The value of GDP
Fri 18 Oct 2013 by Mieke Welvaert.

The Christchurch rebuild is keeping tradesmen busy, Northland's storm clouds gave road workers trees to clear and roads to fix, and if you decided to play cricket against your neighbour's front window, someone will soon be ringing a glazier. On the face of it, all this work increases GDP.

When trying to tell whether society is making progress, we often use GDP as an indicator of economic wellbeing. But is it then true that breaking things makes us better off? Naturally, this seems counterintuitive. To figure out what's missing we need to look at what GDP is, why disasters are often followed by GDP growth and what this really means about how we’re doing.

Why do we use GDP in the first place?

Gross Domestic Product is often used as an indicator for standard of living. GDP measures the market value for all final goods and services produced within a geographic entity over a period of time. Final goods and services refer to products at a stage of manufacture where they will no longer be used for any other purpose within that geographic region.

If we extract crude oil in New Zealand and sell it overseas (as we do with most of our oil), GDP increases by the amount for which we sold the crude oil. However, if we were to process the oil before we sold it overseas or consumed it here, we would value the oil at the last stage of production. One could then consider GDP to be the total of incomes generated from activities which add value to a product. As we enjoy consuming what our income buys, GDP is used to indicate the extent to which people in a region can satisfy their lifestyle demands.

Where does GDP come from?

We can't conjure goods and services out of thin air; we need resources to produce them. We know that there are benefits from producing goods and services – namely that we get to consume them.  However it is important to remember that the resources used in this process all have a cost. Say we're fixing you neighbours window, we need glass (a raw input), a glazier (labour supply) tools for the glazier and probably a van to take all this to your house (capital stock).

More generally, it takes some land, labour, and capital to create the goods and services we want to consume.  It is this combination of inputs that creates output/GDP.  If we are thinking about wellbeing, we need to consider how this process ultimately influences the things people value, namely the ability to consume goods and services, and the cost of doing so.

However, there are a couple of areas that we need to think about to avoid simply mixing GDP and wellbeing:

  1. GDP measures market transactions, but it does not include non-market transactions (such as when you offer to house sit your neighbour’s house), and it does not count the benefit of leisure (as enjoying your downtime is not always a market transaction).
  2. GDP is essentially current consumption plus deferred consumption (investment) – implying that we need to think carefully about where this new post-quake investment is coming from.

Often GDP and general wellbeing are strongly related, but is that really the case when there is a disaster?

Heading back to the disaster zone

An understanding of what constitutes GDP gives us insight into how smashing your neighbour’s window could be perceived as a strategy to help the economy. Thinking this through, the broken window is unlikely to be left unrepaired. You or your unfortunate neighbour is likely to pay someone to fix it. The amount which the glazier is paid is more or less (taking taxes into account) the amount by which GDP increases.  If you put infuriating people aside, why, then, would you not want to smash windows? And if you could put immense emotional trauma aside, could you then celebrate earthquakes?

As your intuition would hopefully suggest, defenestration (the act of throwing someone or something through a window) is not beneficial to the economy.

The GDP growth that follows, restores the GDP level, making the net effect of the exercise equal zero. Following the first and second Christchurch earthquakes, GDP for the region dropped. The (6%pa) GDP growth we are seeing in the region is a sign of a recovery in the level of GDP. This is a positive sign of our ability to regenerate, but it does not mean our standard of living is better than pre-earthquake levels.

Furthermore, the lift in GDP growth is occurring as individuals and households are being convinced to make market transactions they would not have otherwise. A builder may be working longer hours, when he/she previously may have spent time with family or gone fishing.  The lost non-market benefits are a cost to society that is not captured in the GDP figures, even though they are an opportunity cost associated with the rebuild!

Note that when it comes to boosting demand in the economy, a quake may give it a kick however, the Reserve Bank shifts interest rates to cancel this sort of thing out.

Capital costs

The more substantive concern with considering earthquake reconstruction as a booster for growth comes from thinking about investment and capital.  Previously we mentioned that we use land, labour, and capital as inputs to create GDP.  Earthquakes can not only have horrific human costs but, more often, destroy our things (capital).

The lift in GDP growth that occurs is indicative of the fact that we as a society are having to invest a bit more just to have what we had before – we have to sacrifice consumption, and other types of investment, just to rebuild a city that was already there!  This was why the “level” of GDP dropped. It is also why we currently need stronger growth to rebuild lost capital and get back to where we were before.

Fundamentally, investment in a rebuild has an opportunity cost. Taking an anecdotal step to the side to illustrate, when I was a first year university student, I crashed my flatmates car into a BMW. I was uninsured and it cost a lot of money. Thankfully no-one was hurt (because that would have made everyone's emotional cost of the experience far greater).I can tell you now that crashing a car did not enhance my standard of living.

The money spent on fixing two cars would have been nice to hold on to as I had planned to use it on my up and coming exchange. In the microcosm that was both car owners and myself once the cars were fixed, no-one was better off than they were before the crash. Furthermore, I incurred the opportunity cost of what I had planned to spend that money on.

As of May this year, the government has reportedly spent $2.45 billion on rebuilding the city. Had there been no earthquakes, we would have had a complete Christchurch and a few billion in the bank to save and spend as we pleased. In fixing broken things, we use resources that we could have consumed or used to invest in ways we would have preferred.

To summarise:

GDP measures the value produced within a geographic entity. Although it seems damaging property could increase GDP, this is unlikely – and when it does, it does not do so in a way that increases wellbeing.

In truth, it would be better if we didn't have to repair what we have and could just add to it. Although this is not possible in the case of natural disasters, it is possible when we can prevent destructive events from happening. The moral of the story is: If it ain’t broke, don’t break it.

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