updated 9/9/2008 3:45:03 PM ET 2008-09-09T19:45:03

It was a rare bit of stellar economic news. The Commerce Department revised Gross Domestic Product upward last month, saying the broad measure of the economy grew at an annual rate of 3.3 percent for the second quarter, up from an initial estimate of 1.9 percent.

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One problem: A vocal group of analysts and economists isn't buying it.

"Quite frankly, we do not think the report passes the economic commonsense sniff test," wrote economists John Ryding and Conrad DeQuadros at RDQ Economics.

GDP measures the market value of everything produced by labor, plants and properties in the U.S. — a total of $14.3 trillion for the second quarter. The government agency charged with calculating the first estimate of each quarter's GDP has less time to do so than a ten-branch bank has to file an earnings report.

GDP is a crucial variable in setting monetary policy, such as short-term interest rates, but critics say the effort to gather and calculate the data is underfunded, hobbled by government agency infighting and overly reliant on assumptions.

Criticisms of second-quarter GDP were more granular. Disbelievers say it was skewed by some of the conventions that make it consistent from one quarter to the next and strip out foreign inflation.

Calculating GDP is unwieldy
The first problem with calculating GDP is how unwieldy it is.

GDP is supposed to be a summary of the domestic economy. So a $30 copay to a West Virginia internist, a $3,000 rental payment for a Cleveland office and a $30 million shipment of U.S.-built backhoes from the Port of Los Angeles are all supposed to be baked in.

So are haircuts, tuition payments, employer's payments for benefits, each shopping spree by a British tourist in New York City and every penny spent domestically by the government — whether an Indiana dog catcher fills up a town truck with diesel or the Navy orders a U.S.-made aircraft carrier.

The next problem with government data is where it comes from.

Consider incomes. Because of privacy concerns and interagency tussles, it is illegal for the Internal Revenue Service to share personal income data with the Bureau of Economic Analysis, which calculates GDP, until that data is three years old. That's one reason the BEA estimates personal income.

Data that are estimated on the first read of GDP include important components — trade and inventories, said Diane Swonk chief economist at Mesirow Financial. Big swings, such as last month's revision, come as more reliable data arrives.

Still, some of those "more reliable" numbers remain questionable.

"I've never been convinced they're very good at measuring inventories," said David Wyss, chief economist at Standard & Poor's. "My father was treasurer of a small company and I asked him how he filled out the inventory forms. He said, 'I don't know. I just toss them over to my secretary.' Gives you great faith in the data."

Now add funding issues to the brew.

Half the government's spending on economic data is dedicated to agriculture, a quarter to manufacturing, and only a quarter to the service sector, even though services make up 80 percent of the U.S. economy, Wyss said.

The government simply needs to spend more, Swonk said.

Skeptics have extra criticisms for the most recent quarterly read, saying long-held methods of calculating the figure made the second quarter look much better than it was.

To make GDP reflect ongoing business, one-time write-downs are excluded. That makes good sense, except when an industry that comprises a huge sector of the economy is wracked by losses from billion-dollar write-downs, as the financial sector has been.

In the second quarter, Wachovia Corp. lost $9.11 billion, Citigroup Inc. lost $2.5 billion and the nation's thrift banks, which loan most of their money to consumers, lost $5.4 billion. After stripping out those and other write-downs, however, the GDP calculation for the second quarter computed financial companies' profits grew 24.7 percent.

As David Rosenberg, Merrill Lynch's North American economist, put it, "Are you kidding me?"

Then, there's the inflation picture.

To calculate growth, the government tries to strip out the illusion of growth that comes with higher prices. Nominal GDP, which includes inflation, can look great; but strip out that inflation and the picture can change markedly.

"If there's a lot of inflation, nominal GDP will go up," said Peter Schiff, president of Euro Pacific Capital. "The nominal GDP of Zimbabwe is going through the roof, but the economy isn't growing, inflation is just going up."

Matching ‘anecdotal evidence with the numbers’
To strip inflation out of the data, the government devises a "deflator" that subtracts inflation from nominal GDP.

In the second quarter, that deflator was 1.3, a figure that was half what it was in the first quarter and tied with a 10-year low. Starting with nominal GDP of 4.6 and subtracting that 1.3 deflator, we get real GDP of 3.3.

If the government had used the same deflator as it did for the first quarter, 2.6, GDP would have only been 2.0.

Schiff and others say the deflator made inflation look much weaker than it was and the economy look much stronger.

"The irony is a low inflation number gives us the growth," Ryding said.

They have a point. Consumer inflation for July was the fastest it had been in a generation, moving up at a rate of 5 percent for the previous 12 months.

Had the deflator been that large, we would have seen negative growth for the second quarter.

"Whenever people are talking about the economy, they're trying to square the anecdotal evidence with the numbers," Schiff said. "It's not that the people are wrong, it's the numbers. It's not that there's a disconnect between the people and the numbers, there's a disconnect between the numbers and reality."

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