[Editorial] Use of GDP to Measure Economic Health

What is GDP?

  • According to the IMF (International Monetary Fund): “GDP measures the monetary value of final goods and services—that is, those that are bought by the final user—produced in a country in a given period of time (say a quarter or a year)”.
  • It is the primary yardstick used by the multilateral agencies, the RBI and other analysts to measure the health of an economy.

Why is GDP not a perfect measure of economic health?

There are 3 main reasons why GDP is a questionable measure of economic health:

  • The real GDP growth rate is contaminated by ‘double deflation problem’.
    • In the new GDP series, introduced in 2015, the deflator problem was made more critical by the shift from the volume-based measurement system to a nominal value-based measurement system.
    • This means that the real GDP is determined by collecting nominal GDP data in INR and then deflating it using different price indices.
    • The nominal GDP data has to be deflated twice– once for the inputs and once again for the outputs. However, the NSO deflates the nominal GDP data only for the outputs’ value and not for the inputs’ value.
    • To understand why this is problematic, consider a situation where the price of imported oil declines:
      • The input cost drops and the profits incurred by the domestic firms rise.
      • As this increase in profits is merely because of the drop in input prices, it needs to be deflated. Note, GDP is meant to measure the production in the country.
      • However, NSO doesn’t deflate this increase in profits and instead records this purely nominal increase as a real growth in GDP. This leads to an overstatement of growth.
      • According to simulation studies, this effect can be quite substantial.
    • A crude measure of this overestimation can be given by the gap between Wholesale Price Index and Consumer Price Index (as WPI measures the inputs’ cost).
      • In 2014-17, the oil prices declined, causing WPI to drop sharply relative to CPI. This indicates that the real growth was overstated.
      • The exact opposite has been happening in the recent times- with WPI inflation spiking to reach 14% in November, while CPI inflation stood at 5%.
      • This rapid rise in WPI (relative to CPI) has introduced an upward bias to the deflator, which increased at 8% in Q2 of 2021-22.
      • If this deflator is being overestimated, it could imply that the real GDP growth rate is being underestimated.
      • Though there have been arguments that the shift to CPI in the new series has improved the deflators, there are many cases where WPI is still used for deflation.
  • The NSO hasn’t updated the sector-wise weights.
    • The NSO takes a sample of activity, from each sector, and aggregates the figures using sectoral weights to calculate GDP.
    • The NSO updates the weights once every decade to ensure reasonable accuracy. However, it has been over a decade since the weights have been updated. The base year hasn’t been revised either.
    • As a consequence, the currently used sectoral weights are based on the economic structure of 2010-11 (a time when the IT sector, in particular, was much smaller). This means that fast growing sectors (like the IT sector) are being underweighed. This too leads to an underestimation of GDP growth.
  • The measurement of unorganized sector:
    • The measurement of contribution from the unorganized sector has always been difficult in our country.
    • NSO undertakes surveys occasionally to measure this sector. In the meantime, it is simply assumed that this sector grows at the same rate as the organized sector. This worked well as long as the two sectors moved in tandem.
    • Since 2016, the unorganized sector has been disproportionately affected by a series of economic shocks-
      • Demonetization (which affected the cash-dependent firms)
      • GST implementation (which necessitated difficult adjustments for the enterprises in the sector)
      • The NBFC issue in 2018 (which impacted this sector because of its heavy dependence on NBFCs for funds)
      • Pandemic since 2020

Most probable and repeated topics of upsc prelims

What are the arguments in favour of using GDP?

  • The GDP had been designed as a simple measure of the ‘total market value of all final goods and services’. By berating its use by judging it based on societal norms and moral norms, one would be missing the point.
  • To illustrate this point: GDP can rise with both coal mining as well as prostitution. This isn’t the fault of GDP as a metric. The question of whether an economy should allow such activities is separate from the question of what happens to GDP when such activities are openly undertaken.
  • The 2015 revision brought our GDP calculation in line with global practice.
  • Though GDP fails to capture the welfare loss, the reverse is also true i.e. it often doesn’t account for the welfare gains as well. For instance, during the pandemic, a soap bar or a mask (which can be bought for less than Rs 10) provide welfare far more than Rs 10 (the final market value) by potentially saving lives.
  • Regarding the broader question of people’s well-being, GDP is inadequate– but this is by design. To know about air pollution, unequal distribution of wealth, happiness, etc. one would need to cover other measures.
  • There have been many alternatives suggested- such as net domestic product (NDP), carbon dioxide emissions, Gini coefficient (inequality), etc. But in the use of any measure, there are faults, especially when used as a single go-to metric for policy making. Eg: GDP per capita provides a better picture of Indian economy’s ground reality but it too doesn’t account for rising pollution. It could even fail to spot an increase in inequality in certain cases: if the top 100 firms double their income while the rest remains at the same income level, the GDP per capita would increase to give a faulty impression that the average Indian is now better off.

What is the way ahead?

  • A notable controversy regarding GDP occurred when the NSO released the currently used GDP series in 2015. It uses 2011-12 as the base year. Scholars have pointed to several problems in this new series such as measurements problems in the nominal GDP growth rate and the real GDP growth rate. None of these concerns have been addressed and the errors continue to persist.
  • The double deflation problem in our methodology makes India unique among the G20 nations.
  • The 3 problems with measurement don’t mean that the latest GDP data understates growth- because these problems go in various directions. Without more information on the NSO’s methodology, the actual growth cannot be determined from the figures.
  • However, it is clear that there are problems with the GDP data and any growth forecast made based on this data is to be taken with a pinch of salt.
  • Authors of ‘Beyond GDP’ summarized that there isn’t a ‘simple way of representing every aspect of well-being in a single number in the way GDP describes market economic output. This has led to GDP being used as a proxy for both economic welfare (i.e. people’s command over commodities), and general welfare (which also depends on people’s attributes and non-market activities). GDP was not designed for this task.’
  • They call for a move beyond GDP when determining a country’s health. This is to be complementing GDP data with ‘a broader dashboard of indicators that would reflect the distribution of well-being in society and its sustainability across its social, economic and environmental dimensions’.
  • The challenge, however, is to ‘make the dashboard small enough to be easily comprehensible, but large enough to summarise what we care about the most’.

Conclusion:

Depending solely on GDP in policymaking would make the policies blind to people’s wellbeing. However, expecting GDP to measure factors it wasn’t designed to measure is irrational. There is a need to consider other important factors while framing policies for a nation.

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