Flaws of GDP when Discussing International Trade

Gross Domestic Product, better known by its acronym GDP, is frequently cited and understood by non-economists as the measurement of the economy.  But GDP is not the measure of the economy, it’s a proxy measurement for economic activity (creating a measurement for the economy is problematic because the economy is not something that can be measured in its entirety.  Its the grand sum of all human actions, some of which are measurable and observable and some of which are not).

One of the most commonly known things about GDP by non-economists is its accounting formula:

GDP=Consumption (C)+Investment (I)+Government Expenditures (G)+Net Exports (NX), with Net Exports being defined as the difference between imports and exports (Exports-Imports).

It is on this Net Exports figure I will focus the conversation as it is from whence the confusion about the effects of international trade on economic activity comes from.

Often in news reports, we will see a report along the lines of this:

US economy grows 3.0 percent in third-quarter  

The U.S. economy unexpectedly maintained a brisk pace of growth in the third quarter as an increase in inventory investment and a smaller trade deficit offset a hurricane-related slowdown in consumer spending and a decline in construction.

Exports increased at a 2.3 percent rate in the third quarter, while imports fell at a 0.8 percent pace. That left a smaller trade deficit, leading to trade adding 0.41 percentage point to GDP growth.  (Source)

However, this reporting, which states that the trade deficit affects GDP which leads many non-economists to the conclusion that international trade and imports are bad for the economy, is incorrect.  it is based off a misunderstanding of the GDP calculations.  To explain why, we need to understand exactly what GDP is:

GDP stands for Gross Domestic Product.  “Domestic” is the key word there.  We’re focusing on consumption, investment, government expenditures, and exports of domestically produced goods.  So, why are imports in the equation at all?  Why not just simply sum all the consumptions, investment, government expenditures, and exports of domestically produced goods?  Simple: we don’t know what proportion of these components contained imports and what proportion contained domestic goods.  But we do know how many goods/services were imported.  So, we can simply subtract out the imports from the equation to give us the true GDP factor.  In other words, imports are an adjustment factor, not a component of GDP!  Without the import adjustment factor, we’d be overestimating GDP.

I think a simple numerical example will help explain:

For the sake of simplicity, assume a closed economy (no international trade) and only one type of activity, Consumption.  Thus:

GDP=C.

Since all goods are produced domestically, we can say:

GDP=Cd, where Cd stands for Consumption of domestically produced goods/services.

Assume Cd=5.

Thus: GDP = Cd, GDP = 5.

Now, assume the economy opens and only imports (that is, they have a trade deficit).  GDP is now:

GDP=C-Imports (I).  However, C = Cd+Ci, with Ci defined as consumption of imported goods.

Let’s say imports = 6.

Our GDP formula is GDP=C-I.

Rewritten: GDP = Cd+Ci-I

GDP = 5+6-6

GDP = 5.

As we can see here, once we adjust for imports (which is necessary because we’re dealing with gross domestic product), GDP does not change because of the trade deficit!  It is incorrect to say that imports reduce GDP, QED.

To be clear, there may be secondary effects imports have on GDP (say, for example, imports drive out domestic producers, which can reduce Cd, which can reduce GDP), but it is not a given that imports reduce, as I have shown here.  But even then, it is not necessarily a bad thing if GDP falls because of more imports.  GDP is a proxy, not a measurement, of economic activity and well-being.  If one is made better off by buying imported goods rather than domestic goods, then that will not show up in GDP, but it is a real gain nonetheless (for an explanation of this point, see the previous posts in this series).

Update: Here is Pierre Lemieux on this very same topic.

4 thoughts on “Flaws of GDP when Discussing International Trade

  1. Very nice, Jon, thank you. I’ll be surprised if you don’t get some ill-informed comments on this post.

    BTW those news report examples are exactly why I no longer read them.

    Liked by 1 person

  2. I think some countries exist where exports and imports exceed GDP, I believe, Singapore? Maybe Belgium, but i think those circumstances help illustrate your point.

    Like

Comments are closed.