Download 1 Talk given in Peterborough alongside presentation of the Q2 2014... Monitor results.

Talk given in Peterborough alongside presentation of the Q2 2014 Business Confidence
Monitor results.
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Economic growth is almost always defined in terms of percentage increases in Gross
Domestic Product (GDP). The figures quoted in the media are after adjustment for
changes in price levels.
GDP is a measure of the scale of economic activity. In simple terms, it measures the
quantity of goods and services produced by an economy. The quantity is measured in
monetary terms, using market prices where these are available.
The national accounting system underlying the calculation of GDP is a relatively recent
development. Various attempts were made to estimate nations’ income and wealth
prior to the 1930s, yet the results tended to be insufficiently detailed, comprehensive or
timely to be useful for understanding business cycles. This proved problematic during
the Great Depression when US politicians wanted to be able to assess the outcomes of
their economic policies. The first set of official US national income statistics were
requested via a Senate resolution in 1932 and reported in 1934.
With the outbreak of World War II, US national accounts saw a shift in emphasis towards
the products of economic activity. This led to the launch of the Gross National Product
(GNP) data series in 1942. National economic statistics were critical to management of
the US economy during the war as they enabled investigation of the feasibility of
planned military production and the implications for consumer spending if productive
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capacity was diverted to achieve these plans.
Meanwhile, other countries were developing national accounting measures in parallel.
The first official UK national accounting estimates were published in 1941. In 1945, the
League of Nations (shortly to become the UN) convened a committee of statistical
experts which commenced the process of international standardisation of national
accounts. The methodologies have continued to evolve, for example by improving
inflation adjustments and the measurement of international trade in services, but the
main features of the current system were in place by the mid-twentieth century. GNP
continued to be the main statistic of focus until the early 1990s when it was supplanted
by GDP, reflecting the increasing prevalence, and hence importance, of foreign ownership
of domestic production.
GDP can be calculated in three different ways, each of which gives the same answer
(subject to statistical error). The next 3 slides present the formulae for these 3
calculations.
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The expenditure approach focuses on the demand side, in other words those who
purchase the goods and services produced. GDP is calculated as consumer spending plus
government spending plus investment (by firms, households and government) plus
exports less imports, as shown by the pink shaded columns in the supplementary slide.
It is summarised by the formula GDP = C+G+I+X-M (where I stands for investment) which
will be familiar to those who have studied macroeconomics. Note that the first three
components on the right-hand side of this equation relate to customers who are based
in the country in question, but include their purchases of imported goods and services,
so these have to be deducted (the fifth component), and purchases of domestic goods
and services by those based overseas have to be added (the fourth component).
NPISH stands for Non-Profit Institutions Serving Households.
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The output (or production) approach to calculating GDP focuses on producers’ output. It
is calculated as their Gross Value Added (Gross Output less Intermediate Consumption
of non-durable inputs produced by others) plus certain taxes net of subsidies (those
which are linked to the amount of production, eg, VAT and excise duty). This is shown by
the blue shaded rows in the supplementary slide. The cost of durable goods, ie, those
involved in but not used up during the production process, is not deducted from Gross
Output when calculating Gross Value Added.
So GDP is not the total output of all producers in the economy; you only count the
output which is sold to its end-user, not the intermediate outputs which are used as
inputs to production by other domestic producers.
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The income approach to calculating GDP focuses on the distribution of the income from
production between the different factors of production. Broadly speaking, the income is
distributed to employees, producers and government, as shown by the lilac shaded rows
in the supplementary slide. Gross operating surplus means producers’ gross trading
profits. Gross mixed income relates to those producers for which operating surplus and
employee compensation cannot be separated (eg, the self-employed).
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Producers include businesses, government, non-profit institutions and households. But
the bulk of production is by business. So to understand how GDP relates to business
metrics, here’s a very simple representation. You can think of a company’s gross output
(or revenue) as being matched by its expenditure on inputs from other firms, wages,
taxes and profit. The sum of the last three items (shown in red) is known as Gross Value
Added (GVA). If you sum GVA over all producers located within the country’s geographic
boundaries, and add in taxes on production like VAT and excise duty (net of subsidies on
production), you get GDP.
This diagram illustrates the link between an individual producer and the income and
production approaches to calculating GDP. The link with the expenditure approach is
harder to see. You can think of an individual firm’s contribution to the expenditure
approach in two ways. Either you count 100% of its output which is sold to an end-user
(or is exported) and 0% of other output. Or you can think of end users’ expenditure on
products as being made up of the GVA of each producer along the supply chain.
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Capital expenditure is not deducted as part of the input costs when calculating the gross
value added by producers (in the output presentation of GDP). Neither is a deduction
made for the depreciation of productive capacity as existing assets wear out or become
obsolete. The costs of production are, in effect, understated. Indeed, the ‘G’ of GDP
refers to the fact that the calculation is before deduction of capital expenditure. Figures
net of ‘consumption of fixed capital’ (broadly equivalent to the depreciation charge
found in corporate accounting) - Net Domestic Product (NDP) – are calculated but these
are not widely used since the consumption of fixed capital figures are inevitably subject
to considerable uncertainty.
The ‘D’ of GDP refers to the fact that economic activity is allocated to countries on the
basis of the geographic location of production. Gross National Income (formerly GNP) is
similar to GDP but instead allocates economic activity according to the initial destination
of the income generated. So, for example, if a Japanese company repatriates profits
from a US factory, those profits will count towards US GDP and Japanese GNI. If a worker
lives in Belgium and works in France, his wages will count towards French GDP and
Belgian GNI. Although GNI and GDP are very similar for the UK (GNI was 1% higher than
GDP in 2011 ), they differ significantly for some countries (eg, for Luxembourg, GDP was
48% higher than GNI in 2011 ).
GDP measures the expenditure on domestically produced goods, rather than the
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expenditure of the country’s residents, and these can diverge if there is an imbalance in
international trade. Hence it is a measure of production not consumption. It excludes
transfers of income that are not directly related to economic production such as taxes
and welfare payments, transactions with the European Union, overseas aid and private
gifts. GDP also excludes the proceeds from secondary trade in capital goods, for example
buying and selling houses and company shares, as this does not involve production.
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Property sector – rising house prices only indirectly contribute to rising GDP. This is
because selling an existing house is a transfer of money; no goods or services are
produced. Construction of new houses counts towards GDP, as do services associated
with buying and selling houses such as estate agent fees, legal fees and moving costs.
Finance sector – some financial institutions charge directly for their services (eg
brokerage fees on buying and selling shares) and these feed directly into GDP. However,
many banking services which are remunerated through differences between interest
rates for lending and borrowing rather than by explicit fees. These are included in GDP
by modelling the difference between actual interest rates and a reference interest rate.
This can lead to some surprising results; for example, the UK financial services sector’s
GVA peaked in early 2009 (ie, several months after the start of the financial crisis) due to
the rise in interest rates charged at that time.
Public sector goods and services such as healthcare and education are typically not
freely traded on markets and so do not have observable market prices. Instead, the
public sector’s contribution to GDP (when measured in current price terms) is calculated
by valuing its output at the cost of provision, equal to: the cost of inputs purchased from
other producers; plus employee compensation; plus a notional charge for the
consumption of fixed assets such as buildings. This might differ quite significantly from
the amount the service users would be willing to pay for the output if it was provided
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through the private sector instead. When GDP growth rates are calculated in volume
terms, direct measures of public sector output are used instead where possible. These
are based on the activities carried out and services provided, weighted by the associated
unit costs. This enables changes in the efficiency of producing public services to be
reflected in GDP growth rates, which would not be possible if outputs were assumed to
equal inputs. In theory, these direct output measures should be adjusted for changes in
quality, but the techniques for doing so are still at an early stage of development.
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When comparing GDP figures from different periods, it is important to know how much
of the difference is due to changes in the volume of production and how much is caused
by changes in prices. National statistics offices therefore produce two main sets of
figures: the monetary value of GDP in current price terms and percentage changes in
GDP measured in volume terms The former includes the effects of changing price levels
whereas the latter does not. The GDP growth rates quoted in the media tend to be the
ones calculated in volume terms. Growth is measured in volume terms for many sectors
of the economy by adjusting nominal price output figures for changes in price levels; for
other sectors, particularly government services, changes in output are measured
directly.
When calculating changes in volume measures of GDP, it is important to take account of
changes in the quality of goods and services produced. This is particularly important for
sectors experiencing rapid technological changes, such as computing, or when making
comparisons over extended time periods; otherwise, producing the same number of
goods to a higher specification would not be recorded as an improvement (increase) in
output. However, it is often difficult to distinguish changes in quality from changes in
price, particularly for services. There are various possible approaches to volume
measurement and quality adjustment, and this is an active area of research. Even
though improvements are being made, it is an inevitable area of subjectivity and
uncertainty in quoted GDP growth rates. Some authors have suggested that there may
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be a tendency to underestimate quality improvements, in which case GDP growth rates
will be understated.
When comparing countries’ GDP figures, particularly when GDP is being used as a proxy
for living standards, it is important to adjust for differences in the population size. Hence
per capita figures are commonly used. Interestingly, GDP growth rates are rarely
calculated in per capita terms; adjusting for increases in population presents a less rosy
picture of a country’s economic performance (see supplementary slide).
A further complication for GDP comparisons between countries is differences in the cost
of living, as well as the use of different currencies in many cases. It is standard practice to
use purchasing power parity exchange rates to adjust for this. These rates are necessarily
derived using statistical techniques rather than being observable in financial markets, so
this adds an extra layer of uncertainty to GDP figures.
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GDP figures form part of an extensive set of national accounts, which provide a wealth
of supporting information such as GDP’s split between sectors of the economy and
between the main categories of economic actors (households, firms, government).
There are an international set of national accounting rules, intended to standardise
calculations between countries and facilitate international comparison of GDP statistics.
The first international system of national accounts was launched in 1953. The UK
currently uses the 1993 rules, the UN System of National Accounts 1993 (SNA93). The
rules allow considerable flexibility in the methods adopted, not least to accommodate
the vast differences between countries’ economies (especially those at different levels
of development).
A more detailed, prescriptive set of rules has been developed by Eurostat in order to
increase the consistency between EU countries’ national accounts, in particular the GNI
figures used to calculate their contributions to the EU budget. The UK currently uses the
1995 rules, the European System of Accounts 1995 (ESA95), which are based on SNA93.
In its national accounts for the calendar year 2013, due to be published in September
2014, the UK will be adopting the new rules of ESA10, based on SNA08. This is already
attracting media attention. The UK’s GDP (measured in current prices) is expected to
increase by 2% to 3% as a result, although there may not be much impact on GDP
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growth figures. As countries adopt new national accounting rules at different times, this
hinders inter-country comparisons.
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The conceptual framework underlying national accounts has important similarities with
company (entity) accounting. It consists of a linked set of accounts: current accounts
(production, income and expenditure items), accumulation accounts (changes in
asset/liability values), and balance sheet accounts (assets and liabilities).
Economic activity is, in principle, measured on an accruals basis, with revenue matched
against expenditure when transactions occur rather than when the corresponding
payments are made. For example, surveys ask businesses about their income receivable
and expenditure payable (rather than income received and expenditure paid). In this
case, achieving an accruals basis relies on accurate completion of the questionnaires. As
all except the smallest businesses prepare accounts on an accruals basis, it seems
reasonable to assume that most respondents will report accruals-based figures. In other
cases, special adjustments are made to achieve an accruals basis. For example, the ticket
revenue from the London 2012 Olympics was allocated to the period when the Games
took place, rather than when the tickets were sold, contributing to a spike in UK GDP in
the third quarter of 2012. Nonetheless, in practice, some economic activity is measured
using a cash basis.
The conceptual framework for national accounting uses the principles of double-entry
book-keeping that underpin corporate accounting. It is not possible for national
accounting to use double-entry book-keeping directly as relatively few details of
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individual transactions are available. Transaction data is therefore supplemented by
various sets of statistical data, for example from surveys of businesses and households,
plus modelled data where suitable information on market transactions is not available.
Information relating to one party to a set of transactions (the payee or the recipient) is
collated and data from different sources is compared to ensure that, across the economy
as a whole, total payments match total receipts.
The national accounting system is sometimes referred to as a quadruple-entry system
because it incorporates two entries for both parties to each transaction. For example, the
sale of goods to a household might be recorded as final consumption expenditure and a
decrease in cash assets for the household, and sale of goods and an increase in cash
assets for the producer.
In theory, quadruple entry means that every transaction gives rise to four entries in these
accounts so that they always balance and their movements can be reconciled. But in
practice, account entries are estimated using statistical methods rather than individual
transaction data so this reconciliation is not possible. Instead, an extensive ‘balancing’
exercise is used to harmonise the GDP estimates obtained by applying the three different
calculation approaches.
Revisions to GDP occur as more complete data becomes available. A preliminary estimate
is published c.25 days after quarter end, based on the Output approach only. The second
estimate c.1 month later includes more detailed Output data, plus some Income and
Expenditure data. The third estimate appears in the quarterly accounts c.1 month after
that; it contains the first breakdown of Income and Expenditure components. The annual
national accounts contain much more detailed information and include the effects of
balancing the three calculation approaches. The next year’s annual accounts may reflect
further data changes. Revisions in subsequent years are generally due to refinements of
accounting methods.
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GDP figures depend on methodological choices about what exactly is included and how.
Not all economic activity can be measured via observation of market transactions, so
this activity is either excluded (reducing GDP’s coverage) or estimated (increasing GDP’s
uncertainty). For the UK, activities for which estimation is used include:
• Hidden transactions, such as tradesmen’s undeclared income.
• Goods made for producers’ own use, such as farmers consuming some of the food
they produce.
• Public sector production is valued as the cost of inputs; estimation is required for the
capital consumption component of this.
• Banking services which are remunerated through differences between interest rates
for lending and borrowing rather than by explicit fees.
• A notional rental value is included in GDP for owner-occupied properties; it
appears as both production by households and consumption expenditure by
households.
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Source: ONS quarterly national accounts, Q1 of 2013, 27 June 2013
Figure 1: Annual GDP, table A2, CVM SA
For any GDP calculation, a range of figures are possible due to statistical estimation,
methodological choices and (where applicable) inflation and currency adjustments. The
reported GDP figures should therefore be interpreted as, at most, a general indication of
the scale of economic activity, without attaching great significance to small percentage
changes from quarter to quarter. Although national statisticians acknowledge this, the
media and politicians nonetheless place considerable emphasis on short-term
fluctuations in GDP.
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The amount of production is only one of the characteristics of an economy we’re
interested in; many other things are important too. There are signs that the UK media is
now considering a broader range of metrics, in part because the recent recession has
highlighted the way that important indicators can tell different stories. One example is
employment which didn’t suffer as badly as headline GDP during the recession. Another
example is household income and concerns that recent increases in GDP aren’t yet
translating into higher take-home pay.
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GDP aggregates a lot of information into a single statistic, so inevitably it only gives a
limited picture of the economy. Individual people and businesses can find that their
experience of the economic climate is very different to the headline impression given by
GDP.
GDP is most often calculated for countries, although it may also be calculated for smaller
geographic areas or aggregated across countries. Studying economic data at a national
level can give a misleading impression if there is significant variation in economic activity
between regions. For example, whilst it is well-known that average incomes are higher
in London than in the rest of the UK, the extent of the difference may come as a
surprise. The diagram shows that average gross value added (ie, GDP less taxes on
products) per person ranged from 53% of the London value in the North East to 64% of
the London value in the South East in 1989. By 2009, the gap between London and the
other regions had widened, and there was also greater variation between the nonLondon regions: average gross value added per person ranged from 43% of the London
value in Wales to 61% of the London value in the South East.
ONS produces various splits of GDP and related statistics which provide information on
how the income generated by production of goods and services is shared between the
main groups of economic actors. However, because they are based on economy-wide
data, different information sources are needed to understand how income is shared
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within those groups. This is important for understanding the economic well-being of
individual members of society because many countries have a very unequal distribution
of income. Average GDP per person can only give a very crude indication of living
standards: from an individual’s perspective, their own net income and its adequacy for
purchasing the goods and services needed for a high quality of life is obviously much
more relevant.
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GDP can be thought of as providing information on economic ‘flows’: it is a summary
measure of the money, goods and services that flow between producers and consumers
during a given period of time. GDP is therefore, in effect, a single figure from an income
statement. In order to assess the sustainability of economic activity, it is also necessary
(although not sufficient) to have information on the underlying ‘stocks’ or assets used to
generate that economic activity.
The national accounts include a balance sheet which, in the case of the UK, records the
value of some manufactured and natural capital (‘non-financial assets’) and most
financial capital (‘financial assets’ less ‘financial liabilities’). The underlying conceptual
framework document explains how the current accounts (from which GDP is derived)
and accumulation accounts relate to changes in the national balance sheet. However, in
practice, the UK does not publish a reconciliation of the opening and closing positions
and there are conceptual inconsistencies between the national balance sheet and GDP.
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There is a tendency among politicians and journalists to interpret GDP as a measure of
society’s collective well-being, even though most economists and national statisticians
acknowledge that this is inappropriate.
The expenditure approach to calculating GDP is the one most obviously linked to living
standards through the idea that well-being is generated by the consumption of goods
and services. However, GDP is primarily a measure of production, not expenditure, and
includes production for investment as well as production for consumption. Moreover,
consumption is not the only determinant of well-being; well-being is critically dependent
on non-economic factors like personal relationships and a sense of community.
Some production harms well-being yet is included in GDP, for example the production of
cigarettes. In turn, smoking gives rise to other economic activity such as nicotine
patches and addiction support services, not to mention the increased health costs of
treating smoking-related illness. Smoking therefore boosts GDP. A country which was
identical except for having fewer smokers would have lower GDP, yet would generally be
judged to have higher well-being.
Monetary cost may not be a good indicator of value. For example, public services are
included in GDP at the cost of production yet this might differ quite significantly from
the amount the service users would be willing to pay for the output if it was provided
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through the private sector instead. Contrast UK and US levels of healthcare spending: it is
higher in the US yet health outcomes are worse on average.
In addition, there are theoretical issues with summing measures of individual well-being
(eg, consumption expenditure) and using them as a measure of overall social welfare.
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The scope of economic activity which is included in GDP, using the current European
national accounting rules, can be summarised as ‘The production of all goods whether
supplied to other units or retained by the producer for own final consumption or gross
capital formation, and services only in so far as they are exchanged in the market and/or
generate income for other economic units’. GDP is therefore intended as a complete
measure of the human production of goods but a less comprehensive measure of
services. It excludes the value of most voluntary work and unpaid domestic activities
such as cooking, cleaning and childcare. One consequence of this is that GDP increases if
someone starts to employ a cleaner or child-minder rather than doing this work
themselves.
GDP and national accounts do not fully recognise the importance of human, social and
natural capital to economic activity. For example, the national balance sheet is largely
restricted to manufactured assets, financial assets and financial liabilities. Yet other
assets – ones on which monetary values cannot readily be placed provide vital
underpinnings to all production: human skills and ingenuity; social relationships and
trust; and natural resources and ecosystems.
The national accounts are also unable to monitor important characteristics of the
economy such as its stability and resilience. In the run-up to the 2008 financial crisis,
headline economic indicators suggested that the economy was performing strongly. A
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more comprehensive picture of economic performance revealed worrying signs that the
economy was becoming increasingly unstable, such as rising levels of consumer debt,
increasing withdrawal of household equity, and the growing reliance of the banking
sector on securitisation. Focusing on measures such as GDP can encourage actions that
improve apparent short-term performance whilst undermining the system’s ability to
function well over the longer-term.
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This talk is part of ICAEW’s project ‘So what is economic success? Going beyond GDP
and profit’. The diagram is an extract from the project prospectus, available at
http://www.icaew.com/en/technical/sustainability/what-is-economic-success-goingbeyond-gdp-and-profit. It maps out various questions that we are considering.
Today’s talk is mainly within Box 3: How are our current measures calculated? (GDP
only). It also touches on Box 4: What are current measures’ strengths and weaknesses.
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We are hosting a discussion event centred around Box 2 (‘what do we mean by
economic success?’) in Liverpool on 1 July 2014 as part of the International Festival of
Business. Please come and join us, or contribute your thoughts via our online
discussions, accessible via the link in the prospectus.
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The project forms part of ICAEW’s Sustainable Business Initiative. There are several
channels you can use to keep in touch with our sustainability projects.
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Sources: ONS, United Kingdom Input-Output Analytical Tables 2005 and ONS, The Blue
Book, 2011 Edition
Notes:
1. Final Consumption Expenditure
2. Non-Profit Institutions Serving Households (eg charities)
3. Producers' gross trading profits, including self-employed income
4. Taxes and subsidies paid by producers and not linked to the amount of production, eg
business rates
5. Taxes and subsidies linked to the amount of production, eg Value Added Tax, excise
duty
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Sources: ONS, United Kingdom Input-Output Analytical Tables 2005 and ONS, The Blue
Book, 2011 Edition
Notes:
1. Final Consumption Expenditure
2. Non-Profit Institutions Serving Households (eg charities)
3. Producers' gross trading profits, including self-employed income
4. Taxes and subsidies paid by producers and not linked to the amount of production, eg
business rates
5. Taxes and subsidies linked to the amount of production, eg Value Added Tax, excise
duty
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Sources: ONS, United Kingdom Input-Output Analytical Tables 2005 and ONS, The Blue
Book, 2011 Edition
Notes:
1. Final Consumption Expenditure
2. Non-Profit Institutions Serving Households (eg charities)
3. Producers' gross trading profits, including self-employed income
4. Taxes and subsidies paid by producers and not linked to the amount of production, eg
business rates
5. Taxes and subsidies linked to the amount of production, eg Value Added Tax, excise
duty
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The graph illustrates the different impressions that various income measures can give,
using data for the UK from 2000 to 2011. The three measures are taken from the
national accounts and are economy-wide statistics averaged across the population.
• Total GDP increased by 20% over the period (after adjusting for inflation), but
population also increased by 6.5% so GDP per capita increased by only 12.6%.
• Gross Disposable Income increased by almost the same percentage as GDP over the
period, but it followed a notably smoother pattern, suggesting that factors such as
higher net transfers from government (benefit payments less taxes) had shielded
households from the worst effects of the 2008 financial crisis.
The actual experiences of individual households can diverge significantly from the
national average, especially in periods when the degree of income inequality is
changing.
GDI is households’ Gross Disposable Income, which is GDP adjusted for items such as
net transfers from government.
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