Gross Domestic Product, or more commonly known for its abbreviated form GDP, is a measure of the total value of final goods and services produced within an economy over a given time period. It is a direct measure of economic activity, and its year on year change is being used to compute measures such as economic growth.
The concept of economic growth is a very important one for most economies and governments around the world. This is rightly so because many measures of standard of living, such as literacy rates, happiness, healthcare standards and many others have been shown to be highly correlated to GDP. Governments are also concerned about growth because low growth tends to lead to high unemployment, a worsening fiscal position, external problems for the economy and perhaps most importantly, a worsening prospect for re-election or in some countries, regime continuity.
In general, this focus on GDP and growth seems to be well directed. In the golden years of 2001-2007, when most of the major developed countries in the world were experiencing strong economic growth and relative stability, it appeared to most governments that economics had finally cracked the code of growth and development. It seemed for an instance, to some at least, that there was a potential for ever increasing growth rates and income levels as long as governments maintained their control over key variables in the economy such as the level of fiscal spending and the interest and/or exchange rates. The illusion of control and prosperity was short-lived though, as the financial crisis and Great Depression of 2008 burst the bubbles of grandeur and high hopes ruthlessly, just like they did to the housing and credit ones.
But is this necessarily a bad thing?
The detachment of macroeconomic variables and their surrounding discussions from the ideas and tenets of microeconomics has become increasingly apparent over time. Economists and governments seem to be more and more concerned about reviving growth rates and combating high unemployment at all costs. But it seems to me that we are targeting the effects blindly and trying to achieve targets without really thinking about the underlying conditions.
I don’t suppose that there are many out there who still believe that markets functioned efficiently and that investments and consumptions decisions were well made in the periods prior to the Great Recession. When housing prices in the US started falling, painful adjustments had to take place as economic agents who were over-extended in their current consumption or investment had to make different and remarkably difficult decisions. This inevitably led to a collapse of demand in many sectors of the economy as spending was cut back and the fall in aggregate demand was made even worse by the series of domino effects that occurred once incomes started falling. It seemed to be a classic situation in microeconomics, where when you draw a demand and supply diagram, the demand curve suddenly shifts to the left and output levels fall drastically. However, this was not necessarily a bad thing for the economy as a whole, especially when you consider that perhaps most of the demand were driven largely by imperfect information, irrational human spirits and excessive exuberance, and as a result did not reflect true consumer utility and preferences.
It seems logical to conclude that if these demand were excessive to begin with, then we should certainly hope that they will not return. Yet, the focus of governments on growth and reducing short term unemployment and the relevant measures that they have taken to achieve these aims seem to reflect a completely misplaced belief that the economy should return to the way as it was before the crisis. Is that really what we should be striving for?
A new measure is needed
The solution then, is to rethink economics and to rethink the use of GDP and the focus on growth. A new measure of economic activity should be created specifically for measurement purposes after an economic crisis. Governments and economies should be judged by a different standard, not by how much economic activity grows by, but by how fast the adjustment of product markets is taking place.
A shift in focus will not only make more sense and relieve some of the political pressure on governments, it will also bring effective policy options back to the discussion table. Countries no longer have to stress about not achieving growth and employment, and instead can think about how the much needed underlying microeconomic adjustments can be facilitated to take place more swiftly and effectively. The solution in some markets might be to do nothing, because they are best left alone to let the price mechanism function; the solution in others, such as the financial sectors could be more complex, as a wide range of potential market failures plague these markets and the government might have a larger role to play in helping the market achieve efficiency in these sectors.
I do not yet have an idea of what sort of new measure should be created, but I do know that GDP is certainly ineffective in this regard.