The title of this article is a minor adjustment of a favorite saw of Mark Twain’s, but I can’t imagine he’d grudge me the use because the intent is the same as the original. Every times I read business or economic news I become more frustrated by ubiquitous (and to some degree iniquitous) use of three economic indicators. Here’s what they are, why they are wrong, and simple ways to fix them:
GDP is meant to measure the overall size of the economy and, for some reason, has now become a proxy for the overall health of the economy. If GDP is growing, things are good, right? Well, no. GDP can go up while the business sector is shrinking so long as the gap is made up for in government spending (even deficit spending.) After all, it’s just defined by this simple formula:
GDP = C + I + G + (Ex – Im)
Where C is consumer spending, I is business investment, G is government spending, and (Ex – Im) is net exports. But could it really go up while business is in decline? Sure. GDP growth in the US over the years 2012-2015 has averaged around 3.57%. Over roughly the same period, government deficit as a percentage of GDP has been 4.5% and the trade balance has remained negative. Which means that if you subtracted out the “unsustainable” or deficit part of government spending, you’d end up with a net negative GDP.
But there’s an even bigger problem. GDP can go up even while wealth and incomes consolidate to a smaller and smaller number of people. So if it’s being used to inform policy about when stimulus is needed or how taxes should raised, lowered, or structured it gives a complete false impression.
Still, GDP is a single, easily accessible number so you can see why it would be useful for sound bites and news articles, right? Maybe, but not so much since there are better numbers that do something pretty similar. Even just using median income (not average income) would be much better if you want to know how average families are actually feeling.
This is another frustrating one. The unemployment rate is supposed to show how easy it is for people to get jobs. Since there’s always some natural and seasonal churn in the economy it constantly needs to be adjusted and a number of around 4-5% is considered “full employment”. But this one is broken, too. It measures jobless claims as a percentage of the labor force. So it doesn’t take into account the long-term unemployed (who no longer file for benefits) or those who have given up looking since it’s just too hard.
A much better statistic to use is the labor participation rate. This is the ratio of people who are working to the overall population that’s of working age. Admittedly, it still doesn’t help identify patterns among undocumented workers, cash employment, and various other categories, but it’s a darn sight better than the unemployment rate if you only get one data point for measuring the employment situation. It would take some time to adjust since you need to know what “healthy” is, but so did unemployment rate (it isn’t obvious that 4% rather than 0% is “full” employment.)
The DOW Jones Industrial Average
The DOW is the most commonly reported stock market index and it’s also the worst. No serious analyst thinks the DOW is a good measure of the market for a few reasons.
First, it’s small. It only includes a limited number of stocks and those stocks are of the biggest companies out there. If you believe that small business can have ups and downs independent of big business (and the data would support you if you do), the DOW provides a very incomplete view.
Second, it’s price weighted. Each component of the index is weighted by price rather than by market capitalization. This is a problem since price per share is market cap divided by the number of shares and the number of shares is completely arbitrary because a company can just pick how many shares to have outstanding through splits and reverse-splits. Net net, this means a company with a high share price can have a disproportionate impact on the DOW just by having a high share price even if it’s a relatively small part of the overall economy.
For all that, using the DOW to report on the market is probably a less of a big deal than GDP or unemployment since the DOW and broader indexes like the S&P 500 move together roughly 98.5% of the time and never, to my knowledge, move in completely different directions over any significant time frame. Having said that, it’s also the easiest to fix since indexes like the S&P 500 are already widely reported and are much more accurate.