The Edgy Optimist

This week the government released yet another revision of first-quarter economic growth showing that the U.S. economy grew a tad less than initially reported ‑- 2.4 percent rather than 2.5 percent. This revision was hardly consequential, but over the summer the Bureau of Economic Analysis will unveil a new way to calculate the overall output of the United States. And that revision will be dramatic.

Over the past few decades, gross domestic product (GDP) has become the prima inter pares of economic statistics. It is not only a measure of national economic output, it is a proxy for “the economy.” The number exerts substantial influence on what we spend collectively and individually, not just in the United States but throughout the world. China has five-year plans with GDP targets, and the European Union has rigid – albeit loosely enforced – rules about how much debt a government can take on relative to its GDP. It is, in short, a big-deal number.

And it is treated as an accurate gauge of economic activity. That would have come as something of a surprise to its inventors. Simon Kuznets, the economist most responsible in the 1930s for the formation of the national accounts that provide the data for GDP, was always disturbed that domestic work, volunteer work and, of course, transactions in cash are invisible in GDP. The choice to leave those out may have made sense – after all, what is the market price of preparing a family meal? – but it underscores that GDP is not a complete measure.

The BEA is the government agency responsible for compiling U.S. GDP figures, and it is always looking for better ways to measure. Every few years it tweaks its methodology. This time the tweaks will be more than incidental. In fact, not only will they add several hundred billion dollars – statistically, at least – of annual output, but they will also begin an overdue transition of these numbers away from the 20th century, when they were invented, and into the 21st, where we now live.

The change is relatively simple: The BEA will incorporate into GDP all the creative, innovative work that is the backbone of much of what the United States now produces. Research and development has long been recognized as a core economic asset, yet spending on it has not been included in national accounts. So, as the Wall Street Journal noted, a Lady Gaga concert and album are included in GDP, but the money spent writing the songs and recording the album are not. Factories buying new robots counted; Pfizer’s expenditures on inventing drugs were not.

As the fiscal cliff talks evolve and devolve, the latest spat has been whether the arc of federal spending should be curtailed by changing the way that we assess costs. The proposal from the White House is to switch the way cost-of-living adjustments are made for Social Security benefits. Rather than pegging those to the Consumer Price Index as currently calculated, these would be pegged to a “chain-weighted” Consumer Price Index, which would save as much as $125 billion in additional benefits over the next decade.

Sounds wonky, and it is. But so is much of how the federal government accounts for spending, and these metrics intimately shape what we spend, how we spend, and how we think about the present and the future. The primary measure of inflation, the Consumer Price Index (CPI) uses a fixed basket of goods that resets periodically. Chained CPI uses a basket of goods that adjust more fluidly to account for what statisticians and economists call “the substitution effect.” A fixed basket of goods is easier to calculate: just define the basket and then measure the price changes. But in the real world, people don’t passively accept changing prices. They change their behavior. The price of gas goes up? People drive less; they carpool more; they buy more fuel-efficient cars and consume less gas. The price of a domestic flat screen television goes up? They buy a less expensive import. In short, people don’t necessarily bear rising costs passively; they react and shift to maintain their standard of living. The traditional CPI index doesn’t capture that.

For all its wonkiness, the proposal to change the benchmark used to determine Social Security and various other benefits has engendered attacks from all points on the political spectrum: the left assails it as a backdoor technicality that will increase burdens on the elderly and the less well-off; the right scoffs that Obama’s proposals don’t constitute true deficit or spending reduction but are simply accounting tricks, and the media treats it as politics as usual with the cynical corollary that because almost no one understands what these rules are, it makes it easier to enact them.