Considering how ubiquitous talk about GDP and growth rates is, it is noteworthy that as a concept it is of fairly recent vintage. The idea of having a measure of the “income” of a country was invented by the American economist Simon Kuznets for use in a US Congressional report in 1934. The “product” part of gross domestic product refers to the production of goods and services. It is an aggregate measure — and hence a macroeconomic measure. It is a measure of the total amount of goods and services that an economy produces. Full disclosure: I am not a macroeconomist and find the subject painfully boring. But here I am only discussing the limited idea of GDP.
Why am I discussing GDP? Someone on twitter asked me a few questions related to GDP recently. Here’s a consolidated & edited text from several tweets from her:
“We know that GDP growth rate is down 4% points from 2004. But most of us do not clearly understand the impact it is having on our lives . . . What is the loss we suffer if GDP growth rate falls by 1% point . . . Also if China grows at 10% and India grows at 8%, can the huge gap be understood by ordinary people?”
The wiki article on GDP is quite good but perhaps a brief informal discussion on what it means may be of help. So here goes.
GDP refers to production. Indeed, it refers to the total amount of goods and services produced in a nation or a state.
Technical note: It gets tiring to all the time write “goods and services.” So I am going to use a technical term that I favor: stuff. Everything that an economy produces, everything that we consume, everything that we trade, etc. . . . is stuff. End of technical note.
Now, there has to be some metric to state what that total amount of stuff the economy produces. It would be easy if there was only one kind of stuff — say wheat. Then we could just say, “Economy A produced eleventeen million tons of wheat last year and that economy B produced brilligteen million tons of wheat.” Since we can easily tell that brilligteen is larger than eleventeen, we immediately know that economy B is larger than economy A. But real economies don’t just produce one thing; they produce an immense variety of stuff such as shoes and ships, and sealing wax and computers, and dentistry and dance instructions, and books, ad infinitum. To be able comprehend the size of different economies, we have to choose some measure that represents the aggregate production in a way that is meaningful and comparable across different parts of the world at any specific time time (that is known as a cross-sectional study) or for the same economy but for different times (longitudinal study) In other words, we have to choose a numéraire. If you guessed that the numéraire is money, you are right on the money.
The process goes thus:
1. They figure out how much of each kind of stuff was produced in total in a year by an economy. (Say, 4 shoes and 8 widgets. It’s a very small economy.)
2. Then they figure out the market prices at which the various kinds of stuff were sold. (Each shoe sold for $2 and each widget sold for $3.)
3. Then they multiply the numbers of (1) and with the corresponding numbers of (2) above, and add them all up to get the GDP — a great big number which is expressed in $ or rupees or whatever currency makes sense. (The GDP of our small economy is 4×2 + 8×3 = $32.)
It is a total mystery to me how the whole process takes place. An economy produces a stupendous variety of stuff, as noted before. How they figure out how much of what was produced is something I marvel at. I guess some kind of statistical sampling and reporting is involved in the process. I could find out if I really wanted to, but I don’t because I like some things to remain mysterious. It adds charm to life. Anyway, let’s move along.
So here’s the interesting point. GDP refers to aggregate or total production. Therefore it also has to refer to aggregate or total income. What we produce is what we earn as income (in the aggregate.) Certainly, at the lower levels of aggregation, this rigid identity between income and production does not necessarily hold. One can produce a lot and yet receive a low income, and vice versa.
We live in the modern world. One of the features of the modern world which distinguishes it from the pre-modern world is that in our world, the GDP grows appreciably (for most parts of the world.) In the past, the GDP growth rate was so small that hundreds of years would pass by before you could sense any change. For most of human history, things used to be static. Things around you were pretty much what it used to be during your grandfather’s time, and your grandchildren would live lives hardly different from yours.
Now it is different. My life would have been unimaginable to my grandfather, and no one can imagine how different the world will be in 50 years from now. It began with what is commonly called the “Industrial Revolution” around 1750 CE. That’s just two and a half centuries ago. The amount of stuff that the people of the world started producing (and naturally therefore consuming) began to grow. Things are changing and the pace of change is accelerating at an exponential rate.
The word “exponential” is often misused but in the case of the growth rate of GDP (and related matters), it makes perfect sense because we often talk about GDP growth rate for a range of years. The amount added each year gets compounded as the years go by. If the rate of growth is, say, 10 percent a year, then the amount 100 will grow by 10 units the first year but on the second year it will grow by 11 units (that’s 10 percent of 110), and by 12.1 units the next year, and so on.
A nice rule of thumb is that a growth rate of g percent per year will double the initial amount in 70/g years. So if the GDP growth rate is 7 percent per year, the GDP will double in 10 years; if the growth rate is 3.5 percent a year, then the GDP will double in 20 years.
It is hard for us to really intuitively understand exponential growth. The difference between, say, 5 and 7 is not much to write home about. But if you are compounding something over a significant number of periods, the difference explodes. $100 grows to be $800 at 5 percent growth rate in 42 years, but at 7 percent rate of growth, the same $100 grows to $1600 in 40 years.
Allow me to quote an old post which addresses your question about how GDP and GDP growth rates affect our lives:
India’s actual rate of economic growth averaged over 60 years is around 2.1 percent per year, what I call the “Nehru rate of growth” because Nehru was the principal author of India’s socialist development policy. As I argue below, it is one of the greatest man-made disasters in the world. It was totally flawed, and the misery that it caused (and still causes) was entirely avoidable. Considering the present state of India is distressing but it is useful if considered side by side with an alternative that was possible. The counterfactual has to help move us to take a different path. Later on in the series, we will discuss what we have to do.
In the alternative scenario, I used a 6 percent long-run average annual per capita growth rate. Is that reasonable? Yes it was easily possible, and what is more, it still is. India is large, just like China. In 1978, they were both at the bottom of the economic heap, neck and neck in most measures of economic development. China got lucky and its leader Deng Xiaoping (1904 – 1997) steered China out of the socialist trap and made it into a market economy open to foreign investment. China’s economic growth was impressive, to say the least. Over a period of 30 years, it grew at an average around 8 percent annual growth rate. Today China’s economy is at least four times larger than India’s.
India could have easily become a market-oriented, open economy by 1950, and had an average 6 percent annual growth rate for 60 years to become at present a middle-income country. India’s per capita annual income could have been around $10,000, ten times of what it actually is. Its GDP could have been $11 trillion, and India, instead of China, would be the largest economy in the world second to the US.
Economic growth at 6 percent annual rate works marvels. India would have eradicated poverty by 1970. Around 1950, India had around 250 million below the poverty line (out of a total population of less than 400 million.) Today it has 700 to 800 million below the poverty line. That’s what Nehruvian socialism has achieved – a tripling of the absolute number of poor people. Had India followed the alternative model, mass scale poverty would have been history in less than a generation. Today the problem of poverty is much harder to solve because the solution has been delayed so long.
Mass scale poverty has its fellow travelers. India has the largest number of illiterates in the world. India has the largest number of malnourished people in the world. Reports indicate that around half of India’s children below the age of five are malnourished. The overwhelming number of Indians do not have clean drinking water, access to toilets, access to schools, health care, . . . the list is long and heartbreaking. Rural Indians eke out a Hobbesian existence: “solitary, poor, nasty, brutish and short.” Indian farmers are a distressed lot, and one famous journalist has made his entire career solely by reporting on farmer suicides.
There’s more to life than economic growth. Economic prosperity is not sufficient but it is definitely necessary when hundreds of millions are trapped in poverty. China provides evidence that six percent growth is possible for a large country. India had all the necessary precondition – except one – for becoming a middle-income country by now. If it had, this is what we would have had. (We will explore that one missing factor later in the series.)
If India had become a middle-income country, Indians would have read about abject poverty in history books and seen it in documentaries, not actually seen it cities, towns and villages as they do today. India would have been 100 percent literate. All Indians would have had at least graduated high school. India would have had scores of educational and research institutes ranked globally which would have attracted hundreds of thousands of students from the world over.
Indians would have been healthy and their life expectancy close to that of any developed nation. More importantly, they would have had an enviable quality life. India would have had clean, livable cities – and lots of them – hundreds of modern cities with impressive infrastructure. The structure and composition of the Indian labor force would have been mostly in manufacturing and services, and about 10 percent in agriculture. With only of small fraction of the overall labor in agriculture, farm incomes would have been sufficient to make the life of farmers worth living.
With six percent annual growth over a long period, amazing things happen. Income growth has two effects. First, it allows greater consumption. That itself is a good thing if one is below the world average (or at least below a certain minimum.) The second effect of a large income is that savings can be larger – which means that investment can be higher. What you don’t consume, you can invest. This is true both of an individual and a collective.
Individuals grow their assets with savings. They end up with houses and other durable goods, all of which makes life more pleasant and people more productive. Similarly, with higher income, national assets increase. Nations can invest in assets such as manufacturing facilities, and infrastructure such as needed for transportation (roads, ports, railways, airports), housing, water supply and waste management, power generation, heavy machinery, facilities for hospitals, schools and universities, recreational, tourism, etc. All assets have positive feedback effects: the more you have, the more productive the economy becomes, which raises incomes, which then go on to increase the investable savings for building more assets.
GDP measures wealth. GDP itself is denominated in money terms. Actually, all kinds of wealth is expressed in monetary terms. This is a terrible thing because people start believing money is wealth. This confusion has really terrible consequences. Next time.