It incorporates the following variables:
- The inflation rate, whichmeasures the economy’s monetary stance.
- The unemployment rate, whichmeasures the economy’s production stance.
- The budget deficit as a percentage of total GDP, whichmeasures the economy’s fiscal stance.
- The change in real GDP, whichmeasures the aggregate performance of the entire economy.
There is a straightforward calculation that allows us to quickly construct the Economy Index, resulting in an easy to understand number that automatically “scores” the performance of the economy. How does it work?
The Math Behind the Index
We constructed the Economy Index such that it:
- falls when there is inflation or deflation
- falls when the unemployment rate rises
- falls when the government deficit rises
- rises with positive growth in GDP
We begin with a total score of 100% (i.e. the economy at “perfect performance”) and then subtract the inflation rate, then the unemployment rate, then the budget deficit as a percentage of GDP and, finally, add back the percentage change in a real GDP, all weighted and calculated as deviations from their desired values. A letter grade is then assigned to these scores to further communicate economic performance in a methodology easily understood by everyone.
In other words, the EPI is just the following: 100% minus the absolute value of the inflation rate, minus the unemployment rate, minus the budget deficit as a percentage of GDP, plus the percentage change in a real gross domestic product:
100%
− |inflation (%)|
− unemployment (%)
− budget deficit/GDP (%)
+ GDP growth (%)
= the Economic Performance Index
It is really as easy as that!
Note that we consider any deviation from a stable price level – i.e. positive or negative rates of inflation – as leading to welfare losses, so the absolute value of inflation is taken in the formula above.
Changes in the economy affect the EPI in a very straightforward manner. For example, if the inflation rate increases from 2% to 3%, the Index score falls by one percentage point; if an equal change occurs in the opposite direction, the score rises by same amount. Similarly, a one-percentage-point increase in the unemployment rate would lead to a one-percentage-point decrease in the score. On the other hand, a fall in the unemployment rate (i.e. an improvement) improves the score respectively. The same inverse relationship holds for the budget deficit: if the deficit increases, the score falls; if the budget deficit shrinks, the score rises. Finally, if the percentage growth rate of GDP rises, so too does the score; when the percentage growth rate drops, the Index falls proportionately.
Imagine a perfect world, in which inflation is zero, the unemployment rate is 4.75%, the government budget is balanced (zero deficit), and GDP growth is 4.75%. In this case, the Index score would be:
100%
− 0% inflation
− 4.75% unemployment
− 0% budget deficit
+ 4.75% GDP growth
= 100%
This is just one example of a “perfect” score. It is clear that 100% can be achieved in many different ways. For example, an economy with 1% inflation, 5% unemployment, 2% budget surplus, and 4% growth rate, would also score 100%. Note that the score can be more than 100% if the economy is experiencing high economic growth. For example, if the GDP growth in the previous example were 5% instead of 4%, the economy would score 101%. While a “perfect” score of 100% may not seem realistic, our research shows that the U.S. economy achieved this score and even higher in one year out of every ten, on average, throughout U.S. history since 1790.
The provided EPI formula may seem to be too simple. Many economists would say that the volatility of its components is different and averages are different, too. They would also say that, when our Index is applied to different countries, the weights of components should not be the same. We had similar reservations about this simple formula when we started analyzing it.
To overcome problems of consistency during periods of high economic volatility and to make scores comparable across countries, we initially created the weighted Index that normalizes the data by introducing weights and desired values to each sub-component. Weights are determined by calculating the inverse standard deviation of each economic variable multiplied by the average standard deviation of all variables such that the sum of weights is equal to one. The results of our research show that there is very little difference between the raw score and weighted score for many developed economies. For the U.S., the simple and weighted Index formulas give almost identical dynamics of the index throughout the U.S. history. At the same time, the weighted formula has better applications in developing and emerging market economies.
As such, we will use the raw formula throughout our book as the best means for gauging the true performance of an economy, with the caveat that it works best in developed countries.
The Economic Performance Index for 2015 and 2016
So let’s see what the Index looks like when we actually do the math. The official government statistics for the U.S. in 2015 and IMF projections for 2016 are as follows:
| Year | Inflation | Unemployment | Deficit | GDP |
| 2015 | 0.1 | 5.3 | 3.8 | 2.6 |
| 2016 (forecast) | 1.1 | 4.9 | 3.6 | 2.8 |
To determine the Index score for 2015, we would begin with 100%, then subtract the inflation rate of 0.1%, subtract the unemployment rate of 5.3%, subtract the budget deficit of 3.8%, and then add the GDP growth of 2.6%:
100%
− 0.1% inflation
− 5.3% unemployment
− 3.8% budget deficit
+ 2.6% GDP
= 93.3%
The value of 93.3% has an important meaning. It indicates that economy was about more than six percentage points away from perfect condition. According to the EPI, in 2015 the principal factors that depressed a better economic performance were the unemployment rate and the budget deficit.
If we do the same for 2016:
100%
− 1.1% inflation
− 4.9% unemployment
− 3.6% budget deficit
+ 2.8% GDP
= 93.2%
From 2015 to 2016, inflation is likely to increase, the unemployment rate will get marginally better, the budget deficit will slightly diminish, and GDP will improve. The EPI is projected to remain almost the same. Instinctively, most people would agree with this.
Measuring Economic Performance
In order to make the EPI indicator easier for the general public to understand, we have adopted a simple grading system implementing thresholds close to actual distribution of EPI scores:
| Performance | EPI values |
| A+ (Superior) | Above 100 |
| A (Excellent) | 95-100 |
| B (Good) | 90-95 |
| C (Fair) | 80-90 |
| D (Poor) | 60-80 |
| F (Very Poor) | below 60 |
