Earthquakes are bad for the economy, despite the wool some are trying to pull.

Listener: 19 March, 2011.

Keywords: History of Ideas, Methodology & Philosophy;

Business journalists sometimes seem to compete among themselves for the silliest argument, but the height of fatuity must be the crowing that the Christchurch earthquakes will increase our gross domestic product (GDP). Perhaps they will, but it does not follow that this is a good thing. If it were, we could blow up all the offices of business journalists, thereby increasing GDP. Let’s blow everything up and we shall have the highest GDP in the world – huh?

For although GDP is a useful indicator of market activity, it should only be used with caution as an indicator of economic welfare. Economists have known that since it was first developed in 1934.

Economist Simon Kuznets said in his first report, “The welfare of a nation can scarcely be inferred from a measurement of national income.” Ken Galbraith made the same point in an elegant chapter in his 1958 book The Affluent Society, and so did my first economics teacher, Alan Danks, in the lecture in which he introduced the concept. The rest of the world may think GDP is the best measure of social welfare; economists certainly do not.

Kuznets developed the notion of GDP because he wanted to track market production and employment, an important issue during the Great Depression; economists have used GDP for this and related purposes since then.

The acronym hides some very subtle ideas. The P (product) in GDP refers to the output from market activity, which is only part of total human activity. Lots of other things we do add more to our welfare. Of course, we have to produce things – like food – but we also need to live in communities and interact with people, none of which is counted in GDP. Nor is our health or leisure.

The G (gross) refers to the consumption of capital: buildings, infrastructure and equipment – but not financial assets, which are treated in quite a different way because they are contractual obligations and not materially real. Capital wears out. The measure that takes that depreciation into consideration is called “net domestic product”, which is the amount we have left when we have replaced the worn out capital, and which can be used for new investment and consumption.

A major earthquake destroys an awful lot of capital, so it will be harder to produce things in the future. Canterbury’s (and New Zealand’s) total capital stock has been diminished by the earthquakes. Until the capital is replaced, productivity is reduced. If you care about catching up with the rest of the world in GDP terms, then your aims have been set back by the earthquakes, despite the alleged growth in GDP. (Personally I would rather we pursued goals covering education, health and happiness.)

GDP covers all the production in New Zealand, some of which is owned by New Zealanders and some by foreigners (typically foreign companies or the interest payments we pay on our offshore borrow%ings). That is the meaning of the D (domestic). In calculations of “national income”, the income attributable to foreigners is deducted from the net domestic product, and overseas income generated by New Zealanders is added. It better reflects the market incomes of the nation.

Much of the capital destroyed by the earthquakes becomes the responsibility of the overseas insurers, so the income of New Zealanders does not fall as much as the production of the economy as a whole. But while part of the costs of the economic destruction are borne by foreigners, almost all the human costs are borne by us. (So if you blow up journalists’ offices, make sure they are owned or insured offshore – and try not to blow up the journalists.)

GDP will increase if employment and output rises from the reconstruction following an earthquake. That is what happened to the European economies after World War II as they replaced what had been destroyed. That was the source of the German “economic miracle”, which ceased after 15 years when the country got back to the track it would have been on had there not been a war. They were not any better off economically from the devastation of the war. And neither are we from earthquakes.