Asset management

5 August 2013

Economist Insights R&D: Revision & Definition

The US economy is 3.4% larger than previously thought, due to revisions to how GDP is calculated. Previously excluded intangible assets, such as spending on research and development, are now counted as part of GDP. The US is one of the first countries to implement these changes and other countries may follow suit in the next few years. But what changes if GDP is suddenly higher? Nobody is richer, and while ratios such as debt to GDP willneed to be re-estimated, financial outcomes in the realworld do not change. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

No doubt there will be some conspiracy-minded commentators out there who will claim that the announcement last week that the US economy was actually 3.4% larger than previously thought was the government fiddling the books. In fact, it would be better described as the government correcting the books. Previously excluded intangible assets, such as spending on research and development (R&D), are now being counted as part of GDP. Ask any business owner and they will tell you that R&D is an investment: spend money today on R&D and if successful you will be able to produce more products more efficiently in the future. How is that different from investing in a machine (which has always counted towards GDP)? The conspiracy theorists will point to the convenient outcome that the revisions make the recession shallower and the recovery stronger (chart 1). Look into the detail, however, and it turns out that the greater strength of the recovery has almost nothing to do with the reclassification of R&D. The change is the result of the usual annual revisions that are made as more data comes in from more detailed annual and quarterly surveys. Sometimes those revise up (such as in 2013and 2012), and sometimes they revise down (such as in 2010 and 2011). For such a widely used and recognised statistic, the amount of knowledge about what GDP is and how it is calculated is minimal outside of the rather geeky world of economists. Even in the financial world there are many misconceptions. So to explain the changes, lets start with the basics: the commonly used expenditure approach to GDP attempts to

measure final expenditure in the economy. The expenditure must be final because otherwise there would be double counting. Suppose if instead of final expenditure, we counted up all transactions. Company A buys glass from company B to put into a mirror and then company A sells that mirror to a consumer. If we counted transactions that glass would be double counted. To complicate things further, the transaction counting approach would also suggest that our economy became smaller if company A switched to making its own glass, simply because that first transaction would no longer be registered because it occurred within the company.

Chart 1: Rising after dipping US GDP relative to pre-crisis peak set to 100, by vintage 106 104 102 100 98 96 94 2008 Revised 2009 Prior 2010 2011 2012 2013

Source: Bureau of Economic Analysis

When companies invest in machinery or structures, that expenditure counts as final expenditure because those companies do not sell the machinery or structures on to someone else (and if you produce machinery, it becomes someone elses final expenditure when you sell it). When a company engages in R&D, it does not sell that R&D as a product in itself: it uses it to produce more or better products, or to do so more efficiently. Yet before last weeks revision, the US treated R&D as an intermediate expense. There is no conspiracy: the Bureau of Economic Analysis (BEA) has simply managed to gain enough statistical data to make a change that they always knew was necessary. You may well ask why they havent done it already, but the US is actually one of the first countries to implement these changes. Gathering the data on intangibles is not easy. Othercountries want to follow suit, so expect upward revisions to GDP in other countries over the next few years. As a first guess as to how big those revisions will be, we can look at the relative size of R&D spending in each country compared to the US. According to the OECD, R&D spending in the US was around 2.8% of GDP, and the BEA translated this into around 2.5% more GDP. Applying a similar ratio to other countries gives us a rough approximation of how much could be added to their GDP (chart 2). The clear winners from the methodological change will be Finland, Sweden and South Korea, and also Japan. The increase in GDP will be far less substantial for Italy and Spain.
Chart 2: Researching development Approximate impact on size of measured economy

In addition to traditional R&D, the statisticians in the US have also added in the value of artistic and entertainment originals. This is really about accounting for Hollywood properly: when you make a movie, it is an investment that canbe used to generate cinema ticket sales, DVD sales, posters, CDs, downloads and so forth. To estimate the impact of such a change on other economies we have used the relative proportion of employment in arts and entertainment sectors to scale the US change to other countries. Only the UK has a similar sized impact, but for all countries the effect is a lot smaller than R&D. So what changes if all of a sudden GDP is higher? For a start, nobody is richer; just as fixing a faulty thermometer does not make the day any warmer, fixing GDP does not change anything in the real world. Some of the metrics will change: for example, the debt to GDP numbers that markets are so focused on would be revised down. But once again, nothing has really changed. The relationship between those numbers and the economic and financial outcomes (such as yields on government bonds) will have to be re-estimated. So the infamous (and debatable) 90% threshold for debt to GDP thatis supposed to result in slower growth would actually haveto be more like 88%. The Eurozones 60% debtthresholdfor the Maastricht criteria would have to be re-estimated down to 58% (as if that really matters when theaverage for the Eurozone is 90%). Failures of GDP usually have more to do with how people use the data and a failure to recognise its inevitable shortcomings. Statisticians will be struggling with further structural changes in the future as well. Just suppose that a decade from now most people in rich countries have their own 3D printers that they use to make products for themselves and their friends. When every consumer has also become their own personal producer, how will we measure production?

Finland Sweden South Korea USA Japan Germany France Netherlands UK EU average Ireland Spain Italy 0.0 R&D

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Arts & entertainment originals

Source: Bureau of Economic Analysis, OECD, The Work Foundation, UBS Global Asset Management. Note: Data on employment in arts and entertainment was unavailable for Japan and South Korea, so the contribution to GDP could not be estimated.

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