Pretty much everyone who read a newspaper or watched a news program or went online last Friday knows that “GDP grew 2.4% last quarter” in the US. I’m sure everyone can just rattle off what that means, right? I mean, there are only a few things you’d need to know:

  • What is Gross Domestic Product, and how is it calculated?
  • What does the 2.4% actually represent?  Increase versus what?
  • Does it mean it grew 2.4% higher than last quarter or last year?

There are lots of places you can visit to see the official definition of GDP (web definitions of Gross Domestic Product or GDP) but not here.  I want to talk to you about the essence of it and then describe what it means that it increased.

GDP is the broadest and most comprehensive measure of the economy that is widely accepted.  It basically measures the value of all goods and services produced in the country, regardless of industry.  In a sense, that’s what economics is all about, the value of things.  Let me explain with an example.

During a typical day, let’s say that you spend an hour of it sitting on the couch staring blankly at the wall, another hour watching a home shopping network and buying something and another hour doing your telemarketing part-time job.  There are clearly different levels of impact on society for each of your hours spent.

While you sat and stared at the wall, you basically didn’t do anything of value to society.  You didn’t even think about anything or try to get your thoughts organized so that you could do a better job at work.  That contributed nothing to the economy, and guess what?  It contributed nothing to GDP.  Good thing, right?  GDP would be useless if it had.

Watching the home shopping channel and buying the knife that cuts through a shoe actually did society a service.  The most obvious is that the knife company got your money and made a profit with it.  Along the way, there were others who profited: the steel production company that provided the steel for making the knife, the lumber company that sold the wood for the handle, the television channel that was paid by the knife company for featuring their product, etc.  But all of the value that was created along the way to create that knife was fully realized when you finally pulled out your credit card and made the purchase.  That final value is recorded in GDP as private consumption.  Granted, you are not the creator of all that value, but your action represented the final realization of that value.  All across the country, every purchase essentially adds to the GDP.  In fact, about two-thirds of the GDP is accounted for by consumer spending, which is why everyone cares so much about “consumer confidence” or “consumer sentiment” – though we’ll discuss in future posts that they’re not that important, actually.

Lastly, your hour spent doing telemarketing work is another chance to contribute to GDP.  You are providing a service that your employer obviously values, otherwise they would not pay you.  When you make a sale on the phone (at dinner time – always at dinner time!), what the consumer forks over is the value that goes into GDP again.  What the consumer pays covers, among other things, your paycheck.

So, GDP is a fairly good indicator of how much value there is to what everyone is doing in the country.  I’d say that matters, wouldn’t you?  One very important thing has to happen though before we can use it as an indicator on a regular basis.  The value of what is produced generally goes up over time due to inflation.  So, we have to adjust for that when comparing the GDP for one quarter (years are broken up into four quarters: Jan-Mar, Apr-Jun, Jul-Sep, Oct-Dec) to another.  That’s why they actually call it “Real GDP” with the “real” referring to a dollar figure that is adjusted to account for inflation.

So, our real GDP grew 2.4% from the 1st quarter of 2010 to the 2nd quarter.  Keep in mind, that is an “annualized rate.”  That means that it didn’t actually grow 2.4%.  It means that if you take the rate that it actually grew and keep that rate going out for a full year, it would equal 2.4%.  It is really a 2.4% “annual pace” if that helps you understand it.

Is 2.4% a good rate of growth?  We could answer that in several ways.  First, what’s an average growth rate over the country’s history?  The average real GDP growth rate from 1790 to 2009 was 3.76%.  From 2000-2009, it was 1.63%.  So, it’s below historical averages but better than the last decade or so.  Not bad, basically.  But that’s why you hear a lot of people say that the recovery is slowing.  These are not the kind of rates we want to see that would help some things that are really struggling (housing, unemployment) to get back to normal.  Instead, we are really just treading water.

Still, the Q2 2010 GDP report was probably a step in the right direction:

  • Nearly every major category was an improvement, the exceptions being PCE (personal consumption expenditures) and net exports (exports minus imports).
  • Although the “headline number” of 2.4%, the one all the mainstream news channels typically report, was a little lower than consensus estimates of 2.5-2.6%, it was actually better than expected because the Bureau of Economic Analysis revised the GDP figures for the past several years’ worth of data.  If you account for that, the real GDP actually came in higher than forecasts.

Easy Take

The broadest measure of our economy is the real GDP, and it has been growing positively now since Q3 (Jul-Sep) 2009.  The 2.4% growth rate in Q2 2010 versus Q1 2010 is not terrible but leaves much to be desired.  We are seeing the growth rate cool down, as we are now below the US historical average of about 3.7%.  One of the major reasons the GDP has been climbing the last year or so has been the building up of inventories by businesses (yes, this is actually one of the components of GDP – the change in inventories from one quarter to the next).  We are now seeing signs of that inventory adjustment beginning to cool, so it will be up to consumer demand and housing (new home purchases – existing home purchases don’t count toward GDP) to begin contributing more positively to the overall picture.  For that to happen, unemployment will need to improve as well.  While some are concerned about a double-dip recession (going back to sustained negative real GDP before we are fully recovered from the last recession), most would agree it is an unlikely scenario for the near term.

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