., labor wages, rent).
GDP has become a vital statistic (PDF) that businesses, government officials, investors, and trade associations can use to assess the economic health of a country, state, or region. In part, this is because GDP is frequently issued, readily available, and easy to understand and follow from one quarter to the next. Even with a time lapse, the statistic can impact markets if the published numbers conflict with expectations.
Keith Phillips, who was assistant vice president and senior economist at the Federal Reserve Bank of Dallas (Dallas Fed) until his retirement in January, explains that when economists assess GDP, they are not simply looking at a static value. Instead, they examine how the growth rate of GDP has changed over time and what those changes may indicate.
“It’s a measure of the dynamics of the economy — how is it changing?” Phillips says. “It’s not a very good measure of how we’re doing at any point in time.”
Just as doctors monitor a patient’s vital signs over time, for instance, economists look for steady GDP growth as an indicator of healthy, sustainable economic activity. A sharp growth rate may signal an accelerating economy, suggesting higher interest rates are needed to cool it down.
Alternatively, a shrinking GDP rate may signal distress, motivating policymakers to consider lower interest rates or fiscal stimulus.
“If something hurts, pain will radiate through your body,” says JoJo Estrada, an economist in the Comptroller’s Revenue Estimating Division. “Different segments of the economy interact or send signals to each other like the nervous system. If one segment of the economy isn’t doing well, GDP tells us something isn’t clicking.”
GDP is not without faults. As early as the 1950s, 13 years after the measure was introduced, some economists and policymakers criticized the use of GDP as an absolute indicator of a country’s success.
One major drawback of GDP is that it can disassociate from the social progress of a country. In the aftermath of a natural disaster, a country can experience an increase in GDP because of the increased spending needed to repair damaged infrastructure.
The rise does not take into consideration public welfare or account for production losses due to lives lost and work disruptions.
In the absence of context, GDP increases can be misunderstood as signs of growth.
Exaggerated GDP growth can occur, for example, during wartime when the government’s increased spending for weapon production or other commodities may not benefit the standards of living for individuals. And indeed, GDP’s ability to assess a country’s standard of living is another limitation.
Case in point: To address the inconsistency in population sizes of countries around the world, statisticians sometimes will compare GDP per capita, which divides a country’s GDP among the population to examine individual contributions from citizens.
Doing so unfortunately yields a simple average that may lead to an inaccurate depiction. Some countries boast a high GDP, despite their wealth being concentrated among a small, select group of people instead of being more evenly distributed among the population.
According to Estrada, some studies suggest that inequality may be a powerful incentive for lower-income workers to invest in skills and education, growing their incomes and wealth. “However,” he says, “if the opportunities or access to these investments are not present, it stymies their ability” — that is, to earn more, spend more, and contribute more to GDP.
As it becomes more apparent that GDP is not the definitive measure of success, other countries have started exploring alternative metrics to supplement economic analysis.
The Human Development Index (HDI) is a popular measure that assesses factors impacting social well-being (e.g., a long and healthy life, education, and a decent standard of living).
Although more insightful socially, HDI comes with its own set of limitations related to factors such as poverty and security and does not reflect shorter-term trends or inequalities within a population.
Gross State Product and Regional GDP
Gross state product (GSP) is the state-level analog of U.S. GDP. As of 2020, Texas had the second-highest GSP in the nation, after California (Exhibit 3). If Texas were a country, it would have the ninth-largest economy in the world.
EXHIBIT 3: REAL GSP OF LARGEST STATES, 2010-2020
State- and local-level GDP data are useful for providing comparisons. States have seen different rates of recovery from the pandemic, for example, affecting GSP growth over the past year (Exhibit 4). Early in the third quarter of 2021, the Texas GSP rose 3.5 percent to just over $2 trillion in current dollars ($1.8 trillion in real 2012 dollars), making up 8.6 percent of the total U.S. GDP.
EXHIBIT 4: QUARTERLY REAL GDP PERCENT GROWTH, U.S. AND LARGEST STATES, 2021
To complement GSP statistics, Phillips and his former Federal Reserve colleagues improved the reliability of the employment figures for the state and its metro areas by benchmarking the series every quarter as the QCEW (Quarterly Census of Employment and Wages) data were released, instead of waiting for the annual benchmark performed by the BLS.
“While the BLS early job estimates for Texas are revised less than any other states, the early benchmarking performed by the Dallas Fed makes them even more accurate,” he says. “We also improved the data by using a special two-step seasonal adjustment technique that the BLS later adopted for use with regional employment data.”
In addition, says Phillips, the Dallas Fed produces its own business cycle indexes that “smooth out the noise across several important economic series to find out how the [Texas] economy is moving.” These include the Texas Leading Index and the Texas Business-Cycle Index, which are both updated monthly (Exhibit 5).
EXHIBIT 5: ANNUAL CHANGE IN TEXAS GSP AND OTHER INDICATORS, 2010-2021
The Comptroller’s office watches GSP closely as it observes the state economy. The GSP metric plays an important part in the agency’s production of the Biennial Revenue Estimate (BRE) before each legislative session.
Each BRE includes a detailed overview of current economic conditions, as indicated by GSP, in addition to employment, personal income, population growth, and other state and national statistics.
These metrics are all useful in estimating various tax and non-tax collections in the subsequent biennium. Between BRE releases, the Comptroller’s office tracks these and other indicators on its Key Economic Indicators webpage, including inflation, consumer confidence, sales tax collections, and fuel prices.
Revenue estimators at the Comptroller’s office have found that GSP tends to mirror certain sources of state tax revenue.
Tom Currah, associate deputy comptroller for fiscal matters at the Comptroller’s office, emphasizes that the COVID-19 crisis has altered some of these relationships. “To the extent, relationships existed, they got blown up in the pandemic,” says Currah. “Consumers’ habits were different. We had to adjust some of our usual assumptions.” Wherever possible, estimators have also been supplementing those assumptions with additional data.
And though metro and local GDP statistics are provided by BEA, Reynolds warns they should be taken with a grain of salt. “The more regionalized a GDP measure, the more prone to error and the less reliable it is,” he says.
Phillips concurs, and as an example points out quirks in the reporting process for real output in the oil and gas industry that can distort Texas’ GSP.
GDP Still King
The pandemic has highlighted the time lag that exists in GDP data, with new data only available every three months.
As the pandemic rapidly unfolded throughout 2020 and 2021, economists and policymakers found themselves looking to more frequent, less conventional measures to assess the economy.
Yet GDP remains the king of economic data, and each release has helped clarify the sharp impact of the COVID-19 crisis and the rapid recovery.
Dive into the TexIndex webpage (produced by the Comptroller’s Data Analysis and Transparency Division) to see other statistics for the state and its 12 economic regions.
Source: Texas Comptroller