Saturday, July 11, 2009

The Danger in GDP Measures

Some time ago I read an interesting paper from within the field of academic economics. The article, by Ole Rogeburg was written pre-economic crisis, and was titled 'Taking Absurd Theories Seriously: Economics and the Case of Rational Addiction Theories'. Perhaps the most important point of the paper was that it was a case study to illuminate what he saw as a more widespread problem.

I will not detail the entire argument of the paper, but he identifies that economists used mathematics to present a completely absurd explanation of drug addiction, and that the resultant nonsense has been used in the formulation of government policy. The most striking element of the discussion is how the completely implausible might become plausible with the backing of clever academic argument, and the respectability of a veneer of academic rigor.

One of the themes of this blog has been trying to view the current state of the world economy as it might be observed in the circumstances of today, rather than through any particular perspective derived from academic economists. As part of that process, one of the problems with economic theories that I have identified is the obsession with GDP figures as a measure of the health of an economy. I might even go as far as to say that the subject has become something like an obsession of my own. As such, I hope that I will be forgiven a post devoted to the subject, and which pulls together some earlier points that I have made.

Before I continue further, I will quote the understanding of GDP that is described in the UK's official publication of statistics, National Statistics online:
Gross Domestic Product (GDP) is an integral part of the UK national accounts and provides a measure of the total economic activity in a region. GDP is often referred to as one of the main 'summary indicators' of economic activity and references to 'growth in the economy' are quoting the growth in GDP during the latest quarter.

In the UK three different theoretical approaches are used in the estimation of one GDP estimate.

GDP from the output or production approach - GDP(O) measures the sum of the value added created through the production of goods and services within the economy (our production or output as an economy). This approach provides the first estimate of GDP and can be used to show how much different industries (for example, agriculture) contribute within the economy.

GDP from the income approach - GDP(I) measures the total income generated by the production of goods and services within the economy. The figures provided breakdown this income into, for example, income earned by companies (corporations), employees and the self employed.

GDP from the expenditure approach - GDP(E) measures the total expenditures on all finished goods and services produced within the economy.

The estimates are 'Gross' because the value of the capital assets actually worn away (the 'capital consumption') during the productive process has not been subtracted.
Whichever approach is taken, the key point is that the measure is made of activity, and therein lies the problem. A whole host of factors might determine activity, but they offer no indication of the health of an economy.

For example, if we look back to the devastation of Hurricane Katrina, there was a massive programme of rebuilding following the destruction of so much infrastructure. The infrastructure that was destroyed represented an accumulation of investments being destroyed, or the destruction of wealth represented in infrastructure. However, the replacement of the infrastructure would be represented in activity such as construction and cleaning up the areas of devastation. This would, in turn, feed into the GDP figures, such that GDP would see a rise as a result of the devastation of a city. As such, whilst GDP does indeed represent activity, it can not be said to mean 'growth in the economy'. In other words, can replacement and cleaning up of this destroyed infrastructure represent economic growth?

If such a view of economic growth is taken seriously, then the logic of the measure would suggest that a good way to achieve economic growth would be to destroy infrastructure such as factories, roads, bridges, houses etc.

There is an even more significant worry about GDP and the way it is used. An example is taken at random from the news on a Google news search for the term 'US debt % GDP', and produced this article:
The UK is drowning in debt. The total amount owed by our households, firms and the government is staggering – more than five-times our national income. On top of that debt stock, the UK is heading for a 2009 budget deficit of 14pc of GDP – by a long way the biggest in our peace-time history.
I actually support much of what the author this quote says (Liam Halligan of the Telegraph), but think that he is making a major error using GDP as any kind of a reference point. I will explain why.

As I have already identified, the measure of GDP is a measure of activity in the economy. As such, it is a measure that takes no account of the source of activity, such that a hurricane's devastation might increase GDP. However, included in the level of GDP is the economic activity that is resultant from the debt driven consumption. If we then view the idea that debt is '14 pc of GDP' we encounter a problem. What is being measured is the proportion of debt in relation to economic activity that is itself, in part, driven by debt. The economic impact of that debt is itself difficult to quantify.

For example, here are two charts from the UK National Statistics website, regarding fiscal deficits:

The problem that arises is that the measure on the left shows the money that is being borrowed, and the chart on the right shows the total economic activity that includes that borrowing. It is when we see how debt driven consumption actually impacts on the economy that the scale of the problem makes sense.

For the sake of simplicity, we might imagine that a small slice of the money that is borrowed by the government is used to pay the salary of one individual. When that individual goes shopping and purchases a shirt, they will spend some of that borrowed money. The purchase of the shirt will register as economic activity. However, the story does not end there. The retailer will then need to order another shirt for stock, and this will then see economic activity in a wholesaler, which in turn might see economic activity from an importer. Furthermore, the money spent on the shirt will contribute to many of the support services that are a necessary part of retail, creating ever more activity. The money will then contribute to the wages of the staff who will then spend the money, creating yet more activity.

In other words, this tiny slice of the government's borrowing will generate activity far in excess of the headline figures, or in this case in excess of the individual's salary. All of that activity will be recorded in the GDP figures.

The problem that this generates is to ask how the activity that is generated by debt might be stripped out. I will confess that I do not know the answer to this question (comments welcomed), but it is certain that GDP is a measure which has little meaning in the measurement of an economy. More borrowed money results in more activity in the economy such that the measure of the economy becomes a measure of the borrowing against output that includes activity from previous borrowing. The big question here is how a measure that does this might be an indicator of the sustainability of borrowing?

To illustrate this, imagine if a factory's performance was measured against activity rather than cash flow or profitability. The owner of the factory might produce more product if they borrow more money for materials, labour and power, but that would do nothing to indicate the health of the company that owns the factory. If a measure like GDP were used, the output resultant from the borrowing would be seen as an indicator of a healthy business, even though the accumulation of debt would suggest otherwise. However, the measure would consider the debt in relation to the activity, such that the debt accumulation would increase activity, and this would be represented in output. I am not sure this is the clearest description, but I hope the underlying point is clear (if you can phrase it more clearly, please feel free to add a comment).

I will use a related example from a recent post as a further illustration. If an individual earns £50,000, and borrows £10,000 per year, they appear to have an income of £60,000 in their lifestyle. If GDP type measures are used, then the sustainability of the borrowing of £10,00 a year would not be measured on the actual £50,000 of income, but would instead be measured on the apparent income of £60,000 per year. Nobody in their right mind would do such a thing, but this is in effect what GDP measures are doing.

The reason why I highlighted the problem with economic theory at the start of the post is to point out that economics can be a matter of playing with clever ideas. GDP is just such an idea. It seems to be a perfectly rational and clever idea, that an economy's output might be measured through the activity in the economy. However, if an economy is being financed in part by debt, the meaningfulness of the measure completely disappears. Even when an economy is not partly funded through debt, the Katrina example illustrates how fundamentally flawed the measure actually is. It ceases to have any plausibility. Just as with the drug addiction thesis, GDP is being used by economists to shape government policy, but it should be viewed as a nonsense.

The idea that this measure is one of the most important measures in shaping fiscal and monetary policy is deeply disturbing. In particular, GDP is falling in an environment when there is an explosion in government borrowing. If it were possible to strip out the impact of the government borrowing from these figures, then the situation of the absolute borrowing versus the absolute output without the borrowing would reveal a very, very ugly picture.

We have witnessed a private credit bubble economy (in conjunction with expanding public debt) and have seen the damage that this has wrought. During the entire time the damage was being done, the GDP figures created an illusion of a healthy economy. We are now witnessing a massive increase in public borrowing, and again the GDP figures flatter the relative success of the policy, hiding the severity of the crisis, and likely unsustainable debt. With regards to how unsustainable this policy might be, there appears to be no way to measure this, just as there was no way during the private credit bubble.

The problem that then arises is how to determine the actual health of an economy. The answer is actually surprisingly simple. The actual health of an economy overall is determined by whether the economy can be sustained without any borrowing. If borrowing is necessary in aggregate, whether the source of the borrowing is private or public, the economy is unhealthy. In other words, an economy's sustainability is determined by the ability for the economy to have aggregate output which matches the aggregate consumption.

The only question that remains is how to determine how bad borrowing might be, and for this I can offer no solution. However, in economies like the US and UK, the numbers are shockingly large relative to the history of borrowing, and should therefore be a cause for worry. In particular, when comparisons are possible with the debts accumulated in a period of total war (World War II), then there is real cause for worry. Such comparisons suggest that the situation is indeed extremely bad.