Here's why the go-to metric for assessing economic strength is far from perfect - and might need an update

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Here's why the go-to metric for assessing economic strength is far from perfect - and might need an update

London financial district

Simon Dawson/Reuters

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  • Gross domestic product has long served as the standard measurement for national economies, with its historical precedent and simplicity making it appealing to everyone from economists to investors.
  • However, the formula for GDP leaves out factors that are growing increasingly crucial in today's economy.
  • Some experts argue the measurement is slow to account for the rapidly developing service industry, doesn't account for sustainability, and leaves social movements in the dark.
  • Here are GDP's strengths and weaknesses, as well as a few other indicators that cover some of the areas GDP ignores.
  • Visit the Business Insider homepage for more stories.

Gross domestic product continues to serve as the go-to metric for measuring national economies. It's cited in times of expansion and recession, and followed closely by economists around the world.

Yet a focus on maximizing GDP leaves plenty of other key factors out of the equation.

The US posted a better-than-expected GDP reading Wednesday, with 1.9% growth beating analysts' 1.6% estimate. The figure was primarily driven by strong consumer spending as the manufacturing sector cooled.

As CEOs shift their priorities away from simple profitability and companies place greater value in sustainability, the formula for GDP ignores several critical indicators like quality-of-life shifts, environmental degradation, and purchasing power, among many others. GDP is calculated by adding a nation's consumption, government spending, investment, and net exports.

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Here are GDP's crucial strengths and drawbacks, as well as a few other measurements that could eclipse the historical benchmark as a new measure of national progress.

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The Pros

The Pros

Much of GDP's strength comes from its historical precedent. The metric dates back to 1944, after countries attending the Bretton Woods economic conference agreed to start using it as a standardized measurement.

Even through the US was among the last major powers to prefer GDP over other measures — holding off until 1994 — the St. Louis Federal Reserve shows GDP data from as far back as 1947.

Since then, critics have occasionally called for the use of real GDP — a measurement that takes price changes into account — or metrics that place a greater focus on consumer happiness. Yet nominal GDP remains the standardized measure across the world's largest economies.

The widespread acceptance of a single equation is another reason why GDP is so popular. For example, the US has pivoted from its manufacturing-heavy past to an economy more focused on innovation and service sectors.

Meanwhile, China expanded its economy by offering other nations cheap labor and investing in massive manufacturing facilities. Both nations have changed drastically in the last few decades, yet GDP measurements remain dependable and allowed analysts to compare the two economies as they evolved.

Finally, the single figure represented in GDP makes measuring economic power simple. While the measurement doesn't take all economic data into account, it yields an easily-updatable list of the world's most powerful economies and helps analysts study why some nations rapidly jump up the rankings and others lie stagnant.

The Cons

The Cons

For nearly just as long as GDP has been a leading metric for economists around the world, it's also seen its fair share of critiques. Going as far back as the 1930s, economist Simon Kuznets argued the formula didn't account for how individuals' welfare and the quality of their work lives.

"No income measurement undertakes to estimate the reverse side of income, that is, the intensity and unpleasantness of effort going into the earning of income," Kuznets wrote, adding that the US's welfare can "scarcely be inferred from a measurement of national income."

This criticism remains relevant, as researchers call for a new standardized metric that accounts for population growth, purchasing power, and other quality-of-life factors.

New measurements like the Genuine Progress Indicator emphasizes the ever-shifting definition of progress, and accounts for elements missing from GDP like environmental sustainability, crime, unpaid work (parenting, housework, etc.), and wealth distribution.

Other issues have plagued GDP since its creation. Its focus on simplicity hides the massive potential for data collection errors or incorrect sampling. Failure to properly account for seasonal adjustments, survey errors, or irregularities can skew the final sum and leave economists with massively incorrect data.

Finally, the speed with which new technologies and businesses develop leave GDP lagging behind more modern metrics. A 2018 Credit Suisse report detailed how GDP doesn't account for relatively new, yet basic, categories like income from shared assets. This omits growing fields like rideshare drivers, room renters, and food delivery couriers.

The formula fails to account for home production of digital goods like videos, articles, or software engineering, snubbing freelancer writers, influencers, and coders-for-hire. It also ignores "digital intermediation," which covers all categories in which consumers bypass typical brokers and agents and use an online equivalent in their place.

These are just a handful of the categories GDP leaves out in its calculation. As new tech-focused products, jobs, and industries hit the market, the world's default economic measurement leaves them in the dark.

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The Alternatives

The Alternatives

GDP certainly has its value and isn't going away anytime soon, but many economists argue there's room for other metrics that make up for its shortcomings.

Here are a few other indicators that track economic development alongside factors like quality-of-life, environmental consciousness, and income equality.

  • Genuine Progress Indicator (GPI): This measurement begins by assessing consumption data — similarly to GDP — before taking environmental and social information into account. It levies negative scores for items like income inequality, crime, and environmental deterioration. The measurement then adds items like public infrastructure, housework, and volunteering. GPI is also expressed with a single monetary figure, therefore making it just as simple and easily comparable as GDP.
  • Gross Environmental Sustainable Development Index (GESDI): Placing a greater emphasis on environmentalism than other benchmarks, this metric measures the quality of national growth and development. It uses more than 200 non-market values organized into four categories — people, available resources, environment, and economic development — to discern which countries have the highest level of everyday comfort.
  • United Nations Human Development Index (UNHDI): This measurement ranks nations on a 0-1 scale based on how citizens' quality-of-life compares to a global average. It follows life expectancy, expected years of education, and gross national income per capita as separate indicators. Once data is compiled, an average of the three figures forms the HDI. The most recent report placed Norway in first place with a score of 0.953.

The long-term standardized use of GDP has given countless insights into economic trends, developing countries, global superpowers, and emerging markets. Its formula is "still essential for macroeconomic policy," but its shortcomings grow increasingly important, the Credit Suisse report said.

"In thick fog, some light is better than none. For such purposes, GDP serves us reasonably well."