Economics

GDP: A True Measure of Well-Being?

"What we measure affects what we do." - Joseph Stiglitz
GDP: A True Measure of Well-Being?

KEYNES' COLUMN -  Named in honour of British economist John Maynard Keynes, Keynes' column is an article dedicated to the macroeconomic theory and policy that have shaped the landscape of modern economics.

Any self-respecting economist will be quick to point out the many flaws of using Gross Domestic Product as a proxy for societal welfare. Yet, the extensive use of and reliance on GDP in economic and financial discourse, academic textbooks, and news articles might suggest otherwise; we are constantly bombarded with the notion that GDP is an all-encompassing figure which neatly and conveniently reflects the state of the economy and society. However, this is a common and extremely hazardous misconception which has led governments and policy-makers astray from many of the other contributors to societal welfare.

Having said this, over the last several decades, researchers from around the world have worked hard to dispel the specious virtues of the metric. For instance, in 2007, French President Nicolas Sarkozy established the International Commission on the Measurement of Economic Performance and Social Progression to which world-renowned economist Joseph Stiglitz was appointed as chair. In their final report, Stiglitz opened with the following: “What we measure affects what we do, and if we measure the wrong thing, we will do the wrong thing,”[1]. This view has been held by many policy makers and economists for decades, yet the report encapsulated the sense of urgency for countries, particularly in the wake of the 2008 financial crisis, to reduce their reliance on GDP as a proxy for societal welfare. The reasoning for this was very clear. The GDP metric was never designed to serve this purpose.

The Second World War led to developments on a variety of fronts: Technological, political, but unbeknownst to most, also economical. Specifically, the measure of Gross Domestic Product was created after the United States government tasked economist Simon Kuznets, an economist at the National Bureau for Economic Research, with developing a methodology for measuring the nation’s production output. Their objective of the project was to give the government the tools to determine whether they had the means and capacity necessary to defeat their enemies should war break out as global tensions remained high at that point in 1934. While the GDP metric proved invaluable to the United States during a time of war as they fussed over production maximization, it had farless utility in a time of peace. It gave no indication as to how the income generated from production was distributed, how efficiently resources were used in production, or the scale of pollution due to production. When the war had ended, Kuznets attempted to dissuade the government from relying so heavily on the metric for fear that it would be misinterpreted and misused. Despite his objections to policy makers to return their focus to incomes and wealth distribution and his incessant reminders that GDP was purely a measure of aggregate output and not societal welfare, the government continued to fixate on GDP.

Treating GDP as a proxy for societal welfare leads to numerous issues.  Firstly, GDP is short-sighted as it makes no consideration for environmental degradation and resource depletion. This has led to misguided policy as governments, in their efforts to rally immediate support among its people by stimulating short-term growth, often belittle the long-term impacts of certain economic activities like deforestation and oil drilling. Another crucial point is that the production of certain goods, which contribute positively to GDP, are in response to unfavourable social circumstances. For instance, the construction of prisons might suggest an increase in crime rates across a country, yet this will boost GDP due to the rise in production. One must also consider the plethora of intangible factors that affect societal welfare that GDP is incapable of capturing such as physical health, happiness, and the quality of education.

More issues arise when we begin to dissect the composition of GDP more granularly. One important consideration is that GDP per capita is merely an arithmetic mean of the income per citizen in an economy. As evidenced by the United States following the financial crisis of 2008, GDP per capita may poorly reflect the changes in income of the ordinary person. In mid-2009, President Obama announced that the United States had begun to recover from the shocks of the previous year, pointing to a steadily rising GDP figure. However, this statement seemed out of synch with the “facts on the ground” as lower and middle-class citizens struggled to obtain financial security.

"GDP [is] purely a measure of aggregate output and not societal welfare."

In a report titled “Beyond GDP” published by the OECD in 2009, Stiglitz discerned that this disagreement between statistics and first-hand accounts was due to GDP per capita’s sensitivity to statistical outliers.[3] Upon analyzing the data, it was observed that the increasing GDP per capita was largely a result of growing incomes of citizens who resided in the top 1% of society. Meanwhile, citizens of more modest means took little to no part in the post-crisis economic expansion.

Another critical distortion of GDP is that it accounts for the production of intangible goods by multinational corporations which add little material value to the economy. In 2015, Ireland reported an astounding increase of 26.3% to their real GDP from the previous year. However, a working paper published by the OECD discovered that this increase was largely because several multinational corporations had relocated certain economic activity, namely intellectual property, to Ireland for taxation purposes[4]. As a result, sales generated from the use of intellectual property contributed to Irish GDP despite the fact that the majority of the benefits generated by the production would flow out of the country in the form of salaries and bonuses to multinational corporation executives. After adjusting for the net salary flows and property income flows from the rest of the world then subtracting depreciation, Ireland’s growth amounted to a nominal 6.4% as opposed to the 32.4% nominal GDP figure. Naturally, the OECD concluded that GDP cannot be an indicator of a country’s material well-being.

The aforementioned criticisms raise the following question: How can we improve the measure of GDP, or what can we use in lieu of it? There are a variety of recommendations and alternatives in academic literature, however one framework in particular, upon which many other models are based, must be noted. Known as the Index of Sustainable Economic Welfare (ISEW), this alternative to GDP was first proposed by professor Herman Daly, an economist of the World Bank, and professor Cobb, a philosopher of Claremont Graduate School. In their 1989 book “For the Common Good”, the authors outline an adjusted measure for GDP which accounts for uncaptured factors[5]: non-domestic labour (i.e. production from informal markets), costs associated with crime, divorce, income inequality and health, the cost of environmental degradation, and the cost of resource depletion. While it is difficult to quantify such factors, researchers have made considerable progress in estimating, scaling and monetizing them. For instance, the United Nations has developed the Global Green Economy Index which evaluates countries based on a number of environment-related factors such as air quality, corporate sustainability, renewable energy investment and resource efficiency.

However, if you are not convinced of the ISEW or one of its many permutations, there are other simpler metrics which provide an arguably greater insight to a country’s societal welfare than GDP (or GDP per capita). For instance, median income is a statistically robust alternative as it is not skewed by statistical outliers and therefore is a better reflection of the economic state of the ordinary citizen. GNI is also a robust alternative to GDP as it adjusts production for net flows in and out of the country. As showcased by Ireland in 2015, GNI has the ability to capture and correct for immaterial changes to the wealth of an economy. Other measures could involve a greater reliance on factors such as the Human Development Index or happiness as Bhutan has done. The latter has incited some criticism as it is difficult to quantify, but this begs the question whether a misguided numerical quantity proves more valuable than a targeted, yet unquantifiable, framework. In Daly’s book “Beyond Growth: The Economics of Sustainable Development,” he states the following: “It is assumed that we must have some numerical index. But why? Might we not be better off without the GNP statistic? The world before 1940 got along well enough without calculating GNP.” While it is unrealistic to expect a complete and universal abandonment of GDP, Daly raises an interesting point. Have we put too much faith into the facts and figures which pull our attention away from the more important matters?

Since the inception of the GDP metric by Kuznets in 1937, mainstream economics has partially lost its way as we continue to blindly rely on this convenient yet overly simplistic metric. To our detriment, our nearly obsessive fixation on GDP has misled public perception and has misguided governmental policy. In light of the current state of the world, from rampant income inequality in many parts of the world to environmental degradation, it may be time to abandon this reliance on GDP as a measure of societal well-being in exchange for other metrics.

References:

[1] Stiglitz, Joseph E., et al. “Beyond GDP by Joseph E. Stiglitz.” Project Syndicate, 3 Dec. 2018, www.project-syndicate.org/commentary/new-metrics-of-wellbeing-not-just-gdp-by-joseph-e-stiglitz-2018-12?barrier=accesspaylog.

[2] Stiglitz, Joseph, et al. “Chapter 1. The Continued Importance of the ‘Beyond GDP’ Agenda.” OECD Instance, 27 Nov. 2018, www.oecd-ilibrary.org/sites/9789264307292-4-en/index.html?itemId=/content/component/9789264307292-4-en.

{3] “Irish GDP Up By 26.3% in 2015?” OECD, OECD, Oct. 2016, www.oecd.org/.

[4] MariaChelli, Francesco, et al. “The Index of Sustainable Economic Welfare: A Comparison of Two Italian Regions.” Procedia - Social and Behavioral Sciences, Elsevier, 20 July 2013, reader.elsevier.com/reader/sd/pii/S1877042813015243?token=18B1B8A5A66A998883B4D0A613FE106E5A7E92F4EB240B65 9C84ABC66BB359D2680D2003E5E449FC636C25A6230741B3.

[5] Tamanini, Jeremy. “The Global Green Economy Index.” Sustainable Development, Sept. 2016, sustainabledevelopment.org/.

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