Gross Domestic Product (GDP) is a star, as far as economic measurements go. The Consumer Price Index (CPI) (and other members of the acronym club) have their moment in the sun, but the talk inevitably returns to GDP. When it increases, we cheer. When it decreases, we point fingers. It is seen as the weathervane for our economy. This begs the question of how accurate a measure it is, and what it is actually measuring. Upon closer inspection, it appears that there is something truly gross about GDP.
The GDP claims to measure the total value of all goods and services produced within a nation. Seeking to paint the economy in such broad strokes is bound to leave out some details. For example, marriage can exert downward pressure on GDP.
Imagine a masseuse and a deli-owner. The masseuse buys all her lunches at the deli, and the deli-owner gets all his massages from the masseuse. In a romantic haze of pastrami and shiatsu, the two decide to marry. The deli-owner now makes lunch for his wife without charging her and she, in turn, gives him free massages. In this case, GDP has dropped because less lunches are being bought and less massages are being paid for. These kinds of "transactions" irk economists, but taken alone, they don't invalidate GDP.
Buying Your Way to Wealth
The main problem with GDP is that it is heavily skewed towards purchasing and the impact of purchasing on the economy. In a very real sense, GDP doesn't count as a good or service until it is bought by the end user. Consider a car. The car that is sold to a consumer represents multiple smaller purchases – rubber for tires, steel for the frame, spark plugs and their components, and so on. All of these purchases and the profits made on them are factored out to avoid counting something twice. The understanding is that all of this activity is summed up in the final sale of the car.
Left out of this equation is the flow of private investment capital. When profits are made at each stage of production – by the steel maker, tire manufacturer, etc. – they are reinvested into the economy in the form of more inventory, factories, employees, or even simply paid out to shareholders who then reinvest elsewhere. This flow of private capital is calculated out of the economic metric to avoid double counting. By removing this capital from the equation, we end up with a GDP that is 60-80% consumption spending, and around 90% with government outlays added in. Factoring the private capital flow back in lowers consumption spending to 20-30% of total economic activity, making private business a far more important part of the economy.
Wasting Your Money
Consumer and government spending affect GDP disproportionately, even though buying isn't an act of production. It is assumed that the purchase accounts for the capital that went into production. With private purchases, this could be the case in a limited sense. With government purchases, this is rarely so. Every time the government over pays for a project, GDP is increased by the artificial amount, before any benefits are realized; often they are not. For example, consider the $600 for toilet seats or the estimated $90 billion wasted on redundant and ineffective programs. Both cases represent overpaying for a product or service, yet the GDP considers these valid transactions that fully benefit the economy.
Common sense suggests that GDP has serious flaws. It considers spending and overpaying as an indicator of production, while delegating private capital investments to a minor role. Simply put, it doesn't do the job it was designed to do. Trying to measure economic activity with a scale tipped heavily towards consumption spending is like trying to calculate the weight of an object using a ruler. This wouldn't be an issue if GDP wasn't used to set government policy. When the government spends money, GDP increases. The government seems to like spending money, so there hasn't been a lot of political initiative to use a more accurate measure or fix the one they have. The next time someone tells you more stimulus spending is needed to lift the economy, you can inform him that the weight of an average carp is 15 inches. (Learn about GDP alternatives in High GDP Means Economic Prosperity, Of Does It?)