Jobs Growth Continues
Gas Prices Drops Lead to Overall Deflation in November

Sex, Drugs and GDP in Europe

In September,  Eurostat waved a magic wand and increased the GDP in the European Union by 3.53 percent overnight. That is a full year's worth of very solid growth.  But it didn't make Europeans any wealthier because it was actually just due to a new definition of the way GDP is counted.  Eurostat (the economic statistics office of the European Commission) redefined GDP to include many transactions that were previously uncounted and are actually illegal across much of the Eurozone.
 
The new GDP definition includes illegal drug deals, prostitution, and even sales of stolen goods. Specifically, it includes illegal transactions as long as both parties agree to the transaction.
 
European-cannabis-lawsOstensibly, Eurostat is trying to capture part of the shadow economy that is typically not measured in GDP.  This makes sense, right? GDP is supposed to measure the output of final goods and services, so shouldn't we include all final goods and services even if the service is illegal?  In addition, this is complicated when the legality of goods and services varies across nations.  For example, the map to the right (from Wikimedia Commons) shows how cannabis laws vary across Europe - cannabis is essentially legal in some nations like the Netherlands but strictly illegal in others like France. 
 
So, normalizing the accounting standards across nations makes sense. But these illegal activities are difficult to measure.  In addition, if the illegal activities are a relatively stable portion of GDP, then there is really no bias when they are not included.  In fact, the new estimates, in an attempt to provide a more complete measure, may actually introduce more error into GDP measurement due to the difficulty of estimating illegal trade.  
 
So why the change in definition? There is another, perhaps insincere rationale: the new GDP measurements are a bit of an accounting trick to help nations lower their deficit to GDP ratios.  Many European nations are dealing with high deficit (and debt) to GDP ratios. The European Commission has explicit rules regarding these budget measures: a nation's deficit in a given fiscal year is not to exceed 3% of  their GDP, and the national debt is not to exceed 60% of GDP.  When nations exceed these bounds, the Council is directed to bring coercive measures called Excessive Deficit Procedures (EDRs). The Council has certainly been lax in enforcing these EDRs in recent years.  However, increasing GDP by simply redefining how it is measured automatically lowers deficit and debt ratios and helps nations with higher government debt levels. 
 
The figure below shows the effect of the new GDP definition on the GDP level each nation in 2013 (along with the overall EU and Euroarea).  The countries are ordered according to their GDP gains from the ESA 2010.
 
GDP percentage change ESA 10 mac
 
As you can see, GDP for Cyprus jumped 9.8% exclusively due to this accounting change.  This re-definition of GDP then shrank the debt-to-GDP ratio in Cyprus by a full half of a percentage point in 2013 - reducing it from 5.4% to 4.9%.  Therefore, this accounting rule change exaggerates any debt reduction in Cyprus, as they (hopefully) move closer to the EU goal of 3 percent.
 
So while new GDP accounting rules in Europe may normalize national income accounting across the continent, they are particularly helpful to those nations that already have high government debt levels.