When is the value of something not its true value? When you’re adding up Gross Domestic Product (GDP) of course. That may sound ridiculous, given that the rise and occasional fall of GDP is the yardstick by which we measure how we’re doin’ as an economy. Isn’t it just the sum total of all the goods and services that we produce?

The short answer is “no”, but the long answer is “yes”. It depends a lot on what you mean by “goods” or “service” or “produce”. If that sounds like a huge amount of fudge for something so important, you may want to just enjoy the chocolate induced coma for a bit. Because some goods, like computers and software, have been falling in price but increasing in potential and quality dramatically for a while. Hardware is “hedonically adjusted” to take care of this, but software isn’t. And that difference might be extremely important.

Jan Hatzius, Chief Economist at Goldman Sachs.

The problem was noted recently by Jan Hatzius, chief economist at Goldman Sachs. You don’t get more high-powered in the world of economics than him. He earned his pay by shouting loudly in 2007 that something horrible was imminent, probably saving his company by having at least a few people listen to him. When the dust settled around 2011 or so, he was promoted to the post he holds now.

The guy Goldman pays this well is a guy we should all at least listen to.

He noted recently that where computer hardware has gotten cheaper since 1995, software largely hasn’t. That may seem unimportant, but when you look at how they calculate GDP it makes all the difference. Computer hardware’s contribution to GDP is “hedonically adjusted”, or made to look more expensive because its intrinsic value hasn’t changed, only it’s price in the market.

In other words, if you can buy the same computer today for half the price of two years ago, the contribution to GDP should be the same.

If that doesn’t make any sense, there’s more. I’ll let Hatzius’ research from Goldman explain it, since he does a fine job:

…The measured price of computer hardware has plunged by 91.5% since 1995, with most of the decline occurring in the first half of that period.7 Since real output is equal to nominal output divided by the price level, this meant a sharp increase in the measured contribution of computer hardware to real GDP growth.

Exhibit 4 from Goldman’s research, showing how computer hardware has a price “deflator” since 1995 but software does not.

But Exhibit 4 also illustrates that the statisticians have not found a way to capture the improvements in software and digital content in a similar manner, with measured software prices only edging down slightly over the past two decades. This is not surprising because the “performance” of software and digital content is inherently a more amorphous and subjective concept. How much better are the inventory management systems that retail companies contract out or develop for their own account compared with those of twenty years ago? How much better is Grand Theft Auto V than Grand Theft Auto IV? And how much more value do we now derive from our internet connection compared with a decade ago? It is very difficult for a statistician to know, and when we do not know our default assumption tends to be that there is little change.

Yes, you have it. Because Grand Theft Auto V is way cooler than IV the GDP should be revised upward.

Economics has too much hand-waving to be an exact science. But it tries.

If that sounds utterly ridiculous to you, you’re not thinking like an economist. If you’re clearly getting a lot more inherent value for your money the price has effectively fallen. If you look at the adjustment shown for hardware, now multiplied by 12 to get its equivalent 1995 price, the adjustment being used is for much more than lower price – it also reflects the power and usefulness to at least some degree. The computing power we can purchase with $100 is probably way way more than $1,200 in 1995 dollars, but there is at least some adjustment to account for part of the improvement.

We don’t adjust software at all, however. And that makes a big difference.

Hatzius estimates that if we took software’s increasing value into account we’d add about 0.2% to GDP every year – and have been since 1995. That’s a solid $30B per year at today’s rate and it means that the economy is growing much more rapidly than we think.

If you believe in “hedonic adjustment”, that is.

Karl Marx

This may sound like a very silly argument, but there is a practical upside for those of us who worry about an increasing consumer market gradually devouring the planet like a plague of locusts. When the world buys a consumer goods made in faraway places, valuable resources are stripped and people are more or less enslaved to crank out cheap, disposable stuff.

Not so with software. It’s pure labor and doesn’t consume much in the way of resources outside of Mountain Dew and Skittles. An economy that increasingly relies on software is a cleaner, leaner economy that doesn’t have to strip the planet to survive. If that software is always increasing in value, regardless of the price of it, we all slowly rise in our standard of living. It’s enough to make Karl Marx proud.

Scratch that, it’s enough to make the chief economist at Goldman proud. Totally different.

Is software inherently worth more today than it was in 1995? And should our GDP account for that difference, at least to the degree that it does for hardware? Your answer might mean a lot more than you think – and a lot more in the future as we move to a more software based economy.