Economic Growth and Inflation: Can They Be Measured Better?

In his paper, "Evidence of Accelerating Mismeasurement of Growth and Inflation in the U.S. in the 21st Century," Leonard Nakamura argues that economic growth is increasingly taking forms not reflected in current calculations of gross domestic product (GDP). As a consequence, economic growth is likely being reported as slower than it actually is and inflation is likely being reported as higher than it actually is, particularly when we count all the free goods given to consumers and the progress in scientific innovations like gene sequencing. This has important consequences for how we make sense of economic and financial data, including how we interpret interest rates. Consider, for instance, that today's low yield on the 10-year Treasury note (hovering around 1 percent) makes more sense if consumer prices are falling.

Nakamura argues that this mismeasurement, which has become more pronounced during the past two decades, is due to the omission of several components of economic output. Certain investments in research and development (R&D) are among those omissions. The price of sequencing a complete human genome, for example, fell from $1 million in 2007 to $1,000 in 2017, a far faster rate of deflation than the rate experienced by microprocessors over that same time, but this rapid price decline is not reflected in our measures of intangible investment in pharmaceuticals and health care. The speed with which the coronavirus was sequenced is a testament to the value of this decline in price.

Nakamura stresses that for the U.S. economy as a whole, intangible investments such as R&D, when properly measured, exceed investments in tangible goods, although most intangible investment is unrecorded in GDP.

To show more concretely how national statistics understate economic output, Nakamura looks at four large technology firms: Amazon, Apple, Facebook, and Google. His analysis, which includes data from prior research (his own work as well as papers published by other economists), finds that these companies generate immense economic activity missing from indicators of U.S. economic growth.

Apple, for its part, offers a window into the importance of intangibles in misreporting GDP. The firm designs the iPhone and writes its software (thereby providing the intellectual capital), but the actual manufacturing is outsourced to other countries, which ship the new phones to the U.S. and other countries. So, even though retail sales of iPhones appear in U.S. measures of economic output, almost all those sales are cancelled out because the phones are counted as imports when they arrive in the U.S. As Nakamura points out, national statistics inadvertently depict Apple as a wholesaler that imports smartphones, rather than as a producer of smartphones. Ultimately, Apple's intellectual capital is not recorded in GDP, and Nakamura's observations suggest that GDP data are less accurate as a result.¹

He analyzes Facebook and Google to further illustrate how the value of digital services can be misrepresented within U.S. economic data. Instead of showing up in national output or inflation measures, the services provided by these firms appear as higher marketing costs for the products being advertised on their platforms. For instance, when a soap manufacturer buys advertising space from Google, Google is treated as an input into the costs of making and selling soap. The consumer services provided online by Google, however, are available to end users for free, and their zero prices are not included in our inflation measures, although we use them more and more as the Internet grows.²

By showing that the online giants contribute to the costs of GDP without contributing to final output, Nakamura further supports his argument that even though the firms are creating value for consumers, this value is not being captured within GDP calculations. This is a startling finding, considering the influence and growth of these firms. (At the end of 2017, their collective market capitalization reached $2.6 trillion and their after-tax profits reached $80 billion, up from less than $400 billion and $8 billion, respectively, in 2007.)

The misreporting of GDP, Nakamura shows, is accompanied by limitations in inflation reporting. He contends that U.S. inflation has likely been overstated in recent decades, largely due to changes in the basket of consumer goods used to assess price levels. If the basket remains unchanged over time, he says, national inflation statistics approximate a true cost-of-living index. However, this does not hold true when the basket undergoes some sort of change, such as the introduction of new products, the disappearance of old products, a shift in product quality, or the advent of a new use for an existing product. The author probes each of these scenarios, showing how they compromise the ability of official inflation data to reflect price levels that consumers are actually experiencing.³ He finds that each of these areas appears to be a source of mismeasurement, illustrating the difficulty statisticians face when measuring price levels over time.

Although his estimates are uncertain, Nakamura argues that real GDP growth per capita from 2007 to 2017 was approximately 3 percent, versus the rate of 1 percent reported in official statistics. His data suggest that mismeasurement in the period from 1983 to 1995 amounted to approximately 1 percentage point, and that this mismeasurement has accelerated by another percentage point in the 21st century.

The analysis in "Evidence of Accelerating Mismeasurement of Growth and Inflation in the 21st Century" argues that U.S. inflation and growth readings could better reflect true economic activity, while acknowledging that the improvements would require a lot of research and more-aggressive data collection and analysis. Unfortunately, U.S. statistical agencies have long been underfunded and so have been unable to keep up with the pace of economic change.