Taking the P out of GDP
Fri 2 Oct 2009 by Nigel Pinkerton.

Feels good to be out of recession, doesn’t it?   For those who kept their jobs, chances are that a smaller pay rise is about as bad as it got.   Others would have been hit harder, losing their jobs and may be even their houses.   Being told by government officials that the recession has ended will be of small comfort to the second group.   Recessions always create winners and losers, which is why we have a welfare system to smooth part of the burden.   But at least society as a whole is now getting wealthier again right?

Unfortunately it’s not quite that simple, and economists have taken the 0.1% growth recorded in the June quarter with a grain of salt.  The main reason for this scepticism is that GDP, the most quoted economic statistic, has some serious limitations.   These limitations are well understood by economists, but not often talked about in the wider media.

Headline GDP figures don’t really say anything about how production is used or how it is funded.   The current housing bubble demonstrates that how we fund production is important, and the following example about electricity will demonstrate that how we use production is also important.

Luck (even bad luck) had a lot to do with why New Zealand emerged from recession three months earlier than most people expected.     One of the major boosts to GDP during the June quarter was higher electricity production, bought on by the unusually cold winter.   Welfare would have been higher had the winter been warmer, but instead resources were diverted to heat colder houses.   The seemingly contradictory result was that this extra activity boosted GDP and we got to officially wave goodbye to the recession.

How production is funded affects the sustainability of growth.   Behind strong GDP growth we may find excessive plundering of non-renewable resources, depreciation of a capital stock, or large amounts of debt.   The ability of people to borrow against their house to fund their lifestyle has boosted New Zealand’s GDP in recent years.   If a society borrows to consume they forgo future consumption plus interest, whereas borrowing to invest should increase the amount you can consume in the future.   In an impatient society, some level of borrowing for consumption may be optimal.   But the boost such borrowing brings to GDP can lull us into a false sense of security about our ability to pay it back in the future.

Another limitation to GDP is that it can only measure things that the bean counters in Wellington know about.   To take a timely example, anecdotal evidence suggests that more people are taking up edible gardening since the recession hit.   Vegetable gardening comes with many benefits, but nothing produced at home for one’s own consumption shows up in GDP.   A society in which this behaviour is common is seen as poorer than a society which works longer hours and buys all their vegetables at the supermarket.

If gardening isn’t your thing then don’t worry; you can still beat the national accountants by taking up another hobby or simply taking some extra time off work.   Leisure time is a major consumption good, but it doesn’t show up in GDP.   After all, leisure has a price just like any other indulgence, the only difference is that you don’t hand over cash but rather give up income you would otherwise have earned.   For some people, working overtime is just not worth the extra cash so they chose more leisure time.   Individual welfare is enhanced by this decision, yet the more people who chose this lifestyle, the lower national GDP.

Any economist will tell you that GDP is a terrible measure of true welfare, and the French have been working hard on an alternative.  Non-GDP related measures of welfare have been tampered with for years by statistical organizations worldwide.   Moving away from measuring production as a proxy for welfare usually means asking people subjective questions.   There is a famous definition in medicine which states that pain is whatever the patient says it is, and this approach also seems appropriate for measuring welfare.  But subjective measures have their own limitations, and GDP remains the easiest tool to understand and apply in most economic analysis.

GDP remains the best singular indicator of a society’s ability to consume that we have available to us.   But GDP figures can easily be misused when trying to measure economic progress or the welfare of a society.   The developed world has just finished off a decade of unprecedented GDP expansion with a serious economic crisis.   New Zealand should not become so focused on growing GDP that we don’t care where the growth is coming from, and end up walking headlong into another crisis.

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