You might think that calculating the size of the U.S. economy is easy: Add up the value of all the goods and services that American workers produce, and you're done. Unfortunately, this simple procedure has a basic flaw: It leads to a lot of double-counting. For example, If I set up a factory making ceramic frogs and sell them to The Ceramic Frog Store, there's a real danger the frogs will be counted twice: when they leave the factory and again when they're sold to some frog-crazed consumer.
So here's what the government's statistical experts do. Everything that's bought is assigned to one of three bins. The "consumption bin" includes goods and services intended for use by households or the government today or in the near future. Food, haircuts, cell-phone service, and computer games all go into the consumption bin.
A YAK TALE. The "investment bin" includes all long-lived assets expected to contribute to production in the future. For example, shopping malls, airplanes, and business computers all go into the investment bin. Business software was put into the investment bin in 1999. Homes go there, too, under the assumption that they generate a steady flow of housing services for years to come.
Finally, the "intermediate output" bin includes all purchases by a business that are used up today in the production of whatever it is the business produces. The classic case is the purchase of ingredients by a restaurant (say, yak meat by a Tibetan restaurant). The ingredients get completely used up in the making of the meal. Other intermediate outputs include the purchase of electricity or phone service by a business or the hiring of a cleaning company to sweep the floors and put out the trash at night.
So what's the size of the U.S. economy? To simplify, what's called "gross domestic purchases" -- what we buy -- is equal to the value of the consumption bin plus the investment bin. In 2005, gross domestic purchases equaled $13.2 trillion. Consumption equaled $10.7 trillion, while investment equaled $2.5 trillion (including both private and government consumption and investment).
DISAPPEARING ACT. Finally, gross domestic product -- that is, what we make here -- is equal to gross domestic purchases plus net exports. Since the official figure for net exports is negative $0.7 trillion, gross domestic product in 2005 was $12.5 trillion. (To see where these numbers came from, look at Table 3 of the latest GDP release at http://www.bea.gov/bea/newsrelarchive/2006/gdp405a.pdf.)
What happened to the goods and services in the intermediate output bin? They don't get counted as part of GDP because it's assumed that they've been rolled into either consumption or investment. For all intents and purposes, they've disappeared. For example, you can search the overall GDP statistics as long as you want without being able to find a trace of business purchases of telecom services.
Here's the problem: There are all sorts of anomalies where purchases are put into the wrong bin, either for historical reasons or because it's too hard to put them somewhere else. Education -- human capital -- is surely a long-lived asset, but government and personal spending on education is mostly put into the consumption bin (the actual physical plant of educational institutions goes into the investment bin). Academic and government spending on research and development also, by and large, go into the consumption bin.
LIGHTS, CAMERA, INVESTMENT. On the business side, R&D spending mostly goes into the intermediate output bin, even though innovation is the activity with the greatest long-term implications for a company (once again, spending on the actual lab equipment and buildings shows up as investment). Product development is also intermediate output, as is worker training and advertising.
When a Hollywood production company makes a movie, that's mostly assumed to be intermediate output as well. However, the money that the audience pays to the movie theater or to the cable company or whomever is the actual retail distributor of the movie gets counted as consumption. Spending on movie sets or fast computers for graphics get counted in the investment bin, because they're tangible. So only part of the cost of making a movie -- which can easily top $100 million, gets counted as GDP.
The Hollywood example shows that a big portion of the long-term output of American companies -- the innovation, the creativity, the human capital -- isn't being counted as part of GDP. And that, in a nutshell, is the problem. By Michael Mandel in New York