Sunday, January 3, 2010

GDP = C + I + G + X

This is a Keynesian equation representing the measurement of a countries GDP. GDP stands for Gross Domestic Product, the other letters in the equation stand for Consumption, Investment, Government, and net Exports. The question one ought to ask is why are we using this equation for GDP when there is a simpler one. You see, GDP is essentially the total goods produced multiplied by the price of each one of those goods. In theory, one could simply take stock of everything we make in one year and then sum up the prices of all those things. This, however, is impractical, so very smart people have come up with this indirect alternative.

Physics is very cool and I remember learning about gravity, or the attraction between masses. It turns out that the original equation that Newton developed is based not on something fundamental, but on observation. It is a reflection on what we see, not the cause of it. GDP is supposed to be a measure of some fundamental value within society. We don't know this value, no one does. We take a measurement, use it as a proxy for this value. It is blunt, indirect, and dangerous.

What some economists have done is attempt to game the measurement in hopes of changing reality. This would be patently absurd in some other sphere of measurement. Software companies used to measure the productivity of their programmers by counting the lines of code produced. Programmers, those smart chaps, started to produce more lines than necessary. The measurement indicated higher productivity, it was wrong. We can fiddle with what is measured, but never forget that measurement is not the underlying cause of something.

Back to the infamous equation for GDP. What we want to measure is the value of a country. This cannot be done, and what can be done is crude and imprecise. Nevertheless, what is worse is the idea that gaming a certain factor in the equation can actually have an effect on real value. According to this equation if we simply increased consumption (C) our GDP would go up and hence we as a country would be richer. Or we could increase government spending (G) and once again we would be awash in riches.

There's a flaw somewhere. Clearly we cannot spend (consume) our way into prosperity. The bigger flaw is thinking that this equation used for measurement can have any effect on reality at all.


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