The origin of "The Economy"

Last week I wrote about the beauty of the most common measurement system in the world. In the Economics world there is also one measure that dominates all discussions: the Gross Domestic Product (GDP). Before the Great Depression this measure of "how the economy is doing" did not exist. People at the time felt things were going really bad, but no one could agree on how much. Back then they had numbers on how the production of some important industrial or agricultural sector was doing. Presidents Hoover and Roosevelt had to fight the Great Depression on the basis of sketchy data as stock price indices, freight car loadings or incomplete indices of industrial production. But there was no general number for the question "How bad are things?". Hence, similarly to the metric system, the base measure of "the Economy" was born during a crisis.

So the GDP was going to try to add up everything made in the country: houses constructed, beers sold, visits to doctors, etc. (In case you are picky, back then it was actually the Gross National Product, GNP, but I will avoid this difference here). And they needed someone willing to crunch all the reports and summarize them in one number.  And so came an economist described by his best friends as "extremely dry": Simon Kuznets. He first needed to figure out what to count  which is not as easy as it sounds since it should potentially include everything. For example, shall we include the Mafia? The US does not but some countries do. In 1987, after “black,” untaxed transactions were included, Italy showed a brilliant 18% growth and became bigger than the UK (il sorpasso ragazzi!). (I believe this was later undone) And the Italians might do it once again, given EU regulation from 2013 that requires all transactions, regardless of their legal status, to be accounted for. And another big jump forward for Italy might be ahead of us.

Another case of productive activity not usually included in GDP is unpaid work. As the IMF explains, for example a baker who produces a loaf of bread for a customer would contribute to GDP, but would not contribute to GDP if he baked the same loaf for his family (although the ingredients he purchased would be counted).

Well, suppose you have figured what to count out. Now, how do you count it? If it is produced and sold in the US but some of the inputs come from abroad you need to subtract that part (Tough job that requires some sort of input-output tables). Then you have all the goods produced in your country that you want to add up. If you were ever told you cannot add apples and oranges, Kuznets would tell you are wrong. That part was easy. You just need to transform them into a common unit, money, and add that up. 

After 6 years of work (almost too late for the Crisis?), Kuznets published his best seller: National Income, 1929–35. Believe it or not, it sold out. And every country then joined the party and started putting numbers to the health of their economies. A first quantitative picture of the economies around the world was made. And the figure below shows how bad the situation was back then and how things have improved. Economists tend to look at GDP per person as a better measure of life standards (otherwise all big countries are going to be better than smaller ones). This chart shows the terrible effect of the Great Depression and the wars in Germany, USA and UK (PPP is to put everything in a common scale of prices).

Figure: GDP per capita (PPP, log scale)

Note: Scale gives the equivalent GDP value in 2012 US dollars.
Source: Maddison Tables and World Development Indicators.

But even if the GDP measure was too late for the Great Depression, it would come useful later on. The biggest test for this measure came in the 1940's with World War II. They needed to know how many planes and bullets could be made before prices would go up and goods in the cities would become scarce. The army thought they could make a lot. Roosevelt himself gave a speech in 1942 saying they would make 60 thousand planes and 45 thousand tanks. But Kuznets picked up his calculator and told the president it was not possible given the number of factories and steel mills. Of course the economist was right and Roosevelt backtracked. Did the confidence of the US on how to use its resources help win the war? Very likely. And all thanks to a very dry data-cruncher economist.

After this experience many economists thought that if they could measure it, they could control it. They thought it was like physics. If they understood which variables were moving the economy, they could manage them and drive us to the right place. After a century of several bad worldwide crisis experiences, it is probably safer to say if you can't measure it, you can't control it. But I guess that if they had been able to really control it, all us economists would be unemployed. Any mistakes done may just be for the well-being of me and my fellow colleagues.

(In the 17th century William Petty made some progress on some of the concepts behind the national accounts but his estimates did not allow to identify the magnitude of a crisis, the yearly growth nor the size of some particular product in a country's production, which are the main use of GDP estimations nowadays. Petty's objective was mainly to show that landlords did not make as much income as thought. He claimed labor was the source of 3/5 of national income and so if tax revenue was the objective, consumption and labor income taxes should be taken into account.

GDP is still a very messy object to calculate. Next week I will write on how GDP is actually calculated. Hang tight!)

Based on an episode from Planet Money and an article from the Bureau of Economic Analysis.