Weirdly, illegal drugs and prostitution are in European GDP figures
Did the statisticians err?
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Gross Domestic Product (GDP) is a useful concept. It’s an economic measure that correlates with many metrics that make for a good society, and having a broad macroeconomic benchmark makes sense.
Sometimes, those quirky statisticians get carried away. Many intricate conceptual debates must happen so measurement decisions can be made that draw a line around an abstract economic idea.
However, the new GDP era since 2010 has involved some strange choices by some statistical agencies, such as including the value of criminal activities.
For those who missed out on the pleasure of learning what GDP is, the basic idea is that it is an estimate of the value-add of newly produced goods and services within a country’s borders over a particular time period.
It ignores price changes in asset markets, as Apple and BHP shares (stocks) aren’t newly-produced goods and services. Changes in the price of property, bonds, and shares do not affect GDP.
GDP also ignores the informal economy, which is the value-add of production that is never exchanged for a monetary value. For example, when a chef cooks at work in his restaurant, the value-add of that activity is in GDP. When he cooks the same meal at home for his family, this exact same activity, which has the same market value, is not counted. It is informal.
The main exception to ignoring the informal economy is in housing, where the imaginary rent that owner-occupied households pay themselves gets imputed into GDP, with this one component making up about 8% of Australia’s total GDP.
GDP is also about the gross flows of new stuff we make each year, ignoring any depreciation of buildings, vehicles and machinery.
The European statistical experiment
In 2010, the European statistical agencies decided they could improve their GDP estimation methods by measuring more of the informal economy. Instead of the big ticket items like home production, like our earlier cooking example, they decided to focus on illegal drugs and prostitution.
Here’s how The Economist covered the inclusion of some of these activities in Italy’s GDP back in 2014.
THE announcement on May 22nd by Istat, Italy’s statistical body, that from October it would include drug trafficking, prostitution, and alcohol-and-tobacco smuggling in its economic-output numbers has generated a stream of sniggering headlines. To some, it smacks of 1987, when Italy started taking account of its shadow economy, the off-the-books business which makes up about a fifth of Italian GDP. As a result, the economy grew by 18% overnight, surging past Britain to be the West’s fourth-largest economy. The event was hailed as il sorpasso (the overtaking) and the source of much national joy, until two decades of economic mismanagement sent Italy tumbling back down the league tables.
Here’s how some of the troubles measuring prostitution drug trafficking in Spain were reported:
A police source estimated that, with an average of five clients a day paying about €40 a service, that it worked out at €60m a day. Assuming that the sex workers don't work seven days a week and perhaps only half are working at any one time, it could still add up to about €10bn a year.
"In reality it's impossible to calculate," Roca told the paper. "There is no census of prostitutes, nor clubs, nor the number or cost of services. You might as well pick a number."
Spain has long been Europe's port of entry for cocaine from Latin America and hashish from Morocco. Last year the police confiscated 21 tonnes of cocaine, 325 tonnes of hashish and 229 kilos of heroin. As a rule of thumb, police estimate that confiscated drugs represent 10%-15% of the total in circulation.
According to Spain's interior ministry, drug dealing generates close to €16m a day, or €5.7bn a year. Spain's GDP in the first quarter of this year was around €256bn, so the drug trade could account for about 0.5% of GDP, and prostitution 1%.
It’s a tricky task to calculate the value of these activities. Luckily, the European Commission’s EuroStat produced a manual for this very eventuality. It’s simply a matter of plugging numbers into their equations as follows.
And for illegal drugs, plug some numbers into this equation:
It is of course not that simple.
There is enough guesswork and estimation in the formal sectors of the economy when it comes to estimating GDP. This is another level. Estimates rely on how well policing can monitor and estimate criminal activities, and the whole exercise relies on keeping a record of the changing street value of various drugs to adjust for price changes.
Then, there are problems dealing with the external account—adjusting for exports and imports. Here’s the EU guide on how to classify the imports and exports from illegal prostitution services. I doubt there are sensible estimates for any of these subcomponents.
When you take it all in, these changes seem ad hoc, arbitrary, and of very little use. This is why the Australian Bureau of Statistics does not attempt to include estimates of illegal activities in GDP (see Appendix 2.11 here).
As the chart below shows, the EU boffins have had a good shot at estimating these illegal components of GDP and think they account for half a per cent of the total gross value of production in the EU27 member states (this analysis is also worth a quick read on some of the details of how these changes have affected GDP metric).
Reclassifying weapons systems
Another conceptual debate about GDP occurred in 2010 and it was resolved to reclassify military weapons, known in the jargon as Defence Weapons Platforms (DWPs), from consumption to investment. This allows them to be doubled counted in GDP—they are counted at their cost when they are produced, and once again while they are in use to recognise “ongoing services provided by DWPs beyond the period in which they were purchased”.
Another change was to reclassify research and development expenditures to be an investment and not an intermediate good, again boosting measured GDP.
An OECD analysis of the implementation of these various changes in the new GDP era is below. We can see, for example, that Australia’s GDP was boosted by 1.4% due to the research and development reclassification, and 0.3% by the military weapons reclassification.
Italy got a 1% boost, and Spain a 0.9% boost from illegal drugs and prostitution, and another 0.2% and 0.3% gain from military weapons reclassification. Finland and Korea really cashed in on research and development, with 4% and 3.6% gains each for that change.
It is often hard to accept that GDP is a concept we invented. We aren’t discovering it. We are creating it. This means that, like many economic measurements, there are always debates about what to measure and why. Here are some questions that I would ask to progress these debates. What are yours?
If we count illegal activity in GDP, why stop here?
If GDP rises because of a boom in illegal activities, is that good or bad?
Is the next statistical leap to reclassify other goods from consumption to investment, like domestic motor vehicles and home furnishings?
Why ignore the huge value of home production, which is legal but uncounted, and include illegal activities instead?
Should criminals smuggling drugs or women be counted as “in the labour force” and “employed”?
Should prices for these activities be included in consumer price indexes?
What would Simon Kuznets, the inventor of GDP, think of double counting military weapons? He was wary about counting any military spending at all.
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