There’s a fear right now that China’s economy is in worse shape than previously thought. Recently, key data on Chinese manufacturing, retail sales and investment have all come in weaker than expected. The country is not bouncing back from strict zero-COVID policies as strongly as predicted. And all of this is wrapped up in a pile of debt that local governments are facing.
The problem is that China has historically relied on local government investment to stimulate the economy, and that strategy is running out of steam.
Logan Wright, a partner at Rhodium Group, a research and policy consulting shop, watches this issue carefully. He spoke about it with “Marketplace Morning Report” host Sabri Ben-Achour. The following is an edited transcript of their conversation.
Sabri Ben-Achour: So here in the U.S., when we think about the government stimulating or supporting the economy, we think about the federal COVID relief or federal stimulus — it comes from the national government. In China, it is not quite like that. Can you explain how it works?
Logan Wright: When China tries to use fiscal policy countercyclically to stimulate growth, they typically do it not through direct budget allocations in which the central government puts money in people’s pockets, but through investment that is funded largely by local governments. And because local governments can’t borrow directly, except through some very narrow channels, they use these indirect forms of borrowing through local government financing vehicles, these sort of separate companies. They usually are based on business that involves building projects and then selling them back to local governments or other local state-owned enterprises. But the point is, it’s not done directly through a budgetary transfer. And, as a result, you can end up seeing much more local government investment than the government anticipated, which is sort of what happened after the global financial crisis.
Ben-Achour: In the U.S., for many years, there was sort of a stigma associated with supporting one industry over another. I mean, we obviously still did it from time to time. But in China, it’s kind of a different ballgame. So what kind of support does the government, through the local governments, offer to business and industry?
Wright: Typically, the way the Chinese government controls the economy more broadly is through the allocation of credit, and so control over the financial system to direct credit through state-owned enterprises. And then through quasi-fiscal kind of lending through local government vehicles. So often what is involved is the presentation of project plans, like infrastructure project plans. There’s approval of those plans, then there’s a funding mechanism for those to be executed.
And so in some cases, you’ll get direct subsidies for certain industries. But by and large, the focus of policy stimulus in China has been to deliver growth, employment, investment through either infrastructure — construction of large transport, water treatment, railways, all sorts of different infrastructure concepts that have been deployed over the years. Or indirectly encouraging other forms of construction, like the property sector. So Beijing has had a very on-again, off-again relationship with hoarding property-sector growth over several years. In recent years, they tried to discourage it because growth was so excessive in property construction. But, historically, that has also been one of the key drivers of investment growth throughout China’s economy and something that they have relied upon by cutting mortgage rates, by encouraging home purchases by residents in different cities, for example. That’s one of the mechanisms they used to prop up the economy in the past.
Ben-Achour: So we have all of this investment in infrastructure, in property through local governments, and those local governments are in debt. How badly are they in debt?
Wright: Right. So the point is that this local government borrowing was never really designed to be — and these local government infrastructure projects were never really designed — to pay off bank loans that were made at commercial terms. A lot of these are for schools or hospitals or public goods. And so therefore, the entire model that was used to fund them always had an implicit backstop, that somewhere down the line, the central government was going to come in and either transfer fiscal resources to local governments to repay the debt or to basically assume the debt.
Well, that moment is here, precisely because it has become too difficult, given the volume of local government debt, for them to continue funding investment at the same rates as they’ve had in the past. So it is a reasonable estimate that total local government debt is roughly around China’s [gross domestic product] — you know, roughly around 100% of GDP, or around $16 trillion or $17 trillion in total. And so about half of that is held by so-called local government financing vehicles. So these are supposed to be separate companies that are indirectly owned by local governments, and local governments have an implicit obligation to back them, and none of them have ever defaulted.
But this is a very large volume of debt. So if any of them ever do default, it raises an immediate question of, is Beijing going to actually step in and support all of those companies? Are they going to support some of them? Are they going to support only those in certain cities or provinces? Are they going to support only those in certain industries or who fund different types of projects? Those are the questions that are now being asked.
And the reason being is that because, again, these projects, the average return on all of these projects is closer to 1% in pure financial terms, if you look at averages or median levels across local government financing vehicles. Their interest costs are much higher, closer to 5.5%. So this isn’t a sustainable model. And Beijing is now under pressure to make it more sustainable.
Ben-Achour: If Beijing is now possibly on the hook for all this local government debt, how does that connect with the economic malaise that the country finds itself in right now?
Wright: Right. In many ways, the property market crisis in China and the local government crisis are the same crisis. And they’re very much linked. They are a problem of, you cannot continue funding the same pace of investment, whether that is in property or infrastructure, because you do not have a financial system that can continue expanding at the same rates as it has in the past. China’s banking system is around two, two and a half times the size of the U.S. banking system in total assets. It’s not a completely fair comparison because the U.S. has a more diversified financial system. China has a more bank-centric financial system. But the point is, in a banking system that has a little bit over half of global GDP in assets, it’s very hard to keep it growing at the rates that they saw in the past, closer to 15% to 17% over the previous decade. Now it’s growing, it’s roughly 9% to 10%, in terms of credit. So you can’t keep funding the same pace of investment in the future, which means that if investment has been a critical driver of China’s growth — it’s about 42% of the economy at this point — that’s going to slow down, and therefore overall economic growth is going to slow down.
And that slowdown is not cyclical, but structural. You cannot repeat the same drivers of growth as you have seen in the recent past. And so, in many ways, the structural slowdown that China is facing, we are seeing a much sharper break with past rates of economic performance, relative to what you saw over the previous decade. And the fact that you can’t rely upon property and infrastructure investment is one of the key reasons for that.
Ben-Achour: So if I’m to understand correctly, it is as if the local governments in China have had their foot on the gas for many years in terms of the economy. And so if the national government now wants to step in to support an ailing economy, there’s not much more pedal to push.
Wright: Right, and the whole point is that you’ve already been running very large fiscal deficits — and China’s fiscal deficits, including local and central governments, have averaged around 6% of GDP in recent years. That doesn’t prevent you from financing those deficits internally. You can do that. But it does make it a lot more difficult to generate marginal growth from those levels of spending because you’re already committed so strongly to local government investment at very high levels.
And so if you’re going to manage the debt problem — and this is where I think it’s a little less understood — to say that you’re going to manage China’s local government debt problem is implicitly a statement that China is going to rebalance the economy and is going to be less dependent upon investment-led growth in the future. Rebalancing the economy is a very difficult prospect. It probably involves slower growth in investment in the short term, hoping for more sustainable growth that is consumption led in the medium term. But there’s no guarantee that that happens at the same rates as what we’ve seen in the past, which is why this is such a momentous decision. And the fact that Beijing is really at the end of a previous road, in terms of how to support the economy, is so meaningful.
Ben-Achour: They can’t get out of this economic doldrum by writing more checks. Something structural is going to have to change?
Wright: You can’t do it through the same mechanisms as you have been using over the past decade to support growth. So Beijing is going to need different tactics to put money in people’s pockets, to support household consumption, to somehow transfer state resources to households in some respect, but those are longer-term, more difficult political questions, to enable faster consumption-led growth. What is obvious is that you can’t maintain the same pace of credit and investment growth as you have in the past because you are already facing problems in how that investment is being financed at this stage. And the debt levels — if you just continue trying to use the same driver, you’re just going to get much less bang for your buck in terms of trying to deliver additional investment-led growth. You’re not only not going to see the improvement in productivity that will come from more productive investments in the economy, but you’re not even going to see much of that investment get off the ground because the mechanisms you’re using to stimulate growth are using a lot of those proceeds to repay debt as well as fund new spending.
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02
Treasury General Account: The Government’s Checking Account
What Is the Treasury General Account?
The Treasury General Account is the general checking account, which the Department of the Treasury uses and from which the U.S. government makes all of its official payments. The Federal Reserve Bank of New York holds the Treasury General Account.Key TakeawaysThe Treasury General Account is the checking account used by the Department of the U.S. Treasury, from which the U.S. government makes all of its payments.The Federal Reserve Bank of New York is the holder of the Treasury General Account.The Treasury General Account Program is made up of three entities: the TGA Network, the Seized Currency Collection Network (SCCN), and the Mail-In TGA (MITGA). Each program is responsible for different areas of receiving cash and checking deposits.The Treasury General Account is used for U.S. government disbursements, where tax payments are deposited, and where funds from the sale of Treasury debt is collected.Changes in the Treasury General Account affect the deposits at the Federal Reserve.
Understanding the Treasury General Account
Created in 1789, the U.S. Treasury is the department of the government that is responsible for issuing all Treasury bonds, notes, and bills. Key functions of the U.S. Treasury include printing bills, postage, and Federal Reserve notes, minting coins, collecting taxes, enforcing tax laws, managing debt issues, and more. The Treasury General Account also holds money that is credited to the government in the form of monetized gold.
The U.S. Treasury oversees U.S. banks, which cooperate with the Federal Reserve. Each time the Treasury makes a payment from its general account, funds flow directly into the depository institution’s account. In this way, the Treasury’s receipts and expenditures have the ability to impact the balances of depository institutions’ accounts at the Reserve Banks.
The TGA Network is a group of commercial financial institutions that receive and reconcile over-the-counter (OTC) government agency cash and check deposits. The network operates globally. The Seized Currency Collection Network (SCCN), which is made up of commercial financial institutions as well, specializes in receiving funds that law enforcement agencies have seized. The Mail-In TGA (MITGA) is a depositary that receives only deposits, which agencies send via mail.
As of August 2023, the Treasury General Account’s average balance over the prior week was $470 billion.Treasury General Account Services
The Treasury General Account (TGA) Program is made up of three services that check deposits and receive cash. These three services are the TGA Network, the Seized Currency Collection Network (SCCN), and the Mail-In TGA (MITGA). Each program is discussed in more depth below.TGA Network
The TGA Network is a platform that supports electronic transactions between government agencies, financial institutions, and entities. It facilitates interagency coordination, ensuring efficient allocation and transfer of funds based on government priorities. The network also includes real-time monitoring mechanisms to track incoming and outgoing funds, enabling Treasury management of cash flows.
The network can generate reports detailing fund movement, maintaining transparency and accountability. The network adheres to relevant financial regulations and compliance standards, ensuring transactions comply with legal and regulatory requirements.Seized Currency Collection Network
The SCCN refers to a system or network established to manage and process currency and assets that have been seized by law enforcement agencies or government authorities. These assets could have been confiscated as a result of criminal investigations, legal actions, asset forfeitures, or other similar circumstances.
The SCCN includes mechanisms for tracking and managing the seized assets, ensuring that all actions taken with respect to seized assets are compliant with relevant laws and regulations. Seized assets, especially currency and valuable items, need to be stored securely to prevent loss, theft, or damage. The SCCN may also be closely tied to legal proceedings, distribution, or liquidation of such collected assets.Mail-in TGA
The MITGA refers to a service or process that allows individuals or entities to make deposits to the Treasury General Account by sending physical mail, such as cash or financial instruments. This service is especially beneficial for those who might not have electronic transfer capabilities or prefer traditional means of making financial transactions.
To facilitate such transfers, the MITGA service provides clear instructions to individuals or entities needing to facilitate deposits. Individuals may need to prepare deposits in a specific way or remit funds along with required documentation. The MITGA service processes funds, confirms receipts, tracks movement of deposits, and maintains records of the sender’s information.Treasury General Account and U.S. Monetary Policy
The focus of the U.S. Treasury is to promote economic growth and security. Established by the First Congress of the United States in New York on March 4, 1789, the institution has played a key role in U.S. monetary policy ever since.
In general, there are two types of monetary policy, expansionary and contractionary. Expansionary monetary policy increases the money supply to lower unemployment and to boost private-sector borrowing and consumer spending. Contractionary monetary policy slows the rate of growth in the money supply to control inflation.
The Federal Reserve Bank buys and sells U.S. Treasury bills and bonds to control the country’s money supply and manage interest rates, the money of which goes to and from the Treasury General Account. In the United States, this monetary policy helps determine the size and rate of growth of the money supply, which in turn affects interest rates.
The U.S. government embarked on substantial monetary policy in response to COVID-19. As a result, the weekly average balance in the TGA peaked at over $1.8 trillion.Types of Funds Held in Treasury General Account
The Treasury General Account holds various types of funds and revenue streams. Tax revenues, which are collected from individuals, businesses, and other entities, form a significant portion of the government’s income deposited into this account. Government securities issued by the government, such as bonds, notes, and bills, are also deposited into the TGA to finance government operations and pay off maturing debt.
Fees and user charges, collected from various activities like passport issuance and licensing, contribute to government revenue and are deposited into TGA. Miscellaneous receipts, such as proceeds from the sale of government assets, royalties from natural resource use, and investments, are also categorized as miscellaneous receipts.
Agency deposits, managed by agencies like the Social Security Administration and the Department of Health and Human Services, are pooled within the TGA for specific programmatic uses. Congress then appropriates funds for government activities and programs through the federal budget process, which are often disbursed from the TGA to cover authorized expenditures.
Last, emergency funds are allocated and held in the TGA during crises or emergencies to facilitate rapid responses. Trust funds, managed within the TGA, are designed to hold funds separately from the general operating budget, such as the Social Security Trust Fund and the Highway Trust Fund, which are often used to finance specific programs or services.Advantages and Disadvantages of the Treasury General Account Pros of the Treasury General Account
The Treasury General Account is a crucial tool for government funds management, providing a centralized repository for funds and enabling better visibility and control over cash position. It also facilitates liquidity management, cash flow control, risk mitigation, and smooth government operations.
The TGA is essential for maintaining financial stability by providing emergency funding, enabling the government to respond quickly to unforeseen events. It also plays a role in managing government debt by holding funds from Treasury securities, which are used to finance government operations and repay maturing debt. In essence, the TGA is a critical operational aspect to facilitating government funds.
The TGA is integral to the execution of the federal budget, ensuring that government programs and services are funded as intended. It also allows the government to earn interest on its cash holdings, contributing to government finances and more easily distribute funds to more specific holding accounts and programs as approved.
The TGA’s role in managing funds ensures that government agencies have the necessary resources to operate effectively, preventing disruptions due to cash shortages and supporting timely payments to vendors, contractors, and employees. It also plays a crucial role in emergency response during crises or emergencies. By centralizing functions, more control can be had over a singular financial body as opposed to funds less efficiently managed or overseen.Cons of the Treasury General Account
There are some inefficiencies and downsides to the operation of the Treasury General Account. Funds held in the TGA could potentially be invested in other higher-yielding assets. While the TGA can invest in interest-bearing securities, these might not always generate the highest possible returns. Therefore, the nature of this account is often marred with opportunity cost as any funds in TGA could be deployed.
The value of interest-bearing assets held by the TGA can be influenced by fluctuations in interest rates. Changes in rates could impact the value of these assets and potentially lead to gains or losses on the government’s investments. In addition, inflation risk can erode the savings in TGA, reducing the government’s ability to meet future financial obligations.
Managing a diverse range of funds from different sources within the TGA can be complex. Ensuring that funds are appropriately allocated and disbursed for various purposes requires careful coordination and efficient systems. This may also lead to higher transaction costs, more robust labor requirements, or centralized risk to a more concentrated area of government finances.Pros
Provides better visibility and control over spending and receipts
Allows for more effective debt management by managing cashflow
Assists with budget execution by understanding cash forecasts for inflows and outflows
May mitigate risk by creating tighter control over financial processes
Cons
May result in opportunity cost for idle cash
May result in more complex cash management, calling for higher costs to manage
May reduce operational flexibility due to rigid processes
How Does the TGA Differ From Other Government Accounts?
Unlike specific program or agency accounts, the TGA is a consolidated account that holds the government’s overall cash balance. It is used for general purposes and is not earmarked for specific programs.What Is the Relationship Between the TGA and Federal Budgetary Processes?
The TGA is closely tied to the federal budgetary process. It receives funds from various sources, including appropriations from Congress. It also serves as a source for disbursing funds to cover authorized government expenditures. The TGA is a central part of the cash inflows and outflows that ensure government operations and programs proceed, and it is critical that it is included in future planning, especially surrounding cash sufficiency.What Role Does the TGA Play in Managing Government Debt?
The TGA is involved in managing government debt by receiving the proceeds from the issuance of Treasury securities. It also holds funds that are used to pay interest on government debt and redeem maturing securities.Are the Funds in the TGA Invested or Earn Interest?
Yes, the funds held in the TGA can be invested in interest-bearing securities.The Bottom Line
The Treasury General Account is the primary bank account of the U.S. Department of the Treasury, serving as a central repository for various federal government funds. Managed by the Bureau of the Fiscal Service, the TGA plays a crucial role in government financial operations, holding tax revenues, proceeds from government securities issuance, fees, fines, and other receipts.
03
Gross Domestic Product (GDP): Formula and How to Use It
What Is Gross Domestic Product (GDP)?
Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country’s economic health.
Though GDP is typically calculated on an annual basis, it is sometimes calculated on a quarterly basis as well. In the U.S., for example, the government releases an annualized GDP estimate for each fiscal quarter and also for the calendar year. The individual data sets included in this report are given in real terms, so the data is adjusted for price changes and is, therefore, net of inflation.Key TakeawaysGross domestic product is the monetary value of all finished goods and services made within a country during a specific period.GDP provides an economic snapshot of a country, used to estimate the size of an economy and its growth rate.GDP can be calculated in three ways, using expenditures, production, or incomes and it can be adjusted for inflation and population to provide deeper insights.Real GDP takes into account the effects of inflation while nominal GDP does not.Though it has limitations, GDP is a key tool to guide policymakers, investors, and businesses in strategic decision-making.
Investopedia / Zoe HansenUnderstanding Gross Domestic Product (GDP)
The calculation of a country’s GDP encompasses all private and public consumption, government outlays, investments, additions to private inventories, paid-in construction costs, and the foreign balance of trade. Exports are added to the value and imports are subtracted.
Of all the components that make up a country’s GDP, the foreign balance of trade is especially important. The GDP of a country tends to increase when the total value of goods and services that domestic producers sell to foreign countries exceeds the total value of foreign goods and services that domestic consumers buy. When this situation occurs, a country is said to have a trade surplus.
If the opposite situation occurs—that is, if the amount that domestic consumers spend on foreign products is greater than the total sum of what domestic producers are able to sell to foreign consumers—it is called a trade deficit. In this situation, the GDP of a country tends to decrease.
GDP can be computed on a nominal basis or a real basis, the latter accounting for inflation. Overall, real GDP is a better method for expressing long-term national economic performance since it uses constant dollars.
Let’s say one country had a nominal GDP of $100 billion in 2012. By 2022, its nominal GDP grew to $150 billion. Prices also rose by 100% over the same period. In this example, if you looked solely at its nominal GDP, the country’s economy appears to be performing well. However, the real GDP (expressed in 2012 dollars) would only be $75 billion, revealing that an overall decline in real economic performance actually occurred during this time.2.1%
The annual rate of increase for U.S. GDP in the second quarter of 2023. U.S. GDP recorded a 2.0% increase during the first quarter of 2023.Types of Gross Domestic Product
GDP can be reported in several ways, each of which provides slightly different information.Nominal GDP
Nominal GDP is an assessment of economic production in an economy that includes current prices in its calculation. In other words, it doesn’t strip out inflation or the pace of rising prices, which can inflate the growth figure.
All goods and services counted in nominal GDP are valued at the prices that those goods and services are actually sold for in that year. Nominal GDP is evaluated in either the local currency or U.S. dollars at currency market exchange rates to compare countries’ GDPs in purely financial terms.
Nominal GDP is used when comparing different quarters of output within the same year. When comparing the GDP of two or more years, real GDP is used. This is because, in effect, the removal of the influence of inflation allows the comparison of the different years to focus solely on volume.Real GDP
Real GDP is an inflation-adjusted measure that reflects the number of goods and services produced by an economy in a given year, with prices held constant from year to year to separate out the impact of inflation or deflation from the trend in output over time. Since GDP is based on the monetary value of goods and services, it is subject to inflation.
Rising prices tend to increase a country’s GDP, but this does not necessarily reflect any change in the quantity or quality of goods and services produced. Thus, by looking just at an economy’s nominal GDP, it can be difficult to tell whether the figure has risen because of a real expansion in production or simply because prices rose.
Economists use a process that adjusts for inflation to arrive at an economy’s real GDP. By adjusting the output in any given year for the price levels that prevailed in a reference year, called the base year, economists can adjust for inflation’s impact. This way, it is possible to compare a country’s GDP from one year to another and see if there is any real growth.
Real GDP is calculated using a GDP price deflator, which is the difference in prices between the current year and the base year. For example, if prices rose by 5% since the base year, then the deflator would be 1.05. Nominal GDP is divided by this deflator, yielding real GDP. Nominal GDP is usually higher than real GDP because inflation is typically a positive number.
Real GDP accounts for changes in market value and thus narrows the difference between output figures from year to year. If there is a large discrepancy between a nation’s real GDP and nominal GDP, this may be an indicator of significant inflation or deflation in its economy.GDP Per Capita
GDP per capita is a measurement of the GDP per person in a country’s population. It indicates that the amount of output or income per person in an economy can indicate average productivity or average living standards. GDP per capita can be stated in nominal, real (inflation-adjusted), or purchasing power parity (PPP) terms.
At a basic interpretation, per-capita GDP shows how much economic production value can be attributed to each individual citizen. This also translates to a measure of overall national wealth since GDP market value per person also readily serves as a prosperity measure.
Per-capita GDP is often analyzed alongside more traditional measures of GDP. Economists use this metric for insight into their own country’s domestic productivity and the productivity of other countries. Per-capita GDP considers both a country’s GDP and its population. Therefore, it can be important to understand how each factor contributes to the overall result and is affecting per-capita GDP growth.
If a country’s per-capita GDP is growing with a stable population level, for example, it could be the result of technological progressions that are producing more with the same population level. Some countries may have a high per-capita GDP but a small population, which usually means they have built up a self-sufficient economy based on an abundance of special resources.GDP Growth Rate
The GDP growth rate compares the year-over-year (or quarterly) change in a country’s economic output to measure how fast an economy is growing. Usually expressed as a percentage rate, this measure is popular for economic policymakers because GDP growth is thought to be closely connected to key policy targets such as inflation and unemployment rates.
If GDP growth rates accelerate, it may be a signal that the economy is overheating and the central bank may seek to raise interest rates. Conversely, central banks see a shrinking (or negative) GDP growth rate (i.e., a recession) as a signal that rates should be lowered and that stimulus may be necessary.GDP Purchasing Power Parity (PPP)
While not directly a measure of GDP, economists look at PPP to see how one country’s GDP measures up in international dollars using a method that adjusts for differences in local prices and costs of living to make cross-country comparisons of real output, real income, and living standards.GDP Formula
GDP can be determined via three primary methods. All three methods should yield the same figure when correctly calculated. These three approaches are often termed the expenditure approach, the output (or production) approach, and the income approach.The Expenditure Approach
The expenditure approach, also known as the spending approach, calculates spending by the different groups that participate in the economy. The U.S. GDP is primarily measured based on the expenditure approach. This approach can be calculated using the following formula:
GDP = C + G + I + NX where: C = Consumption G = Government spending I = Investment NX = Net exports \begin{aligned}&\text{GDP} = \text{C} + \text{G} + \text{I} + \text{NX} \\&\textbf{where:} \\&\text{C} = \text{Consumption} \\&\text{G} = \text{Government spending} \\&\text{I} = \text{Investment} \\&\text{NX} = \text{Net exports} \\\end{aligned}GDP=C+G+I+NXwhere:C=ConsumptionG=Government spendingI=InvestmentNX=Net exports
All of these activities contribute to the GDP of a country. Consumption refers to private consumption expenditures or consumer spending. Consumers spend money to acquire goods and services, such as groceries and haircuts. Consumer spending is the biggest component of GDP, accounting for more than two-thirds of the U.S. GDP.
Consumer confidence, therefore, has a very significant bearing on economic growth. A high confidence level indicates that consumers are willing to spend, while a low confidence level reflects uncertainty about the future and an unwillingness to spend.
Government spending represents government consumption expenditure and gross investment. Governments spend money on equipment, infrastructure, and payroll. Government spending may become more important relative to other components of a country’s GDP when consumer spending and business investment both decline sharply. (This may occur in the wake of a recession, for example.)
Investment refers to private domestic investment or capital expenditures. Businesses spend money to invest in their business activities. For example, a business may buy machinery. Business investment is a critical component of GDP since it increases the productive capacity of an economy and boosts employment levels.
The net exports formula subtracts total exports from total imports (NX = Exports – Imports). The goods and services that an economy makes that are exported to other countries, less the imports that are purchased by domestic consumers, represent a country’s net exports. All expenditures by companies located in a given country, even if they are foreign companies, are included in this calculation.The Production (Output) Approach
The production approach is essentially the reverse of the expenditure approach. Instead of measuring the input costs that contribute to economic activity, the production approach estimates the total value of economic output and deducts the cost of intermediate goods that are consumed in the process (like those of materials and services). Whereas the expenditure approach projects forward from costs, the production approach looks backward from the vantage point of a state of completed economic activity.The Income Approach
The income approach represents a kind of middle ground between the two other approaches to calculating GDP. The income approach calculates the income earned by all the factors of production in an economy, including the wages paid to labor, the rent earned by land, the return on capital in the form of interest, and corporate profits.
The income approach factors in some adjustments for those items that are not considered payments made to factors of production. For one, there are some taxes, such as sales taxes and property taxes, that are classified as indirect business taxes.
In addition, depreciation, which is a reserve that businesses set aside to account for the replacement of equipment that tends to wear down with use, is also added to the national income. All of this together constitutes a nation’s income.GDP vs. GNP vs. GNI
Although GDP is a widely used metric, there are other ways of measuring the economic growth of a country. While GDP measures the economic activity within the physical borders of a country (whether the producers are native to that country or foreign-owned entities), gross national product (GNP) is a measurement of the overall production of people or corporations native to a country, including those based abroad. GNP excludes domestic production by foreigners.
Gross national income (GNI) is another measure of economic growth. It is the sum of all income earned by citizens or nationals of a country (regardless of whether the underlying economic activity takes place domestically or abroad). The relationship between GNP and GNI is similar to the relationship between the production (output) approach and the income approach used to calculate GDP.
GNP uses the production approach, while GNI uses the income approach. With GNI, the income of a country is calculated as its domestic income, plus its indirect business taxes and depreciation (as well as its net foreign factor income). The figure for net foreign factor income is calculated by subtracting all payments made to foreign companies and individuals from all payments made to domestic businesses.
In an increasingly global economy, GNI has been put forward as a potentially better metric for overall economic health than GDP. Because certain countries have most of their income withdrawn abroad by foreign corporations and individuals, their GDP figure is much higher than the figure that represents their GNI.
For example, in 2019, Luxembourg had a significant difference between its GDP and GNI, mainly due to large payments made to the rest of the world via foreign corporations that did business in Luxembourg, attracted by the tiny nation’s favorable tax laws. On the contrary, GNI and GDP in the U.S. do not differ substantially. U.S. GDP was roughly $26.80 trillion as of Q2-2023 while its GNI was about $25.84 trillion at the end of 2022.Adjustments to GDP
A number of adjustments can be made to a country’s GDP to improve the usefulness of this figure. For economists, a country’s GDP reveals the size of the economy but provides little information about the standard of living in that country. Part of the reason for this is that population size and cost of living are not consistent around the world.
For example, comparing the nominal GDP of China to the nominal GDP of Ireland would not provide much meaningful information about the realities of living in those countries because China has approximately 300 times the population of Ireland.
To help solve this problem, statisticians sometimes compare GDP per capita between countries. GDP per capita is calculated by dividing a country’s total GDP by its population, and this figure is frequently cited to assess the nation’s standard of living. Even so, the measure is still imperfect.
Suppose China has a GDP per capita of $1,500, while Ireland has a GDP per capita of $15,000. This doesn’t necessarily mean that the average Irish person is 10 times better off than the average Chinese person. GDP per capita doesn’t account for how expensive it is to live in a country.
PPP attempts to solve this problem by comparing how many goods and services an exchange-rate-adjusted unit of money can purchase in different countries—comparing the price of an item, or basket of items, in two countries after adjusting for the exchange rate between the two, in effect.
Real per-capita GDP, adjusted for purchasing power parity, is a heavily refined statistic to measure true income, which is an important element of well-being. An individual in Ireland might make $100,000 a year, while an individual in China might make $50,000 a year. In nominal terms, the worker in Ireland is better off. But if a year’s worth of food, clothing, and other items costs three times as much in Ireland as in China, however, then the worker in China has a higher real income.How to Use GDP Data
Most nations release GDP data every month and quarter. In the U.S., the Bureau of Economic Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the quarter ends, and a final release three months after the quarter ends. The BEA releases are exhaustive and contain a wealth of detail, enabling economists and investors to obtain information and insights on various aspects of the economy.
GDP’s market impact is generally limited since it is backward-looking, and a substantial amount of time has already elapsed between the quarter-end and GDP data release. However, GDP data can have an impact on markets if the actual numbers differ considerably from expectations.
Because GDP provides a direct indication of the health and growth of the economy, businesses can use GDP as a guide to their business strategy. Government entities, such as the Fed in the U.S., use the growth rate and other GDP stats as part of their decision process in determining what type of monetary policies to implement.
If the growth rate is slowing, they might implement an expansionary monetary policy to try to boost the economy. If the growth rate is robust, they might use monetary policy to slow things down to try to ward off inflation.
Real GDP is the indicator that says the most about the health of the economy. It is widely followed and discussed by economists, analysts, investors, and policymakers. The advance release of the latest data will almost always move markets, although that impact can be limited, as noted above.GDP and Investing
Investors watch GDP since it provides a framework for decision-making. The corporate profits and inventory data in the GDP report are a great resource for equity investors, as both categories show total growth during the period; corporate profits data also displays pre-tax profits, operating cash flows, and breakdowns for all major sectors of the economy.
Comparing the GDP growth rates of different countries can play a part in asset allocation, aiding decisions about whether to invest in fast-growing economies abroad and if so, which ones.
One interesting metric that investors can use to get a sense of the valuation of an equity market is the ratio of total market capitalization to GDP, expressed as a percentage. The closest equivalent to this in terms of stock valuation is a company’s market cap to total sales (or revenues), which in per-share terms is the well-known price-to-sales ratio.
Just as stocks in different sectors trade at widely divergent price-to-sales ratios, different nations trade at market-cap-to-GDP ratios that are literally all over the map. For example, according to the World Bank, the U.S. had a market-cap-to-GDP ratio of 193.3% for 2020, while China had a ratio of just over 83.2% and Hong Kong had a ratio of 1,777.2%.
However, the utility of this ratio lies in comparing it to historical norms for a particular nation. As an example, the U.S. had a market-cap-to-GDP ratio of 141.6% at the end of 2006, which dropped to 78.5% by the end of 2008. In retrospect, these represented zones of substantial overvaluation and undervaluation, respectively, for U.S. equities.
The biggest downside of this data is its lack of timeliness; investors only get one update per quarter, and revisions can be large enough to significantly alter the percentage change in GDP.History of GDP
The concept of GDP was first proposed in 1937 in a report to the U.S. Congress in response to the Great Depression, conceived of and presented by an economist at the National Bureau of Economic Research (NBER), Simon Kuznets.
At the time, the preeminent system of measurement was GNP. After the Bretton Woods conference in 1944, GDP was widely adopted as the standard means for measuring national economies; however, the U.S. continued to use GNP as its official measure of economic welfare until 1991, after which it switched to GDP.
Beginning in the 1950s, however, some economists and policymakers began to question GDP. Some observed, for example, a tendency to accept GDP as an absolute indicator of a nation’s failure or success, despite its failure to account for health, happiness, (in)equality, and other constituent factors of public welfare. In other words, these critics drew attention to a distinction between economic progress and social progress.
However, most authorities, like Arthur Okun, an economist for President John F. Kennedy’s Council of Economic Advisers, held firm to the belief that GDP is an absolute indicator of economic success, claiming that for every increase in GDP, there would be a corresponding drop in unemployment.Criticisms of GDP
There are, of course, drawbacks to using GDP as an indicator. In addition to the lack of timeliness, some criticisms of GDP as a measure are:It ignores the value of informal or unrecorded economic activity. GDP relies on recorded transactions and official data, so it does not take into account the extent of informal economic activity. GDP fails to account for the value of under-the-table employment, underground market activity, or unremunerated volunteer work, which can all be significant in some nations and cannot account for the value of leisure time or household production, which are ubiquitous conditions of human life in all societies.It is geographically limited in a globally open economy. GDP does not take into account profits earned in a nation by overseas companies that are remitted back to foreign investors. This can overstate a country’s actual economic output. For example, Ireland had a GDP of $529.24 billion and GNI of $383.48 billion in 2022, the difference of about $145.76 billion (or over 28% of GDP) largely being due to profit repatriation by foreign companies based in Ireland.It emphasizes material output without considering overall well-being. GDP growth alone cannot measure a nation’s development or its citizens’ well-being, as noted above. For instance, a nation may be experiencing rapid GDP growth, but this may impose a significant cost to society in terms of environmental impact and an increase in income disparity.It ignores business-to-business activity. GDP considers only final goods production and new capital investment and deliberately nets out intermediate spending and transactions between businesses. By doing so, GDP overstates the importance of consumption relative to production in the economy and is less sensitive as an indicator of economic fluctuations compared to metrics that include business-to-business activity.It counts costs and waste as economic benefits. GDP counts all final private and government spending as additions to income and output for society, regardless of whether they are actually productive or profitable. This means that obviously unproductive or even destructive activities are routinely counted as economic output and contribute to growth in GDP. For example, this includes spending directed toward extracting or transferring wealth between members of society rather than producing wealth (such as the administrative costs of taxation or money spent on lobbying and rent-seeking); spending on investment projects for which the necessary complementary goods and labor are not available or for which actual consumer demand does not exist (such as the construction of empty ghost cities or bridges to nowhere, unconnected to any road network); and spending on goods and services that are either themselves destructive or only necessary to offset other destructive activities, rather than to create new wealth (such as the production of weapons of war or spending on policing and anti-crime measures).
Global Sources for Country GDP Data
The World Bank hosts one of the most reliable web-based databases. It has one of the best and most comprehensive lists of countries for which it tracks GDP data. The International Money Fund (IMF) also provides GDP data through its multiple databases, such as World Economic Outlook and International Financial Statistics.
Another highly reliable source of GDP data is the Organization for Economic Cooperation and Development (OECD). The OECD not only provides historical data but also forecasts GDP growth. The disadvantage of using the OECD database is that it tracks only OECD member countries and a few nonmember countries.
In the U.S., the Fed collects data from multiple sources, including a country’s statistical agencies and The World Bank. The only drawback to using a Fed database is a lack of updating in GDP data and an absence of data for certain countries.
The BEA is a division of the U.S. Department of Commerce. It issues its own analysis document with each GDP release, which is a great investor tool for analyzing figures and trends and reading highlights of the very lengthy full release.What Is a Simple Definition of GDP?
Gross domestic product is a measurement that seeks to capture a country’s economic output. Countries with larger GDPs will have a greater amount of goods and services generated within them, and will generally have a higher standard of living. For this reason, many citizens and political leaders see GDP growth as an important measure of national success, often referring to GDP growth and economic growth interchangeably. Due to various limitations, however, many economists have argued that GDP should not be used as a proxy for overall economic success, much less the success of a society.Which Country Has the Highest GDP?
The countries with the two highest GDPs in the world are the United States and China. However, their ranking differs depending on how you measure GDP. Using nominal GDP, the United States comes in first with a GDP of $23.32 trillion as of 2021, compared to $17.73 trillion in China.
Many economists argue that it is more accurate to use purchasing power parity GDP as a measure of national wealth. By this metric, China is actually the world leader with a 2022 PPP GDP of $30.33 trillion, followed by $25.46 trillion in the United States.Is a High GDP Good?
Most people perceive a higher GDP to be a good thing because it is associated with greater economic opportunities and an improved standard of material well-being. It is possible, however, for a country to have a high GDP and still be an unattractive place to live, so it is important to also consider other measurements. For example, a country could have a high GDP and a low per-capita GDP, suggesting that significant wealth exists but is concentrated in the hands of very few people. One way to address this is to look at GDP alongside another measure of economic development, such as the Human Development Index (HDI).The Bottom Line
In their seminal textbook Economics, Paul Samuelson and William Nordhaus neatly sum up the importance of the national accounts and GDP. They liken the ability of GDP to give an overall picture of the state of the economy to that of a satellite in space that can survey the weather across an entire continent.
GDP enables policymakers and central banks to judge whether the economy is contracting or expanding, whether it needs a boost or restraint, and if a threat such as a recession or inflation looms on the horizon. Like any measure, GDP has its imperfections. In recent decades, governments have created various nuanced modifications in attempts to increase GDP accuracy and specificity. Means of calculating GDP have also evolved continually since its conception to keep up with evolving measurements of industry activity and the generation and consumption of new, emerging forms of intangible assets.
