How Misleading Economic Data Increase Investor Risks

Most investors heaved a sigh of relief when the nation's gross domestic product, a broad measure of economic activity, rose 3.5% in the third quarter, signaling that the recession had ended. But the Bureau of Labor Statistics (BLS) later revised it downward to 2.8%, and on Dec. 22, GDP was lowered again -- to 2.2%.

This 37% reduction in GDP certainly calls the entire data collection process -- and the value of these "headline" numbers -- into question.%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%% Statisticians acknowledge that the collection process overstates both GDP and productivity. Because investors, companies and the government all rely on such statistics, flawed data could result in poor investment and business decisions.

Bias and Errors

Susan Houseman, senior economist at the W.E. Upjohn Institute for Employment Research, was a participant in a recent conference on the problem. "We don't have the data-collection structure to capture what's happening in a real-time way, or what's being traded and how it's affecting workers," Houseman says. "We have no idea how to measure the occupations being off-shored or what's being in-shored."

Houseman's paper Offshoring Bias: The Effect of Import Price Mismeasurement on Manufacturing Productivity highlights holes in the valuation of imported goods. As the data are now collected now, a $50 imported auto part may be valued at the $100 price of the American-made part it replaces, and the difference gets attributed to rising productivity of American workers.

That official statistics can't capture the actual value of imported parts is bad enough. But to suggest that that these supposedly $100 parts are now being produced by fewer American workers, is a grave miscalculation of the fundamentals of economic activity that the GDP is supposed to measure. "What we are measuring as productivity gains may in fact be changes in trade," says William Alterman, assistant commissioner for international prices at the BLS.

A Mirage of Rising GDP

Granted, the heavily globalized $14 trillion U.S. economy has a lot of moving parts, and no collection system can track every one of them. But the inability to truly reflect imported goods and worker productivity overstates GDP, which sets up a potentially misleading confidence in a mirage of rising GDP and worker productivity.

That's not the only serious statistical flaw in the GDP. BusinessWeek recently reported that by overlooking cuts in research and development, GDP probably overstates the economy's strength by at least one percentage point.

The gap between the data and reality arises from the U.S.'s classification of "tangible" investments, like machinery and buildings, and "intangible" investments, like worker training and R&D. As the U.S. economy has geared up to compete in an increasingly global economy, these intangible investments have come to exceed the value of tangible investments: $1.6 trillion to $1.2 trillion in 2007.

The problem is that U.S. companies alike have slashed intangible investments in the recession. Since R&D isn't fully reflected in the GDP, the net result is that the GDP overstates the strength of the recovery and grossly understates the long-term damage wrought by the reduction of future product development and the reduction of worker training.

Tangibles and Intangibles

In the long term, Corporate America appears to have boosted its short-term profits by slashing investments in the foundation of future earnings: new and improved products and highly trained employees. Thus, even the revised 2.2% increase in third-quarter GDP may well be mostly illusory -- a false gain created by cheaper imported goods and the reduction of R&D staffing, a move that could significantly lower future real growth and productivity.

Not fully reflecting intangible investments creates misleading data in both recession and times of high growth. In periods of rising intangible investments, then the GDP as it's now measured will understate real growth -- a gap between data and reality just as misleading as the one that has probably overstated real GDP in the third quarter.

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