The Relevance of GDP Growth Rates

Christian Ølgaard, Economics

INTRODUCTION

An evaluation of a country's economic performance often focuses on GDP in constant prices. Countries with high economic growth over a period of time are often pinpointed, and the – explicit or implied – conclusion is that these countries operate with competitive economic models that can be a lesson to low-growth countries. On the surface, this may seem to be the case, and, depending on the agenda of the sender, it may be the basis for policy  recommendations to politicians and the general public.

However, a comparison of simple GDP growth rates across countries is associated with several pitfalls – even though all countries follow the same manual for compilation of national accounts. This article focuses on pitfalls that are (too) often overlooked:

• The significance of demographic factors.
• The significance of terms of trade.

The conclusion of the analysis is that demographic factors and terms of trade can be of great significance to the evaluation of the relative performance of the individual countries.

DELINEATION OF THE ANALYSIS

For the sake of clarity, the analysis is limited to 13 OECD countries covering the full range from high to low GDP growth. The period under
review is 1993-2005. The choice of period is not immaterial since, among other factors, the cyclical position of the individual country in the first and last year of the period impacts on growth in the interim period. The choice of a 12-year period diminishes this problem, as does the selection of countries that were either at or close to a trough in 1993, measured in terms of the OECD's output gap. At the same time, the period is so long that the differences among the countries are not likely to be merely a coincidence, and not too long for the results not to be relevant today.

In terms of simple GDP growth rates, Ireland clearly tops the list with an average annual growth rate of 7.4 per cent in the period 1993-2005, cf. Chart 1. It is followed by Finland, Spain and the USA with growth rates of around 3.5 per cent. Denmark's growth rate of 2.5 per cent puts it in the middle, while Germany, Italy and Japan are at the bottom of the list. These are well-known facts.

Disregarding Ireland, the differences in growth rates may seem modest, but even minor differences may accumulate to substantial levels over a 12-year period. Sweden's average growth rate has been 0.5 percentage point higher than the Danish rate, which means that over the period Sweden's GDP growth has exceeded Denmark's by 6 per cent.

THE SIGNIFICANCE OF DEMOGRAPHIC FACTORS

Demographic trends are significant to a country's growth potential. All other things being equal, growth will be higher in a country with an increasing population of working age than in a country with no such increase. If higher growth in country A than in country B solely reflects that there are more hands to do the work, the gap cannot be taken to mean that country A has outperformed country B in economic terms. This elementary aspect is often overlooked – perhaps in the belief that " the gap is negligible anyway" .

The fact is, however, that demographic factors can vary considerably across countries over prolonged periods. In the period 1993-2005, countries with high GDP growth rates also showed high growth in the population of working age, and vice versa, cf. Chart 2. The number of people of working age rose by 26 per cent in Ireland in the period under review, and by 16 per cent in the USA, but fell in Japan, Germany and Italy. This difference in the supply of labour impacts on the growth potential of the economies, and thus on actual growth.

Adjustment of GDP growth rates for the change in the number of people of working age^[1] reduces the growth gap, cf. Chart 3. Ireland still has the highest growth rate by far, but the adjustment brings the growth rates of the other countries much closer together. A change in the order of the countries is also observed. A particularly noteworthy aspect is that the USA's growth rate is now lower than Denmark's and only slightly higher than e.g. Germany's rate. Contrary to the argument often put forward, the USA's relatively high economic growth in the last 10-15 years is first and foremost attributable to a strong influx of labour. After adjustment for this effect, the development in the USA has been close to the average.^[2]

THE SIGNIFICANCE OF TERMS OF TRADE

Recent years have seen increasing focus on the fact that GDP growth rates – adjusted or unadjusted for demographic factors – do not capture the effect of ongoing differences in terms of trade, cf. e.g. Beier and Pedersen, 2005, Ministry of Finance, 2005, and OECD, 2006.

Finland in particular is often cited as an example. In simplified terms, Finland has seen rapid growth in the ICT (information and communications technology) sector since the mid-1990s, with Nokia as a case in point. Today ICT accounts for a much larger share of total output than in other countries. ICT output has been characterised by high productivity gains, not only in Finland, but worldwide. The greater weight of the ICT sector in the Finnish economy compared to most other economies has given Finland high growth in labour productivity. This is the background to Finland's rapid growth in GDP in constant prices. However, the high productivity growth in the ICT sector has not been accompanied by equivalent growth in earnings. Thanks to the strong competition in the ICT sector, the productivity gains have first and foremost been to the benefit of consumers and ICT-consuming business enterprises, as lower prices. On the other hand, the opposite factor – a strong drop in sales prices for ICT products, causing Finland's terms of trade to deteriorate by more than 10 per cent since 1993, has no impact on real GDP growth.

The example illustrates that statistics for real GDP or productivity growth can be misleading. A strong increase in productivity does not enhance a country's performance if the country at the same time has to sell goods and services at falling prices.

Finland is not the only country whose terms of trade changed significantly in the period 1993-2005. Sweden's terms of trade deteriorated almost as much, and Japan's even more, cf. Chart 4. In contrast, Norway's terms of trade have improved strongly since the late 1990s, first and foremost driven by rising oil prices. Denmark's terms of trade have improved too, but more gradually. Only a minor share of Denmark's improvement can be attributed to North Sea oil and gas production.

All other things being equal, an increase in GDP in constant prices increases a country's real incomes, while deterioration in the terms of trade has the opposite effect. The question is: to what extent is a given level of additional GDP growth offset by deterioration in the terms of trade?

There is no clear answer. The terms of trade reflect certain price effects which GDP in constant prices as such is designed to eliminate. This makes it difficult to equivalate GDP and terms of trade.

An estimate of the significance of the terms of trade can be obtained by calculating what GDP would have been if export prices had developed in parallel with import prices. This corresponds to calculating export volume as the volume of imported goods that export revenue can buy. More specifically, the value of exports is deflated by the import price index rather than the export price index:

where y is GDP in constant prices, y_k is adjusted GDP, x is exports in constant prices and p_x and p_m are the national accounts' deflators for respectively exports and imports of goods and services. The same method is applied in Ministry of Finance (2005) and OECD (2006).^[3] This static calculation, based on all-other-things-being-equal, does not provide the full picture. Had the terms of trade followed a different pattern, the development in the rest of the economy would also have been different, but such derived effects are disregarded here. Nevertheless, the calculation does give an indication of magnitude.

Compared to adjustment for demographic factors, adjustment for terms of trade has a more limited effect on growth rates. Norway accounts for the greatest change, as its annual growth rate rises by 1.6 percentage points. On the other hand, the growth rates of Finland and Sweden are reduced by 0.5 and 0.3 percentage points, respectively, cf. Chart 5. Japan's growth rate is reduced by only 0.2 percentage point, even though Japan clearly accounts for the strongest deterioration in terms of trade. This reflects the more closed nature of the Japanese economy compared to the Nordic economies, so that the deterioration in terms of trade impacts less on the overall economy.

Denmark's GDP growth rises by 0.25 percentage point per annum. After adjustment for terms of trade, Denmark's GDP growth is thus slightly higher than Sweden's, and the gap to the USA widens.

After adjustment for terms of trade, Norway shows the second-highest growth rate after Ireland. Since Norway's terms of trade are highly sensitive to oil prices, the adjustment will tend to vary more year-on-year than is the case for other countries. For as long as oil prices remain high and oil production is substantial, the growth adjusted for terms of trade will exceed the unadjusted growth.

After adjustment for demographic factors and terms of trade, Finland is in third place, but Finland's growth rate is only slightly higher than that of e.g. Denmark. It should also be taken into account that in 1993, i.e. the first year in the period analysed, Finland posted a negative output gap of 11-12 per cent of GDP, after a number of years of severe economic crisis. None of the other countries were equivalently below their output potential in 1993. At that time, Denmark posted an output gap of 3-4 per cent after seven " lean" years. In other words, in 1993 the Finnish economy had a far greater output lag than the other countries in the analysis. Finland's relatively high growth since 1993 thus not only reflects structural differences, but also the country's weak cyclical position from the start.

TERMS-OF-TRADE EFFECT IN KRONER

As an alternative, the effect of the change in terms of trade can be quantified in kroner per capita. Chart 6 (left) illustrates the change in GDP per capita (current prices) compared to a situation with unchanged terms of trade. In 2005, Norway's GDP per capita was 53,000 Danish kroner higher than would have been the case with unchanged terms of trade. Denmark showed a terms-of-trade gain of kr. 7,000 per capita in 2005. This corresponds to 3.5 per cent of (private and public) consumption, cf. Chart 6 (right), while the gain for Norway was 24 per cent of consumption.

Conversely, Finland's terms-of-trade loss reduced GDP by kr. 11,000 in 2005, corresponding to 6 per cent of consumption.

The calculations illustrate that terms-of-trade gains accumulated over a prolonged period can have a considerable impact on incomes and consumption, even though the adjustment of annual GDP growth may appear to be limited.

CONCLUSION

The above calculations have illustrated that it can be misleading to base assessment of a country's economic performance solely on simple GDP growth rates. The adjustments for demographic factors and terms of trade reduce the growth gaps between the countries, and their ranking changes. Norway and, to a certain extent, Denmark move up considerably, while the growth performance of the USA, Finland and Sweden becomes less impressive. Thus, after the adjustments, Denmark's growth in 1993-2005 was clearly higher than in the USA and Sweden, and at the level of Finland, while in terms of unadjusted figures Denmark ranked lower than these countries.

This article has focused on demographic factors and terms of trade, but other factors, too, can lead to diverging measures of GDP growth, without actually reflecting differences in economic capacity to generate real income. For example, capital is not taken into account. A high growth rate may be attributable to rapid expansion of the capital apparatus. In principle, the consumption of fixed real capital, i.e. depreciation, should be deducted from GDP. The problem is that the capital apparatus is difficult to quantify and that there are no internationally comparable statistics for depreciation.

The analysis can be expanded by more broadly considering measures of the countries' standards of living. However, this is a different discussion that includes such aspects as who benefits from the added value. Particularly in Ireland and Luxembourg, an increasing share of output has gone out of the country for remuneration of the considerable
foreign investments and labour that these countries have attracted over the last decades. As a result, GNP has increased less than GDP, cf. Chart 7 (left). The opposite trend is observed in the four Nordic countries that for a prolonged period have posted large current-account surpluses, cf. Chart 7 (right). In principle, an almost indefinite number of adjustments can be made, so it is important to keep the current focus in mind.

The point of departure of the analysis in this article is the change in the countries' GDP over a period. Adjustment of GDP growth for demographic factors and terms of trade results in a measure of the countries' economic performance, or perhaps more accurately the countries' ability to generate income through output, that is better than simple GDP growth. The measure thus describes a key dimension of the countries' competitiveness.

LITERATURE

Beier, Niels C. and Erik Haller Pedersen (2005), Wages, Competitiveness and the Balance of Payments, Danmarks Nationalbank, Monetary Review, 1st Quarter.

Danish Ministry of Finance (2005), Economic-Policy Cooperation (in Danish), November.

OECD (2005), OECD Economics Surveys, Denmark.