Why was the calculation of UK GDP changed? Lower recorded inflation so higher growth?

Today sees the publication of the UK figures -Gross Domestic Product or GDP- for economic growth in the third quarter of 2012. This particularly matters because of the state of the UK economy which has shrunk in the previous three quarters on the same measure and has an overall level which is still around 4% below the peak reached before the credit crunch hit. On the political side there was a ratcheting up of tension when the Prime Minister announced this yesterday at Prime Minister’s Questions.

The good news will keep on coming

As you can see this was not specific. Also if we look at the latest result from the NIESR (National Institute for Economic and Social Research) then good news was expected anyway.

Our monthly estimates of GDP suggest that output grew by 0.8 per cent in the three months ending in September after growth of 0.1 per cent in the three months ending in August 2012.

What does headline GDP tell us?

This is treated as a number which tells us all manner of things which it is not designed for. It does not for example give us any real clue as to national well-being and as a blunt number is not even especially accurate. It is also often used as a type of national balance sheet indicator when at best it tells us something about income. Also the use of a single number hides the fact that there are three ways of measuring GDP (income,output and expenditure) and they regularly tell a different story. It is not easy to get a grip on the size of this problem as some years ago the then Chancellor Nigel Lawson thought that such differences might disturb people and instructed the Office for National Statistics to “merge” them into the same number. This is the output number and it is something of a shame as for example in the United States there has been research suggesting that it has been the income measure which has been a superior guide and measure in the credit crunch era.

For those wondering about the size of such disparities I was looking at Portugal’s numbers earlier this year and they were 4% of output at their maximum which gives some perspective to discussions about 0.1% or 0.2% movements in GDP does it not?

What is Gross Domestic Product?

Gross Domestic Product is the market value of goods and services produced by workers and property in the country concerned, regardless of their nationality. So it is defined with geographical boundaries.

Gross Domestic Product = consumption (personal)  + government spending + business  investment + net exports (exports – imports)

Should we not use GDP per capita?

One obvious problem with using overall GDP numbers is that they make no allowance for population changes. If we look at countries where there is net emigration right now such as Portugal and Greece this means that headline GDP numbers are likely to make the declines look worse than they are. For the UK we have been experiencing inflows to our population so in terms of the individual or per capita the overall number has been flattering the numbers. We were given some insight into the effect of this since the credit crunch began earlier this week.

Given that the UK’s population increased steadily throughout the period and is the denominator used in the per head calculation, the falls on a per head basis are even greater …………a fall of 7.0 per cent for GDP.

As this number which takes us to the end of the second quarter of 2012 compares to an overall GDP fall of 4.1% we can see that individually we are on average worse off than the headline figure would tell us.

In fact the number which is considered to be a better  measure of national well-being tells us an even grimmer story.

In the second quarter of 2012 net national income per head in real terms was 13.2 per cent below its level in the first quarter of 2008; a sharper fall in economic well-being than the GDP data alone indicate

I wish to make it clear here that I am differentiating between the individual and the government as for it the overall measure of GDP is important as it reviews debt and deficit sustainability although even it must have concerns about the impact of falling numbers per capita or head.

Today’s GDP numbers

Here we have some good news released by the Office for National Statistics.

GDP was estimated to have increased by 1.0 per cent in Q3 2012 compared with Q2 2012

Output of the production industries was estimated to have increased by 1.1 per cent in Q3 2012 compared with Q2 2012

Output of the service industries was estimated to have increased by 1.3 per cent in Q3 2012 compared with Q2 2012

So we can permit ourselves a smile. However not everything is doing so well

Construction sector output was estimated to have decreased by 2.5 per cent in Q3 2012 compared with Q2 2012, following a decrease of 3.0 per cent between Q1 2012 and Q2 2012

The construction sector has been a consistent problem which is not helped by the bickering amongst the bodies which measure it as to actually what is going on. Also if we look for some perspective we see that we have climbed the hill back to where we were a year ago.

GDP in volume terms was estimated to have been flat in Q3 2012, when compared with Q3 2011

If we look back we see that it was estimated that we “lost” some  0.5% of GDP in the second quarter of 2012 due to bank holidays and so on so we are down to maybe 0.5% of underlying growth. There was also an additional 0.3% of GDP in Olympics ticket sales registered in this quarter but of course the Olympics had a downward influence on other areas such as shopping in Central London.

Revisions are a danger

These numbers only contain some 45% of the data that will be known in a year’s time so the danger of revisions is present and they may be substantial.

Why the numbers are being overstated if we compare with the past

If we look at the ONS report we see this.

Unless otherwise stated, all data in this bulletin are seasonally adjusted and have had the effect of price changes removed (ie the data are deflated).

What they mean by that is that the numbers are collected and then a measure of inflation is used to convert them into “real” or volume numbers. This is not especially complicated but the way that this measure called the GDP deflator is constructed has been changed in recent times. It is my contention that this is likely to lead to a lower measure of inflation and with the same price level a higher level of recorded growth. Or as the group Pilot put it some years ago.

Hey,hey it’s magic!

Let me explain what has happened

It used to be that the GDP deflator was based on the Retail Price Index but this was changed.

The second is replacement of Retail Price Index (RPI) series with Consumer Price Index (CPI) series in forming the deflators

Oh okay why?

However, CPI has a number of advantages over the RPI for this purpose, as discussed below, and the international guidance is clear that the CPI should be using in preference.

Missing in the list of advantages is that fact that the CPI tends to give a lower number for inflation than the RPI sometimes substantially lower! Now I do not wish to overstate the impact of this as it was already in minor use (5%) but around 18% of the data collected used the RPI. So on that a lower inflation measure for the same reading will give a higher growth measure. Also I have discussed before around 18 months ago if I recall correctly changes to producer price inflation methods which tended to reduce the level of inflation recorded. So again here for this sector lower recorded inflation for the same number leads to higher recorded economic growth.

So we are left with the uncomfortable view that since this change in September 2011 we will record the same circumstance as giving a higher rate of economic growth than before. Or if you like ceteris paribus no longer exists.

This adverse change in how we measure inflation is something of a curse of our time is it not? I will be at the RPI consultation tomorrow to argue the case against it being “improved” too. Also I think that “improved” can go into my financial lexicon too.

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19 thoughts on “Why was the calculation of UK GDP changed? Lower recorded inflation so higher growth?

  1. Hi Shaun
    Superb analysis.
    My reading of the situation is that overall the UK economy is flat-lining and on a per capita , non-seasonally adjusted, ‘old’ RPI adjusted basis is declining by about 1.5% per annum. As you imply the GNP and household income decline is far sharper. If there is to be about a 30% decline in standard of living for the 99% , we are probably still not yet half way there.

    • Hi JW

      Thank you. You know my view which is that until we start a genuine reform program that starts with our banks (who are behaving exactly the same as bafore and have not told the truth about their bad debts) then there will be no long-term recovery.By the way did you see Santander’s results?

      • Hi Shaun
        UK operation posting nearly the same profits as the parent. Not just Spanish pain but also Brasil was poor.
        Do you think the growth in UK deposits was Spaniards changing their Euros for a new home?

  2. Hello Shaun

    If I’m lead to believe that the Olympics caused 1% Growth and we spent approx 11billion ( from what I can find out )

    wouldn’t it have been better if we spent all that QE 375billion , on building more stadia and other works ?

    Atleast we could see our money in action ……

    or to put it another way , if there was no QE of 375 billion , would our economy have contracted by xyz% over the QE time period ?

    ( another way of pointing out that QE did or did not do anything !)

    375/ 11 = 34 % growth in one quarter (!) or 8% year or 4% over two years

    ( obviously this is too simplistic , or is it ? )

    Alternatively , if the figures have been Gerry Mandered , then we’ll have a big drop next quarter and a downward revision a year later when all the data is in – who knows with this lot ?

    ah interesting times indeed !

    Forbin

  3. Presumably GDP has been boosted by all the QE. Is it possible to estimate how much has come from QE? Would it make sense to try to?

    • Hi Peter and welcome to my part of the blogosphere.

      I have a section on QE where you can see my views on QE from the beginning (nearly 3 years now, with the gap on mindful money). I had doubts from the beginning about how much good it would do thinking that we would probably get more inflation than output.

      The Bank of England has had a go – moral hazard alert considering it is reviewing itself!- and decided that the first £200 billion of QE provided a boost to the economy of between 1.5% and 2%.They did at least have the decency to use the word “uncertain” in relation to it.

      As time has gone by and we have seen the effect on real wages I have begun to fear that it may have dome no good and maybe has even made things worse.

  4. Goodhart’s Law: “Once a social or economic indicator or other surrogate measure is made a target for the purpose of conducting social or economic policy, then it will lose the information content that would qualify it to play such a role.”

  5. Hello Shaun,

    Almost forgot , isnt there a danger in using the Creative Price Index ( Consumer ) that if many of us get so poor we stop being consumers ( of the non essential things if covers ) that it become irrelavent ?

    I mean if all I can afford is fuel and food ( and live in a tent example ) and longer “consume” ipods and TV’s then what ?

    Forbin

    PS ; oh yes I forgot – I’d have no residence so I wont be voting – so I dont count anyway …….

    • Hi Forbin

      I am not sure that they have thought that far ahead. The more we learn about our “lords and masters” the less evidence of any real long-term planning emerges and instead they will only think of the near term gains for them.

  6. So by action/ omission, identifying the need to change the way CPI/ GDP is calculated shows ‘they’ know there is no end in sight for a normal economic recovery and this coma of an economy is going to require life support for as far as anyone can see into the future – aka to infinity and beyond.

    Its worth noting that the BBC headline news highlights that we’ve turned the corner to be out of recession and below it that Ford is to close 2 plants with the loss of up 1400 jobs.

  7. @ Alex +10 !

    those 1400 jobs will be replaced with part time cleaners and other servants in “our” new economic miracle model – possibly in the new shopping malls to be built on those former Ford sites……

    Forbin

  8. A great deal of bureaucratic effort is placed behind the indices mentioned here. As others have said, that’s not really a surprise. Other measures, for example GDP/capita at ppp (purchasing power parity) are quite useful for ranking our efforts relative to others’. The US government thinks we are 33rd in the world on that basis, not exactly encouraging. I bet you have never heard a politician quote that – they like to say we are the 6th (or so) richest country! But of course individuals feel the per capita numbers, not the total country ones, which are really only useful when deciding whether to do something national like hosting the Olympics or building an HST line.

    More seriously, there is the matter of why all these endless changes are made. The truth, I strongly suspect, is that there is no good news on the real per capita growth front and there probably won’t be. Worse, through borrowings, we spent the future growth in the last spendthrift decade and now desperately need it to materialise so that at least we can get the accounts straight for the naughty noughties. Unfortunately those who spent all that money had no concept of what would happen in the next decade and now we are discovering that it is not all that nice. Our national and personal situation is that we still are at about 2004, nearly a decade later. Brown was disturbingly wrong in his rather too loud statement that he had ended boom and bust. Sadly he only ended the first. But then his true agenda was about redistribution of the existing pie, not boosting pie size.

    • Hi Zak

      Going back into “recession” requires two negative quarters in a row which is double the one quarter it took us to come out so there is a slightly higher threshold for a triple-dip.

      I’ve got that line from that song on my mind now but I am determined not to look it up as it’s the only line I can remember…

  9. Hi Shaun, thanks for explaining this, you’d never know about this from the MSM and today’s hullabaloo over the marvellous figures. Good luck tomorrow.

    Talking of your lexicon, I see that according to the IMF today that Portugal is on track again…

    • I can almost hear the screams of “not again please” from Lisbon in London tonight. For those who have not followed this issue Portugal’s decline into what I believe is an economic depression has been accompanied by the IMF saying it is on track.

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