The Parliamentary Budget Office has released a report (pdf - h/t to Kady O'Malley) that makes note of the distinction between Gross Domestic Product (GDP) and Gross Domestic Income (GDI), and shows that by the latter measure, the fourth quarter of 2008 was even more dreadful than the GDP numbers that made all the headlines.
As a public service, I'm going to explain what the difference is between GDP and GDI and how it relates to the current recession. It starts below the fold, and yes, there will be beer and pizza.
We know that Canada - along with other commodity-exporting countries - has benefited from the rise in commodity prices since 2002. But it's hard to talk about the effect of changes in the relative prices between two goods in the context of a standard single-good macroeconomic framework. So you need a two-good model. And whenever economists are forced to consider a world with two goods, their thoughts turn to beer and pizza. At least mine do.
Suppose that Canada produces 100 beers, but we have to have a pizza with each beer. We don't produce pizza, but other countries do, and we can trade beer for pizza with them at the rate of one beer for one pizza. So we can export 50 beers, import 50 pizzas, and we happily consume our 50 beer-and-pizza combos.
There are two ways that we can see our lot improved. One way would be if we simply produced more beer. If we were somehow able to improve our productivity by 50%, then we could produce 50 extra beers, trade 25 of them for pizzas, and we'd now have 75 beer-and-pizza combos.
Since Canada produces only beer, the increase in GDP is the same thing as the increase in beer production. But what we really care about isn't beer production, it's the consumption of beer-and-pizza combos - and this is what GDI measures. So long as the rate at which beer and pizza are traded on the international markets stays at 1:1, it doesn't matter which measure you use. GDP has gone from 100 to 150 (50% increase), and GDI has gone from 50 to 75 (also a 50% increase).
But there's another way that our situation can be improved. Suppose that beer production is 100, but for some reason - less beer on international markets, more pizza or some combination of the two - the relative demand for beer increases, and beer producers are now able to obtain three pizzas for one beer. This 200% increase in Canada's terms of trade - the ratio of the price of the good it exports to the price of the good it imports - means that Canada can trade 25 beers for 75 pizzas. Even though beer production hasn't changed, we can now consume 75 beer-and-pizza combos.
It is here that the distinction between GDP and GDI becomes important. Since beer production hasn't changed, Statistics Canada would record no increase in GDP. But since we're now able to consume 75 beer-and-pizza combos, measured GDI would increase by 50%.
This story is useful in interpreting what's been going on in Canada since 2002. Although commodities are not the only thing - or even the main thing - that Canada exports, its prices are so volatile that they have been the main driver of movements in the terms of trade:
The commodity price series is from the Bank of Canada; note the differences in the scale of the vertical axes. The run-up that started in 2002Q1 went fairly smoothly until 2007, at which point it accelerated, culminating with the crash in 2008Q4.
So how did Canada respond to the increase in the terms of trade? Pretty much as you'd expect from the beer and pizza model - we imported more:
Look at what happened in 2008Q4. Real exports fell, but real imports fell even more: the effect of net exports on real GDP growth was a positive contribution of one percentage point. If all you were looking at was the effect of the global meltdown of world trade on Canada's net exports, you'd have a very hard time explaining just how Canada went into recession last quarter.
Statscan publishes data that decomposes the contributions of GDI growth by component. In the beer and pizza model, there are only two components (GDP and the terms of trade), but since StatsCan is obliged to work in the real world, it takes other factors into account as well. But it turns out that those other things have only a marginal effect:
The decline in real GDI in 2008Q4 is pretty dramatic - and most of it comes from the decline in the terms of trade. Over the past weeks and months, there have been any number of articles about how and why Canada fell into recession. But the real story has little to do with declines in housing prices or consumer debt loads. It's all about the terms of trade.
But here's the thing: that decline looks very much like a one-time episode. The Bank's weekly commodity price index has been holding more or less steady so far this quarter. The terms of trade may not be contributing to GDI growth for awhile, but at least it's stopped contributing to its decline.