How can we measure the economy?

Jens Stanislawski tells us,in this newspaper, that GDP isn’t the be-all-end-all of economic life. This is entirely correct.

GDP does not, for example, account for the value of a baby’s smile nor a mother’s love — and we all agree there’s nothing of more value than that combination. To be a little more serious, GDP doesn’t even include most of the things we’d like to be measuring about the economy.

It would be good if we could do better.

However, there’s also something very valuable abut the GDP:It’s objective. It doesn’t depend upon someone’s entirely subjective evaluation of worth or value. Thus, we should still use and and we should still use it as a target. As long as we understand what it should be a target of.

As far as economists ever do make jokes — not far, if we’re honest — the one here is that gross domestic production should be net national income, NNI not GDP.

We can measure things net or gross, obviously. Here, one usual critique of GDP is that cleaning up pollution is an increase in GDP. Eh? But yes, it is, for we’ve got to recall what it really is that we’re trying to measure.

We don’t want to record economic transactions — or, at least, that’s not our measure of what we want to achieve. People selling something back and forth between themselves is economic activity but it’s a pretty sterile form.

What we’re actually interested in is how much value is added by economic activity. So, we’re measuring value added in GDP. So, cleaning up pollution adds value. Therefore, we should include it.

However, the creation of the pollution is obviously a reduction in value, not an addition. The problem with GDP is that we don’t include the losses from pollution, but do record the activity of cleaning it up. This stems from that “gross” part. We should be measuring net — so, value added minus value subtracted.

We can indeed, and we do, talk about the domestic part of the economy. But that is a measure of “what is done here” which isn’t really what we want to know. We are much more interested in “what accrues to the people who are here?”

Because, obviously, it’s people who are important, not the place, lovely and precious to us though it is. In economics, this distinction is that, between domestic and national,“national” means what ends up in the hands or use of the people, not just what was actually done here.

Finally, it’s not really production that interests us. As above, it’s people who are important. So, it’s what people get to have which is that important measure for us, not what people have made. Thus, we’d prefer to be measuring income instead of production.

All of this is well known among economists and much of it was pointed out by the inventor of the whole process, Simon Kuznets. After the 80 years since then you’d have thought we would have got this worked out and thus changed from GDP to NNI. Except, obviously, we haven’t.

Why?

The answer being that GDP is relatively easy to calculate. We can also do it fairly quickly. We can have the initial numbers for any one period a couple of weeks after the end of that period. Thus, it can be not just a target but also a management tool for the economy. We can’t do that with NNI.

For example, if we’re to have the net position we need to know what depreciation is. How much has the value of machinery and infrastructure fallen over the period? That’s obviously a subtraction from value.

But that’s the sort of thing we only know perhaps a year later when companies report their results and present their accounts. Being a year late might make us accurate but it’s not overly useful as a number to inform management of the economy. So, we’re rather stuck with GDP.

There are those other complaints too. That it doesn’t measure inequality, or the distribution of income. Therefore, we need a new measure which does. But this is to become subjective. What is the value of greater, or lesser inequality? Among economists, there’s no agreement even as to whether inequality is a positive thing to have or a negative, let alone applying more accurate numbers to it.

Thus, any attempt to use it as a target is simply saying “in my opinion, it’s too much,” or too little perhaps. And politics aside, opinions aren’t the way to run that economic management.

We have much the same problem with all of the other suggested additions. The state of the environment perhaps. Well, yes, that is important. But what’s the price of it, the value?

Remember the important thing –we’re trying to come up with a number we can both calculate and which is useful to use as both a measure and a target. So, we must be able to reduce whatever measures we’re using to a number so that we can do sums.

So, again, what’s the number for a river, a mangrove swamp? Given that there are no transactions here we can only, again, be having opinions, can’t we? And it’s that which underlines the true value of GDP as a tool. We can calculate it, yes, but also that we do so from entirely objective numbers. There is no opinion making that goes into it. That’s what makes it useful.

And, as it happens, for all its above faults, it is an objective measure of something useful and important too. It is the value added in the economy. And if we want to solve problems, it is value we have to apply to those solutions.

Thus, an increase in the value produced in the economy is an addition to our capacity to solve problems. Yes, it,s entirely true that GDP doesn’t tell us how many problems we’ve solved. But as long as we recognize it for what it is, simply that measure of value added, it works just fine.

If we want to measure progress on other issues then why not? in fact, we should. But that’s to use other measures in addition, not to get rid of GDP as one.

Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.