By Diane Coyle, Managing Director of Enlightenment Economics. Originally published at VoxEU.
The debate about how best to measure economic activity dates back to well before the ‘invention’ of GDP by Richard Stone and others during the Second World War (Stone 1947). The earliest attempt was William Petty’s 1665 estimate of income and expenditure in England and Wales, followed by a variety of other approaches in the 18th and 19th centuries. By the 1930s, partly in response to the demand from policymakers for a better handle on what was happening in the economy, the current approach to national income was taking shape (Coyle 2014).
One of the key questions debated in the 1930s concerned the aim of a single headline indicator of the economy as a whole. Should it measure social welfare, or should it instead just measure the level of activity? Simon Kuznets, often misleadingly described as the father of GDP, argued in favour of the former, but the needs of wartime production settled the debate in favour of an activity measure: GDP.
Economists have always been aware that GDP does not measure welfare, but in practice its growth has come to be widely used as the general litmus test for the health of the economy, both in the economic literature and in the media and public policy debate. So it is not surprising that the tension between measuring welfare and measuring economic growth has re-emerged several times over the decades since World War II. James Tobin and William Nordhaus argued in 1972 that maximising the growth of GNP (more commonly used then) was not a proper objective for economic policy (Nordhaus and Tobin 1972). They proposed a Measure of Economic Welfare in its place.
Subsequently others have suggested a number of alternative measures. One of the best-known is the Index of Sustainable Economic Welfare, proposed by Herman Daly and John Cobb in 1989, and its successor the Genuine Progress Indicator (Daly and Cobb 1989). This subtracts a range of ‘costs’ from GDP, including resource depletion, pollution, and the costs of crime, commuting, and unemployment. By definition, growth in the GPI (or similar indices) is lower than GDP growth.
However, one flaw of the single alternative indicators is that they all omit positive contributions to welfare that are not captured in the GDP statistics either. Despite the use of hedonic price indices to capture some of the quality improvements in a range of goods such as computers or housing, GDP understates – probably to a large degree – the increases in consumer welfare due to quality improvements, new goods, and increased choice. Even apparently trivial innovations such as a novel flavour of breakfast cereal seem to have led to large gains in consumer welfare (Hausman 1996).
A further flaw is that the alternatives to GDP obscure the conceptual distinction between activity and welfare, and all involve an implicit weighting of the different dimensions of welfare. For some purposes – macroeconomic policy for one – an activity indicator is essential. What’s more, the prominent alternative indices do not all rest equally firmly (if at all) on an explicit theory of social welfare; for example, the components of the GPI and the components of the widely-used Human Development Index differ greatly because of the choice of component indicators. Finally, a single welfare indicator obscures unavoidable trade-offs between components. The most obvious trade-off is that between income and what is often called ‘work-life balance’, or in other words the amount of leisure.
For these reasons, dashboards of indicators have much to recommend them as ways of monitoring social welfare, although these are relatively new. One example is the OECD’s Better Life Index. Another is the annual publication Measures of Australia’s Progress. The trade-offs are explicit in a dashboard, and individuals can place their own preferred weights to different sub-indicators in assessing progress.
The other issue obscured by proposed alternatives to GDP is the question of sustainability. Although this is clearly a contributor to social welfare, combining sustainability indicators into a single index along with indicators of current activity and welfare obscures another important set of trade-offs made between present and future consumption. GDP itself has this flaw, making no distinction in the aggregate measure between current consumption and investment. But it is impossible to assess sustainability without making a number of assumptions about the future: what is growth in the interim likely to be? What might be the possible technological innovations? How might people’s behaviour change in response to changing prices, technology and incomes?
Given the uncertainty about these questions, a partial indication of sustainability is given by the current change in net national product, which has the advantage of being derivable from currently available statistics. However, it omits some crucial aspects of sustainability, notably natural assets. We are a long way from having a readily available set of statistics on the changes in national wealth in its widest sense, and it is hard to see how public debate about sustainability can advance without more work in this area.
As a measure of economic activity, which is all it was ever intended to be, GDP is imperfect, but no more so than any single indicator of the whole economy. However, public policy debate about the economy is often focused on GDP growth to the exclusion of questions of social welfare and sustainability. This is unlikely to change until there are equally convenient and regular statistics, so the calls for alternatives to GDP are understandable. Many of the proposed alternatives to date have significant flaws, although dashboards look more promising. Statisticians have a lot of work to do.
Diane Coyle runs the consultancy Enlightenment Economics and has been appointed a Professor of Economics at the University of Manchester.
Stone, R (1947), Definition and Measurement of the National Income and Related Totals.
Coyle, D (2014), GDP: A Brief but Affectionate History, Princeton University Press.
Is Growth Obsolete? by William D Nordhaus & James Tobin in Economic Research: Retrospect and Prospect Vol 5: Economic Growth, Editors William D. Nordhaus and James Tobin, NBER.
Daly, H & J Cobb (1989), For the Common Good, Beacon Press, Boston.
Hausman, J A (1996), “Valuation of New Goods under Perfect and Imperfect Competition“, in Timothy F. Bresnahan and Robert J Gordon (eds.) The Economics of New Goods, University of Chicago Press.