Understanding GDP: What it does and does not tell us about the economy

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GPD Uses

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 Limitations

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.

Employment data are a useful supplement to GDP, he says. “The most common indicator used at the regional level is jobs. People understand job numbers.” In particular, he points to the industry detail, accuracy, and timeliness of the Current Employment Statistics (CES) series, compiled by the U.S. Bureau of Labor Statistics (BLS).

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.

Note: GSP is shown in adjusted 2012 dollars. Source: BEA

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.

Source: BEA

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).

Sources: Federal Reserve Bank of Dallas; BEA (GSP)

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.