GDP Growth: Seriously Flawed but Not Going Anywhere

Mariano Torras Complexity, Ecological Economics, Environment/Sustainability, General, Macroeconomics, Methodology/Statistics, Politics, Public policy/Wellbeing, Reflections Leave a Comment

December 31, 2020

“Where do people earn the Per Capita Income? More than one starving soul would like to know.” (Eduardo Galeano)

U.S. GDP plunged in the second quarter of 2020 at an annualized rate of 31.7 percent. From the standpoint of history, the report was shocking (although perhaps not surprising, given the abrupt policy response to the pandemic). Equally shocking (and unsurprising) was the news for the third quarter, which reported an unprecedented growth rate of 33.1 percent. Yet for most people alive in 2020, there was no such change of fortune. If anything, quality of life plunged back in the Spring and remains low to this day. What, then, are we to make of the GDP numbers?

Formally, GDP – the most touted indicator from what economists call the national income accounts – reflects the nation’s output, spending, and income. While seldom explicitly declared to be an indicator of wellbeing or progress, ideologically it has served our national purposes to set GDP growth as the preeminent policy goal. Today, political leaders and policymakers arguably ascribe greater importance than ever to the GDP accounts. But the Covid-19 crisis, if nothing else, lays bare how misguided all our attention has been. 

As a measure of wellbeing a country’s GDP is abounding in weaknesses. Were it not for its ideological utility, nations the world over would have discarded it long ago. Before seeking to explain why it persists, allow me to review GDP’s many shortcomings. They fall into three broad categories: mismeasurement, myopia, and market fetish. 

Mismeasurement

I will begin with the obvious question: How is it possible to track all economic activity for an entire economy – never mind one as large as ours? The answer is that it is not possible. Since the 1940s, economists have been exploiting the power of statistics to extrapolate national numbers from relatively small datasets. Nobel laureate Paul Samuelson, among others, has defended GDP and national income accounting as a truly great innovation. I concede that statistics do often allow us to obtain useful population information from very limited sample data. But while GDP is rendered as a precise figure – $21.2 trillion for the United States in the 3rd quarter of 2020, for example – its accuracy is highly questionable. It is indeed reasonable to conclude that the quarterly numbers are usually off by (plus or minus) five percent or more. 

Add to this the well-known fact that we do not even measure all income or economic output. What economists euphemistically refer to as the “informal” economy includes everything from black market and otherwise illegal activity to legitimate but unreported activity. On numerous occasions I have, for example, paid my mechanic in cash to save on the taxes he would then not be paying since he is not reporting the income. To be sure, the informal economy accounts for a much smaller share of our economy than economies of developing countries like, for example, India or Kenya. Still, it is possible that 10 or 15 percent of our economic activity is absent from the U.S. GDP figures.

The above facts alone make a mockery of GDP, and especially attention to its growth. We tend to get excited about an annual GDP growth rate of, say, four percent and depressed over a rate of one percent. But Oskar Morgenstern, in his under-appreciated book On the Accuracy of Economic Observations, points out that because GDP estimates are customarily off by five or ten percent, it is ludicrous to make anything of a difference of tenths of a percentage point in the quarterly numbers. Yet analysts, pundits, and politicians do so routinely.

Even without the aforesaid inaccuracies, GDP misleads. It is also, for example, blind to the income distribution. With sufficient inequality, for instance, strong growth numbers can conceal middle class stagnation. If, say, the average income growth of the richest five percent of the population were 10 percent while the rest of the population gained zero percent on average (i.e., many actually got poorer) GDP growth would amount to 1.0 percent, which is indeed very weak. But I do not know of many countries in which the richest five percent earns only 10 percent of national income. Indeed, in most countries they obtain much more. So, if instead we assumed that the richest group got 25 instead of 10 percent of all income, GDP growth becomes 2.5 percent, a rate generally considered respectable. The upshot is that a strong GDP growth rate does not imply that the entire population is benefitting. 

Myopia

I said that in addition to being mismeasured, GDP is myopic. It fails, in other words, to account for the medium and long term. (Somewhat analogous to corporate share prices, but this is for another discussion). The same way that you would not call “income” the proceeds from deliberately depleting your savings account, economists should not count depletion of national productive assets as part of GDP. While our system of national accounting correctly subtracts the value of fixed capital depreciation from “gross” income, it does not make similar adjustments for natural assets like lumber, minerals, oil, or soil. So, a national economic strategy predicated on deforestation or exploiting of fossil fuel deposits is myopic and unsustainable in the same way that living off your savings account is. 

Economist Robert Repetto was among the first to point out that we should deduct depletion of natural asset stocks from GDP. Otherwise, GDP could deceptively show growth even as a country consumes its national wealth. His observation more or less coincided with the birth, c. 1989, of ecological economics, a non-mainstream subfield of economics that challenges the idea that GDP even could grow perpetually. Briefly, the premise of ecological economics is that material and energy limits place an upper bound on the size of our global economy, and that sustainable growth is a patent oxymoron. Some claim that we can circumvent our resource constraints by progressively “dematerializing” GDP – i.e., having a declining share of GDP over time actually require material and energy flows.

Market Fetish

Whether or not it is possible to do so in the long run is not my concern here. More interesting is the matter of what a “dematerialized” GDP would look like. Or more generally, how exactly is GDP related to society’s wellbeing or quality of life? Leaving aside measurement accuracy and long run sustainability, is GDP growth even desirable?

Make no mistake: Progress achieving GDP growth most certainly is desirable for poor countries. Many are far less diversified than rich countries, disproportionately producing primary products. Strong GDP growth can therefore reasonably be taken as a sign that the country is better providing its people with life’s essentials like food and clothing – hence making progress. But as the architect of GDP accounting Simon Kuznets himself presciently warned, GDP growth is not the same thing as progress.

Worshippers of GDP growth tend to fetishize market values. Mainstream economic thinking is that subjective comparisons of the relative importance of different markets is taboo. So, a dollar spent that you spend at the tanning salon is the social equivalent of a dollar that I spend on food or shelter. As economies grow richer a greater share of the average budget is spent on superfluities or, worse, merely keeping up with the Jones’s. The problem is that incremental material gains contributing virtually nothing to wellbeing “count” every bit as much as gains in basic necessities.

The ideological benefits of a GDP growth policy orientation were never clearer than during the Cold War. W.W. Rostow in 1960 famously developed his “Stages of Economic Growth” theory, subtitled “A Non-Communist Manifesto.” I won’t go into details here, but Rostow effectively claimed that economic progress or development required sustained GDP growth, and that a “high mass consumption” economy was the apotheosis of progress. Because nothing less than the outcome of the war between capitalism and communism was at stake, policymakers happily took to Rostow’s analytical framework.

But really, how relevant is GDP growth beyond the point where most of the population obtains all the material necessities? Not very. Rostow might have considered high mass consumption the pinnacle, but the incremental benefit derived from GDP growth (economists call it “marginal” benefit) diminishes as a country grows richer. It is analogous to what economists mean when they discuss the “diminishing marginal utility” of increasing income. Unfortunately, the opposite is the case for the incremental cost. The more prolonged a country’s economic growth, the greater the associated social and environmental costs.

So, there is at best a weak link between GDP growth and wellbeing improvement. But it gets even weirder. A host of social benefits that happen not to be traded in the market do not, for this very reason, count in GDP. If more of society’s hours are devoted to childrearing, home cooking, or volunteer work – and fewer to, say, assembly line work – GDP would drop. Is there anything inherently more important in factory production than in housework? Or is it just that only the first is remunerated in the market? 

GDP arguably omits many billions of dollars’ worth of benefits or services to society simply because they carry no price. Conversely, many priced products or services should not be included in GDP but are. Defensive expenditures are possibly the most well-known example. When environmental pollution induces corrective measures, cleanup efforts, and the like, good money is spent merely on returning the country to its earlier non-polluted state. Or to take another case, if a state spent billions on corrective facilities in response to a skyrocketing crime rate, it would be to lower the crime rate back to its earlier level. In other words, in neither case is the country making “progress” in the traditional sense. The money being spent on correcting such problems is merely money spent. It is incorrect and dangerously misleading to imply that such spending should contribute to any indicator of wellbeing or progress. 

Alternatives to GDP

Growth in a nation’s GDP, then, is a measure of how rapidly national output, spending, and income is growing – nothing more, nothing less. Its link to progress is increasingly tenuous. Consequently, there have been numerous efforts at alternative indicators or measures that purportedly reflect wellbeing or progress more accurately. Possibly the best known is the UN’s human development index (HDI), first introduced in 1990. It is a national measure that reduces national income, population health, and education to a single number meant to reflect the extent to which a country has “developed.” It is simple and easy to understand and offers a broader perspective on wellbeing than GDP. Yet its major drawbacks are at least three. First, it is somewhat artificial in that it is an index and therefore does not measure unit quantities of anything in particular. Second, it is questionable how much new information it adds since, with a few exceptions, countries with high GDPs tend to have healthier and more educated populations – hence higher HDIs. And finally, even though its scope exceeds that of GDP, it nevertheless omits most relevant dimensions of human wellbeing.

Other potential GDP substitutes include the genuine progress indicator (GPI) and the index of sustainable economic welfare (ISEW), both actually quite similar measures of social progress. Unlike the HDI but like the GDP, they are both denominated in currency units. Without going into too many details, each is based on the consumer portion of GDP, with adjustments for inequality, resource and environmental depletion, and defensive expenditures. In contrast to GDP, they both count spending on consumer durables as an item to subtract, but they add back the estimated value of the benefit or “service” flows. Here we would, for example, include the value of the utility we obtain from a refrigerator. Both indicators also add in an approximation of “non-market” benefits such as childrearing or cooking.

While neither progress indicator has gotten as much press as the HDI, one potentially momentous finding is how consistently across different countries per capita GDP over time compares to per capita wellbeing. Every study that I have seen shows either GPI or ISEW diverging from GDP at some point in the 1970s and flattening thereafter – while GDP continues to rise. Kubiszewski et al. (2013) notice a similar pattern when global aggregates are compared (see Chart). What it appears to signify is that, beyond some theoretical income level, continued increments to GDP matter less and less to wellbeing.

Source: Kubiszewski et al. (2013). Beyond GDP: Measuring and achieving global genuine progress. Ecological Economics 93: 57-68.

None of this, unfortunately, sounds the death knell for GDP. While its weaknesses are very real, proposed alternatives also are not without flaws. Possibly the main reason that the HDI is the most “press worthy” of the GDP alternatives is that it is based on relatively reasonable and transparent variables. Despite the GPI’s and ISEW’s conceptual soundness, the devil is always in the details. Neither indicator would withstand much scrutiny of its assumptions and estimation methods. 

Complexity, Subjectivity, and the Inexorability of GDP

In short, the GPI, ISEW, and other lesser-known measures – even the HDI – are irredeemably subjective. But so what? It would be a grave error to assume that GDP were not also biased. While the former privilege “non-market” dimensions of life, the latter focuses on market transactions at the expense of all else. The bigger story, about which I’ll have more to say in future posts, is that any time we aim to represent something as complex as human wellbeing or progress quantitatively, bias is unavoidable. Who decides what variables matter and which we should leave out? (the identification problem). Moreover, even if we could somehow decide objectively, who then decides the relative value or weight that we place on each variable? (the aggregation problem). Even the assumption, for example, that leisure time, population health, and after-tax income all are equally important is itself subjective. Let’s not kid ourselves.

It is why our leaders need to exhibit greater courage and confront complex multidimensional challenges like climate change or pandemics on their own – often qualitative – terms instead of supporting the reductionism that produces single indicators or banal “rankings lists.” We should also be transparent about lack of exact information, since feasible estimates or ranges can inform policy much better than made up numbers, no matter how precise. As E.F. Schumacher once said, judgment is a higher function than being able to count or calculate, despite the beguiling concreteness of quantitative figures. In a world that presents us with increasingly complex challenges, society would be wise to favor judges and philosophers over quants and technicians.

Yet the lamentable paradox is that the more complex the world becomes, and the more visible are GDP’s limitations, the more society embraces quantitative precision – seemingly as a reaction to our insecurity about the complexity. Supporters of consumer capitalism are therefore doubling down on GDP growth as the quality of life of the majority declines. And in a uniquely vicious cycle, quantitative indicators like GDP not so subtly help reinforce the economic system itself. Yet long run GDP growth is a likely death sentence for many. Nothing short of revolutionary change in humanity’s way of thinking will supplant it. Which brings us back to the present pandemic. The time is ripe.

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