GDP & The Terms Of Trade Issue
I start with James Hamilton. He use a "Crusoe"-island approach, which I kind of like.
"In 2007, Islandia produced 500 coconuts, which residents sold to themselves for $1 each, and imported 1 barrel of oil, which cost $100. The oil was paid for by borrowing from foreigners.
Ready to calculate GDP? We want the dollar value of domestically produced final goods and services, to wit, the dollar value of the 500 coconuts. Got the answer? Very good. Nominal GDP in Islandia for 2007 was $500. If you wanted to describe that in real terms, you'd call it 500 coconuts. You don't count the oil in either nominal or real GDP because Islandia didn't produce any oil.
Here are the numbers for 2008. We grew 510 coconuts, sold them for $1.01 each, and still imported 1 barrel of oil, paying $125 for it. So nominal GDP was $515.10 (a 3% increase) and real GDP was 510 coconuts (a 2% increase). The change in the implicit GDP deflator would be the change in the ratio of nominal GDP to real GDP, namely, +1%.
But wait a minute, Islandia's pundits decry. How can your crummy accounting claim that inflation was only 1%? Last year we bought 500 coconuts and 1 barrel of oil for $600, but this year if we tried to buy the same thing it would cost us $630. The inflation rate, they tell you, is obviously 5%, not 1%. You must have intentionally cooked the books, they charge, just to make the economy appear better than it is!"
However, as much as I like the approach, his conclusion is wrong. As he wrote, what we want is the value of domestic production. But what value? Value is not intrinsic in the things we produce, value is value in terms of the things we want. The value of a worker's earnings does not lie in how many things he produce, but in how much he can buy for it. Saying that terms of trade is irrelevant for the value of domestic production is like saying that the relation between wage and consumer price levels is irrelevant for real weekly earnings of workers.
The logic behind the GDP deflator approach would thus imply that if a company executive tells workers that they're going to have to accept a 90% wage cut even as their cost of living is unchanged, they shouldn't mind because the workers will continue to work as hard and produce as many goods as before for the company and since their personal GDP deflator falls 90%, the value of their wages are unchanged (even though their nominal wage is down 90% and their cost of living unchanged)! Similarly, a company executive could tell shareholders not to worry about the 50% decline in revenues since that decline was entirely the result of reduced prices on the goods they sell, and since the company's GDP deflator is down 50%, revenues aren't really down at all!
Or similarly, supermarkets could raise prices by 50% and tell customers that they shouldn't mind paying more because their wages (their personal GDP deflator) haven't been raised! And suppliers to a company could similarly tell the company that they shouldn't object to paying more to them as long as they abstain from raising the price they charge their customers! Or in the case of Islandia, those foreign oil producers could tell them that even though the world price is $125, they shouldn't mind paying them $200 since that won't affect the GDP deflator and thus not reduce real GDP!
As for knzn, he takes a different approach and says that he does not care about the value of production. Well, he is free to care or not to care about whatever he wants, but
the vast majority of people do care about the value of their income and that is why people laugh at Phil Gramm's "mental recession"-remarks (See here for a clip of how people spontaneously laugh when Obama tells them about those remarks) that contradict their daily experience even as the official GDP statistics support Gramm. Economists who want people to think that GDP isn't something laughable better care.
He continues by saying "Personally, I care a lot more about the people that don’t have jobs, or potentially won’t have jobs in the future." But first of all, why then look at GDP numbers in the first place? Why not only look at employment numbers? And secondly, the employment numbers are far more consistent with the terms of trade adjusted GDP number as employment has been falling (and would have fallen a lot more if not for the flawed "Birth/Death" model).
He then says that he cares more about productivity (which he defines in unadjusted terms) because that is supposedly more stable then terms of trade movements. But even setting aside the fact that GDP is supposed to measure the value of production regardless of how stable or not certain aspects are, it is not true that productivity is particularly stable. If you go to the Bureau of Labor statistics web site, you see that their measure of productivity (non-farm business output per hour) moves up and down in a quite erratic way. In 2003 for example, productivity at an annualized rate rose by 5.6% in the second quarter and 10.3% in the third quarter only to fall by 0.4% in the fourth quarter.
As for Brian Wesbury, who delivered the by far worst GDP forecast of all economists(3%, even as he assumed a 3% increase in the GDP deflator!), he agrees that 1.1% is a far too low inflation figure and notes like I did that if you deflate the nominal GDP increase with the domestic purchases deflator, real GDP declined. However, he says that would be misleading and says that if you include import prices to calculate real GDP you must add imports to GDP, a sum he says increased more than 5%. But that does not follow. What the domestic purchases price index include is first of all usually not directly import prices, but the prices of various forms of domestic demand, like private consumption, government consumption and business investments, and that is usually not the same even for imported goods, as the retail price of for example a sweater made in China includes the margins of the American retailer (and often also wholesaler). That means that including imports would double-count it. However, as discussed above, the value of domestic production is determined (partly) by how much imported goods that domestic production can buy.