This article was previously published at GoldMadeSimpleNews.com on May 25th, 2011.
“There are lies, damn lies and then there are government statistics”
Today we got the second revision of UK GDP from the government-funded Office for National Statistics. The economy is growing at an expected 1.8%, not brilliant but right around HM Treasury’s forecast for 2011, so all is good, right?
Not so fast – next week we’ll be releasing data going back 60 years of GDP and going into detail what exactly it is and how it is calculated. But today we present a little teaser using today’s figures.
When calculated more accurately GDP in the UK is ‘growing’ at a tiny annual 0.14%.
First lets look at the raw data provided by the ONS in todays release:
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First let’s calculate the increase in Q1 2011 from Q1 2010
Q1 2010 GDP was £359,147bn
Q1 2011 GDP was £375,693bn
£375,693bn subtract £359,147bn is £16,546bn. So the increase in GDP from a year earlier is £16,546 or a 4.6% annual increase. But hold on, we were told today that GDP was 1.8%, according to that simple calculation the economy grew by an impressive 4.6%. So what gives?
You may have noticed but the pound today buys you a lot less than a pound of a year ago (thank you Mr King). This depreciation in the purchasing power of the pound in your pocket is better know as inflation.
We’ll leave aside for now the woeful inadequacies of using the consumer price index (CPI) as a measure of inflation – read this to get up to speed – but in its simplest terms if CPI is running at 5% annually, £100 a year ago is worth £95 pounds today, or 5% less.
So to work out what our ‘real’ GDP is we simply subtract the rate of inflation over that period to give us a better measure of just how much our economy has grown.
The latest CPI figure for inflation over the past year was 4.4658% (rounded up to 4.5% when reported in the news). So, simple math time again:
UK economy grew 4.6% over the year
Your money lost 4.4658% over the past year
So, subtracting one from the other gives us a ‘real’ UK growth rate over the past year of 0.14%. Yes you read that correctly, the UK economy is in fact growing at stall-speed 0.14%.
But what gives again? Weren’t we told that the economy was growing at 1.8%, now we’ve gone too far in the other direction.
Well that 1.8% number published by the ONS is the number adjusted for inflation. Just not the inflation number that we’re always told about in the news. You see, when the ONS comes to work out ‘real’ growth in the UK it doesn’t use CPI as its inflation gauge it uses its own ‘special’ measure called the GDP deflator.
Go back to today’s ONS release and on page 4 it tells you what number they punch in for GDP deflator – It’s 2.8%. So we can see how they arrived at their 1.8% growth rate for the year. Nominal growth was 4.6%, minus out the ONS’ version of inflation of 2.8% and that gives you, hey-presto a bang on government forecast target of 1.8% – how convenient.
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This raises many questions. First up, why in the world are we using a different measure of inflation when calculating GDP? Surely we should pick a measure and use that. For all it’s faults, CPI inflation is the one that is presented to us each quarter; its the one we’re all familiar with. CPI is used as the target for the Bank of England. So why in the world should we use a separate measure of inflation when calculating GDP?
Also, when this data is presented in the news does anyone ever point out that a different rate of inflation is being used other than CPI – and that it is substantially lower than CPI inflation?
The second question this raises is: are we really honestly to believe that inflation has only gone up 2.8% in the past year? Many have argued that inflation is in fact a lot higher than even the CPI reports, so surely believing the print of 2.8% is a bit of a stretch.
So just how do the wise GDP deflator prophets over at the ONS arrive at the 2.8% number. A quick trip to Wikipieda on the subject explains all:
“Unlike some price indexes, the GDP deflator is not based on a fixed basket of goods and services. The basket is allowed to change with people’s consumption and investment patterns. (Specifically, for GDP, the “basket” in each year is the set of all goods that were produced domestically, weighted by the market value of the total consumption of each good.) Therefore, new expenditure patterns are allowed to show up in the deflator as people respond to changing prices. The theory behind this approach is that the GDP deflator reflects up to date expenditure patterns. For instance, if the price of chicken increases relative to the price of beef, it is claimed that people will likely spend more money on beef as a substitute for chicken.”
And how’s this for a bit of an understatement:
In practice, the difference between the deflator and a price index like the Consumer price index (CPI) is often relatively small. On the other hand, with governments in developed countries increasingly utilizing price indexes for everything from fiscal and monetary planning to payments to social program recipients, the even small differences between inflation measures can shift budget revenues and expenses by millions or billions of dollars.
Got it? The ONS can hedonically substitute its heart out until it comes up with a number it is happy with. In the past when CPI inflation has remained broadly inline with the GDP deflator this hasn’t really been much of an issue. But when one figure is 4.5% and the other is 2.8% that’s a massive difference.
As we’ve demonstrated above, if a GDP deflator closer to the CPI was used it would show that our economy has ZERO growth and would blast holes in the UK government’s growth targets for the year. We will leave it for you to decide if the ONS is deliberately using a lower deflator number to produce higher growth numbers that are more palatable.
Here’s a quick lesson why that GDP deflator is so important – and why the next time you hear on the news our GDP numbers you should go and find what GDP deflator is being used:
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Look at the difference just a slight change to GDP deflator has on the GDP numbers:
So if the ONS used a GDP deflator of say 2.2%, just above the BoE’s target, this would give you a growing economy of 2.4%, way above government forecast.
Even if the ONS used 3.5% as their GDP deflator in today’s release – a number still a full 1% below the CPI number – growth in the UK would be just 1.1%, well below the government’s forecast. Can you imagine the headlines and market reaction to such a GDP miss? And that’s still using an inflation number woefully short of reality!
But what happens to these numbers when you use another measure for the purchasing power of the pound in your pocket, like say gold? Gold has increased nearly 15% in the past year. Well, you do the math.
Why don’t they just use the deflater all the time instead of the CPI then if it’s so much more reflective of what is truly happening with consumer spending patterns?
GDP, or output as it’s sometimes known, may be a poor way to measure the health of the economy. Price indexes such as the CPI, RPI or GDP deflator may be inaccurate. I certainly think the CPI underestimates inflation.
But, it’s completely standard to measure real GDP using a GDP deflator, it’s the right way to do it.
GDP is a measure of all of the output of an economy during a period of time. If we ignore foreign trade and foreign investments then it is:
GDP = Consumer Goods + Government Spending + Investment
Each of these have a separate deflator. In the context of GDP this is logical. If the price of investment goods rises more than consumer goods then that should be accounted for, and the same applies if it falls more.
GDP isn’t supposed to be a measure of the current welfare of consumers. It’s a measure of the output of the economy, Investment doesn’t provide anyone with satisfaction now, but it does help later. That’s why if the output of consumer goods falls, but investment rises to compensate GDP doesn’t change. Similarly, if the output of consumer goods rises but investment falls. For the same reasons, in a measure of output it makes sense to account for price inflation in each aggregate.
I’m wondering how much impact the VAT increase has on this. I imagine that the 2.5% increase will bump up the RPI and CPI but not the GDP deflator, as this is used to measure output.
That said, the way the RPI and CPI are calculated are dodgy, and even if you believe the statistics, output is still well below it pre-crisis peak.
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