The GDP Target

Appendix 1 of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.

Keywords: Growth & Innovation;

The growth debate in New Zealand assumes an appropriate economic target is per capita Gross Domestic Product, or GDP. This appendix pays little attention to the population dimension of the target, but it looks at, as intensively as space allows, GDP. Initially it explains what the concept is, what was the measure’s original purpose – understanding the business cycle, and how it became interpreted to have a broader meaning – as a measure of welfare. Then the chapter looks at some of the criticisms of the measure – most notably its coverage and its distribution. However far more important is the extent to which it actually measures a nation’s welfare. The evidence is that it does not.

What is GDP?

GDP is intended to measure the total market activity of the production of goods and services in a domestic jurisdiction (such as New Zealand). It is the production which occurs in a time period, typically a year.

There are a number of ways of calculating it, but the simplest to understand is that it is the sum of the New Zealand products which are bought by households and invested by businesses. In addition the output of the public sector (such as education, health care, military services and so on) is included, valued at cost. Some New Zealand products are bought by foreign households and businesses, and so are a part of GDP. Conversely the outlays of households and businesses which are produced overseas and imported are not a part of New Zealand GDP.

There are a number of complications to this story, most of which can be avoided in this exposition. Importantly double-counting is avoided so that the milk produced by a farmer, is only valued when it is sold as cheese or whatever.

The biggest market omissions from GDP are financial transactions, because it only concerned with goods and services. Thus a transaction involving the purchase of a $100m of foreign exchange or government bods does not appear in the measure. Money spins around much faster than goods and services, so these transactions exceed are substantial. If it is not obvious why they are excluded from GDP, consider buying an appliance with your credit card, and paying the card company out of your cheque account, having transferred money from a savings accounts to do so. That means the financial transactions amount to three times the cost of the appliance, but it would be meaningless to include them all in GDP. (Insofar as the credit card company and the bank charge you for the convenience of using their services, that does appear in GDP.)

The ‘gross’ in GDP refers to there being no deduction for the wearing out of capital goods (depreciation). It might be more sensible to deduct the depreciation, but it is harder to calculate, so Net Domestic Product is not as reliably measured. (However, as Keynes said ‘it is better to be vaguely right, than precisely wrong’.) As it happens the ratio between GDP and NDP remains roughly constant over time and between countries so it is the distinction is not so important.

The ‘domestic’ of GDP refers to production in a region (typically a country). However not all the product of a country may be produced by its nationals, as when the profits are owned offshore or a passing through rock star receives a performance fee. Then again the residents of a country may receive profits from their investments overseas and fees. A better measure for nationals is Gross National Product (GNP), or better still NNP which is called ‘National Income’. The reasons that the domestic measure is used is because it can be defined more rigorously. (However Tommy Balogh complained about economics that suffered from rigour to the point of rigour mortis.) The ratio of GDP to GNP varies between countries, so the distinction matters. Moreover, a country could increase its GDP by a lot of foreign investment without as much impact on GNP – so that it produced more but its residents did not have correspondingly higher incomes.

In one sense this is all very boring – and it gets worse with the detail in the centimetre thick manuals which set out the exact rules. (In my time I have got tangled up with what one did about exploratory oil wells which proved to be dry, or how one treated floating oil rigs coming to and leaving New Zealand). What the reader needs to know is that GDP is an exactingly defined concept, but an increase may not always translate into local improvement, however it is defined.

There is one further complication that needs attention. What prices are the products to be valued in. If they are in the prices of the day, then the production is measured as ‘nominal GDP’ (or ‘GDP at current prices’). If it is measured in the same set of prices in different years it is ‘constant price GDP’, or ‘real GDP’ or ‘volume GDP’ (which is my preference). When people talk about GDP growth they are usually referring to changes in volume GDP.

This approach is not without its hazards, since it assumes that one can make comparisons through time. But how does one value a car today compared to one of a decade ago, given the changes in accessories and reliability that have occurred. And what about new products? A decade ago there was hardly any mobile phones. Any procedure is likely to underestimate the benefits from the convenience and opportunities of the innovation. Statisticians try to allow for such changes over time, but some economists think that they still underestimate the benefits of the quality improvements (by as much as 2 percent p.a. some say, but that seems to me to be extravagant). However, presumably these quality generally apply to all countries (or to all rich ones) so it is not so important for inter-country comparisons, providing all statisticians make the same quality adjustments (they probably dont).

Since different currencies have different prices and different currency units, international comparisons involve some common pricing standard. Once upon a time, for want of anything else, the conversion was on the basis of exchange rates – that is the ratio between the value of the domestic currency on the foreign exchange markets and, say, the US dollar. It was a very unsatisfactory method since the rates could change quickly – a devaluation might reduce a county’s comparative GDP by 20 percent overnight. Today (effectively starting about two decades ago) individual prices are carefully collected for each product from a range of countries, averaged, and applied to the products in each country to calculate GDP at a common purchasing power parity (PPP). The averaging is important, and it may be that it is less fair to smaller countries such as New Zealand. It is these PPP figures which are sued for the international comparisons.

The Purpose of GDP

Estimating the total activity in an economy has a long history going back over three hundred years. However the systematic development goes back only about three quarters of a century. There were many reasons for calculating the figure – perhaps initially no more than curiosity – but by the 1940s the prime concerns were business fluctuations (the trade cycle), unemployment and financing the Second World War with a minium of inflation (exemplified by Keynes How to Finance the War). To this day GDP, and the accounts which underpin it, are crucial for the government setting its fiscal policy and the monetary authority (the Reserve Bank in today’s New Zealand) setting monetary policy.

This was a time when economic growth was not in the public agenda in the way it is today. That really only begins in the 1950s, in part with the systematic attempts to measure economic activity (and perhaps from Krushev’s famous – and ineffective promise – that the Soviet Union would ‘bury’ the Western economies). Previously economists had tended to think that while an economy would grow in the medium term (and there would be fluctuations around the trend) eventually it would stagnate. (Keynes talked about the ‘euthanasia of the rentier’ which occurred when there was no more investment opportunities, so there were no rewards for saving). In fact, as best we can measure and caveats abound, there has not been a marked growth trend for the majority of human time. Growth as we know it is less than two centuries old. What made the difference – invalidating thus far the prognostications of such great practitioners of the dismal science as Keynes and Marx – is the creation of new technologies. If there is a stagnation level of economic output, then recent experience is that it keeps being lifted by innovations. Whether there is a limit to them, and hence a long run cap on the stagnation level I dont know. My guess is that humankind may be seeking new ends before that occurs.

If macro-economics (cycles, unemployment, and inflation) was the initial purpose of the new measure, subsequently – the key paper is due to Paul Samuelson in 1949 – it was shown that under some assumptions (which include that the economy can be represented by a single consumer) a higher National Income (not GDP, you note) represents an increase in consumer welfare. This uses standard consumer theory, which assumes that more consumption makes a person better off. We will explore this assumption below.

Even without Samuelson’s paper it seems likely that the populists would have latched onto GDP per capita as some measure of welfare, simply because the statistics were there. We have already seen that there are numerous caveats to the claim that GDP is associated with wellbeing, but there is a tendency to cling on to an available statistic like a drowning man clings to flotsam (even if it takes him over the falls).

Problems with GDP

The Distribution of GDP

Earlier we mentioned, almost as an aside, that a key assumption which relates GDP to welfare amounts to an assumption that the economy could be represented by a single consumer. I propose not to go through the complications of this assumption but, rather, point out the implications if there are numerous consumers who have different incomes.

In particular some may be rich and other poor. An increase in GDP does not distinguish between whether the extra income and consumption goes to the rich or to the poor. Indeed suppose GDP were to increase as a result of taking income from the poor and giving it to the rich (perhaps the lower taxes on the rich give them a greater incentive to produce more, while the poor also work longer to make up some of their lost income). Does that mean the nation is better off?

Economists have got into a muddle over this, when they say that the increase in GDP means that the poor could be made better off without the rich being worse off. But suppose they are not (suppose – as in the previous paragraph – the increase arises because the poor are being made worse off). One could say that the rise in GDP had the potential to be a rise in the nation’s welfare – but that does not mean it has actually happened.

There is another oddity as far as distribution is concerned over the living. Suppose everyone over working age – say 65 years – were to drop dead overnight. There would have to be some adjustment as individuals moved from industries which support the elderly (rest home care; providers of food) but in simple terms GDP per capita would rise (by almost enough to get New Zealand back to the OECD average). Would that be a good thing?

What to Do with Bads and Inputs

Consider a country which suddenly comes under military threat. It immediately diverts a lot of its productive activity into defending itself. Workers and the unemployed are recruited by the forces, which order various military equipment and requisition civilian goods and services. GDP may even go up as more of the unemployed diminish and the remaining workers work longer hours as a part of their war effort. Is the country better off? The higher GDP might suggest it is, but in fact it is worse off because of the military threat, and people’s material standard of living diminishes – evident by the higher taxation and the cutting back of civilian public services in order to finance the war.

The same applies for other threats. Consider a new health threat such as HIV-AIDS. Again the country will deploy resources to combat it, and possibly GDP rises, but is it better off? The same applies for the threat of crime.

Or consider two countries, one of which has a benign climate while the other requires airconditioning and central heating for a reasonable life style. Since the cooling and heating involves market transactions (equipment purchase, energy, maintenance) it adds to GDP. But does the higher GDP actually say the country with the inferior climate is better off.

A recent paper by (American) economist Robert Gordon compares the GDP per capita figures for the US ands the EU. The official measure is that the US OECD per capita is 23 percent higher. However after adjusting for inputs differences (including transport disadvantages from the sprawling US metropolises) and for greater European leisure and choice, Gordon concludes the difference amounts to only 8 percent. People in some European countries are almost certainly better off in terms of an adjusted GDP per person, than the US average.

There is an enormous amount of judgement in these comparisons, but the basic conclusion is probably right. Comparing living standards on the basis of GDP per capita between countries is not very satisfactory and may be subject to great error. The 15 percent difference which Gordon identifies between the US and Europe due to quality and input differences is also the difference between the NZ per cap GDP and the OECD average. This does not mean that NZ is really at the OECD average, but it illustrates just how inaccurate the statistics are for valid comparison purposes.

Note however that these criticisms apply mainly to inter-country comparisons. They are not as significant for comparisons through time.

Non-market Activity

Gordon’s adjustment for leisure occurs because people get value from not-working and having time for leisure. Suppose someone choses to retire early, going onto a lower material standard of living for ‘life style’ reasons. GDP goes down even if this person’s well being goes up (in their judgement).

This is one example of a non-market economic activity. Another important one is all the production that goes on in the home. Suppose neighbours were to take in each other’s washing and mow each other’s lawns for which they pay each other the same amount. GDP, that is the market value of production, would go up, but economic activity would not. All that has happened is that some has been transferred from the informal non-market sector to the formal market sector. It is not evident that this has made anyone better off.

This transfer from the non-market to the market sector has been underway for a long time. Parents use child care rather than leaving the child with the mother; households eat out rather than cook at home; rather than washing at home they use a dry cleaner; many purchases of commodities (easy to prepare foods, household equipment ) reduce housework. The issue is further complicated by whether the change results the houseworker entering the paid workforce (in which case it boosts GDP) or in more leisure (in which case it does not). It seems likely that the tendency has been to boost GDP (that is market production) faster than total production including non-market production.

A common demand is that the GDP measure should be extended to include non-market activities. Leaving aside that the required data base does not exist, it is far from clear what should be included (sexual services between consenting adults?) or at what price. In any case if the primary purpose of GDP is to assess business cycles, unemployment, and inflation in order to assist macroeconomic management, it is unclear what use the extended measure would be.

The international statistical community which governs the System of National Accounts (SNA) which measures GDP encourages the development of supplementary tables to cover non-market (including environmental) phenomenon. The idea is to allow countries to experiment, and then when enough experience is accumulated, to set international standards. (As someone who has puzzled over the relationship between non-market and market economic activity for three decades, I suspect they we are still some distance from a comprehensive theory, and that the best will be to extend the market economy into certain non-market activities without getting the peculiarities of non-market activity.)

However even this approach cannot cover some of the things we value most. Following the end of the communist regimes, the GDP of Soviet Bloc countries fell dramatically, but how are we to value the switch over to a time when an early morning knock at the door was from a postman and not a policeman? We take such things for granted in the West, and while there are variations between countries – my judgement is that New Zealand is one of the most secure in terms of improper repression by the state – providing we are comparing those whose civil society is based on due process and respect of citizen rights, there would need to be little adjustment to the relative economics.

Another phenomenon which the market may not properly value is choice. The Gordon paper mentions readily accessible French shops with over 200 kinds of cheese, contrasting their easy choice with the rarer US gourmet supermarkets with comparable choice and the lesser choice elsewhere. GDP comparisons do not properly catch this contrast, although the importance of varieties of cheese is another matter.

Environmental Issues

Sometimes one economic actor’s market activities are to the detriment of another economic actor, who may be incurred costs. The traditional example is the smoke from a factory which dirties the washing of local householders, but water and soil quality as well as air quality may also be affected by these ‘externalities’. Presumably any environmental deterioration should be deducted from GDP, although like other non-market measurements that is easier said than done. A further curiosity is that later on, when the damage is cleaned up GDP rises, even though the community may have less access to material goods and services because some is being diverted got the remediation.

Another concern has been the depletion of resources. Some of the highest GDP per capita rates are in oil producing countries, but for the most cases the reserves are being depleted rapidly. One way of thinking about this is that the depreciation component of GDP is unusually large, because it should include the value of the depreciation of the reserves. (This means GDP is the same but actual National Income is lower than as conventionally calculated.) Another is to treat the depletion as an inventory run down. (GDP would be lower than as conventionally calculated, and National Income the same as in the previous method.) . A third is to note that the reported GDP is not sustainable. There is no obvious best practice.

While the problem of depletables is evident for the oil producers and some other economies over-dependent upon them (e.g. Naru on phosphate), it applies also to New Zealand and other more conventional OECD economies. New Zealand has an economic history of resource depletion – sea-mammals, birds, minerals, forests, soil, ecologically sensitive environments – and some of that depletion continues. In a few years New Zealand GDP will be (slightly) decreased by the Maui gas field running out and some of the large petrochemical instillations being closed down.

A Conclusion

Recall that GDP was originally designed for one purpose – evaluating the state of the macroeconomy – and was kidnapped for another – evaluating welfare. It does this second purpose not at all well.

One might conclude that GDP should be confined to its macro-economic purpose, and some new indicator of economic welfare should be constructed. There have been various proposals such as ‘Net Economic Welfare’ (NEW) and ‘General Progress Indicator’ (GPI). However while they may patch up some of the defects described above, they introduce other difficulties, especially arbitrary assumptions that the Samuelson theorem draws attention to. In my view the approach is deeply flawed because it assumes that it is possible to rank countries on some single dimension of economic welfare.

This assumption is all the more ironic because for over half a century economies have eschewed person to person comparisons, because they are not ‘scientific’. Why should country to country comparisons be any more valid?

However the public wants measures, and we might as well stick to GDP per capita, as the internationally measured and available indicator of material output. One recalls as Bob Solow quoting the addicted gambler using a crooked roulette wheel ‘because it is the only game in town’.

Even so, as Chapter 1 argues material output is not a single compelling goal for a nation, although we may have to enlarge material output in order to pursue vigorously our other goals.

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