GDP: an accurate measure of economic health?

Reports suggest GDP may not be the whole story when it comes to gleaning economic health

Author: David Orrell
January 15, 2014

One doesn’t usually think of the late 1970s as an economic boom time. Unemployment and inflation in the US were at record highs. In the UK, the winter of 1978-79 became known as the ‘winter of discontent’ because of its widespread strikes, with union leaders demanding higher pay agreements. But according to a recent report published in the journal Ecological Economics, the year 1978 represented something of an economic peak, the like of which we may not see again for a long while.

As the report notes, the GDP of industrialised countries has roughly tripled since then. But economic metrics can be misleading and viewed through the mirror of GDP, progress may appear larger than it really is. The methodology behind the GDP metric was developed in the US during the Second World War as a tool to plan the enormous expansion in military procurement, while controlling inflation. It simply totals up the amount spent for all final goods and services produced within the country.

The measure was never intended as much more than a useful accounting device. Simon Kuznets, who led the effort, warned at the time that “the welfare of a nation can scarcely be inferred from a measure of national income.” However, it has since been adopted as a kind of totem of economic wellbeing. Forecasters and analysts scrutinise the numbers for signs of where the economy has been, and where it is headed. In difficult times an insignificant shift of 0.1 percent (less than the measurement error) can spell the difference – for writers of headlines, and politicians – between growth and stagnation.

Gross domestic product is certainly a valuable tool. Governments like it, for example, because it correlates strongly with tax receipts. Unfortunately, though, it misses out on a number of effects, which together have an impact that is rather larger than the percentage-point statistical revisions quarrelled over by economists.

Growth and debt
One of the larger problems can be summed up in one word: debt. GDP only deals in positive numbers, so doesn’t subtract out things like future obligations. As the Czech economist Tomas Sedlacek observed in 2012: “when we talk of GDP – and this I find stunning – we’re very happy about two to three percent growth in GDP reached in certain European countries last year. Nobody mentions that in this very same year, they had seven to eight percent deficits. So, in a simplified model, they paid seven percent in debt and got three percent out of it. There is no reason to celebrate! We’re unable to disconnect growth from indebtedness.”

GPD only deals in positive numbers, so doesn’t subtract out things like future obligations

Obviously it is easy to boost the economy by borrowing a lot of money. Another way to do is to borrow it from future generations, in the form of resource extraction.

Consider, for example, the Canadian economy, which is dominated by companies working in energy, materials and financial services. The first two make up about 40 percent of the market capitalisation of the Toronto Stock Exchange, while finance, insurance and real estate contribute about 30 percent. Much of the economic activity therefore consists of taking material such as oil or metals out of the ground; exchanging said materials for cash; and then recirculating the money in the financial system (for example by inflating the property market).

There is a lot to be said for the Canadian economy, including its banking system, which weathered the recent global financial crisis much better than most. But a sound and honest reckoning of economic progress would have to take into account the fact that materials in the ground are an economic asset even before they are extracted. We speak of oil and gas ‘producers’, but the real producer here is not companies, it’s geology.

It does not therefore make sense to count a resource like oil as a form of wealth once it is on a boat out of the country, but not while it is resting undisturbed in the ground. The economic value has simply been borrowed from future generations, for whom it will no longer be available. Another way to look at this is that Canada has always been incredibly wealthy because of its resources, and that source of natural capital is slowly being depleted.

Measuring economic wellbeing
Just as GDP does not take into account our debt to future generations, it also ignores a variety of other affects such as pollution. An economy-boosting project like the oil sands in Northern Alberta looks much less viable when you apply a reasonable cost for carbon emissions, whose effects on the climate will persist for generations. Chinaís meteoric rise in GDP looks less impressive if you take into account the enormous damage to the countryís environment. Being the world’s workshop comes at a price that does not appear in the national accounts.

As the authors Kubiszewski et al. of the Ecological Economics paper note, we need an alternative to GDP to measure economic wellbeing. The one they apply to obtain their somewhat surprising conclusions is known as the Genuine Progress Indicator (GPI). This has been around in one form or another for about 25 years, but has generally failed to catch on with policy makers (though in the US the state governments of Maryland and Vermont recently adopted GPI as an official indicator). There are a number of differences between GDP and GPI, but the chief one is that GPI includes negative effects such as the depreciation of natural capital.

Now, for many people, except perhaps disco lovers, it may seem a stretch to say that 1978 was some kind of peak year for human society. There has been real progress since that time in things like technology and poverty reduction. But how much of that wealth has been earned, and how much has been borrowed from the future? And to what extent has it been counterbalanced by factors such as environmental damage? These are the questions to which GDP is blind, and which require a broader approach.