GDP up, good; GDP down, bad? Not so simple, especially when assessing progress in terms of citizens’ wellbeing. A growing number of alternative measures aim to fill that gap, but none can entirely replace GDP, writes our columnist – and in any case, the real issue lies deeper...
First published by Pioneers Post
As US presidential candidate Robert Kennedy put it in his election speech, “it [GDP] measures everything in short, except that which makes life worthwhile”.
Kennedy made that statement back in 1968. More recently, the argument that gross domestic product, the shorthand measure for the health of our economy, is a flawed way of measuring changes in a society’s wellbeing, has been gaining ground. Not that we have stopped using GDP – but something is clearly not working if GDP is rising at the same time as climate change is bringing us to the edge of meltdown.
The main criticisms of GDP are that it misses things out and that it is not a good way to measure progress. What is needed is a way to measure quality of life, so that we can make decisions to improve it. As an example of missing things out, if I pay you to provide childcare for my children and you pay me to provide childcare for your children, we are adding to GDP. If we look after our own children, we do not. No economic transaction, no GDP effect. As an example of its flaws in measuring progress, average life expectancy in Cuba is similar to the United States, despite the large difference in GDP per head.
Those responsible for calculating GDP point out that it is not intended to be a measure of social wellbeing. Which is true up to a point. GDP is a measure of economic activity – but this relates to financial transactions between households, organisations and government. Unfortunately, in the absence of anything else it keeps getting used as a proxy for social wellbeing. GDP up = good. GDP down = bad.
But why do we measure economic activity? The UK’s Office for National Statistics’ own explanation states that “GDP is the standard measure of the size and health of a country’s economy. It’s the way we measure and compare how well or badly countries are doing”.
What is the point of a healthy economy if not to create value for the people that live in that economy?
A standard measure of the health of an economy, of how well a country is doing. But what is the point of a healthy economy if not to create value for the people that live in that economy? What does ‘doing well’ mean, if not improving wellbeing?
Economic activity is therefore being used as a proxy for wellbeing. It would be possible to argue that it is not intended to be a complete measure and only relates to wellbeing that arises from financial transactions. But this would just push the problem down the line. If the point of measurement is to inform decisions to increase wellbeing and the information being used is both a proxy and incomplete, then the risk of making decisions that are wrong is significant. Especially if GDP is seen as a way of measuring how well or badly countries are doing in reference to their citizens’ wellbeing.
There are a growing number of alternatives, for example:
Human Development Index (HDI)
Genuine Progress Indicator (GPI)
Thriving Places Index (TPI)
Green GDP
Better Life Index (BLI)
Inclusive Wealth Index (IWI)
Social Progress Index (SPI)
Genuine Savings Indicator (GSI)
Happy Planet Index (HPI)
They take different approaches to the sources of the data they use, ranging from primary data to using existing or secondary sources. And they have many of the same issues as GDP since they also involve estimation and may be incomplete from the perspective of others. It is easy to forget or perhaps not realise that the calculation of GDP draws on primary data on a country’s economic transactions. That process requires significant resources, both financial and from statisticians and economists; it sits alongside an international system for national accounting with internationally agreed concepts, definitions, classifications and accounting rules. Whatever the pros and cons of this system, and the pros and cons of these alternatives, this is not likely to change anytime soon. And so the best that can be expected of alternatives is that they sit alongside GDP and that policy and public investment decisions will be informed by both.
GDP alternatives are solutions at the wrong end of the pipe
But they are solutions at the wrong end of the pipe. The solution is to fix the data going into the pipe and that means fixing financial accounting. To see why this is the case means having a closer look at how GDP is estimated and what data it relies on.
GDP can be estimated in three ways:
the sum of all production activity within the economy (the production approach), as estimated using gross value added (GVA);
the sum of all final expenditures within the economy (the expenditure approach); and / or
the sum of all income generated by production within the economy (the income approach), again, as estimated using GVA.
These are not three different versions of GDP, just three different ways of estimating the same thing.
Three ways to estimate GDP
The production approach
Gross value added (GVA) is the sum of all output, less costs of intermediate inputs, or, in national accounts terms, intermediate consumption. There are two main types of output: that produced for the market (mainly by corporations) and services not for market sale (mainly by government and non-profit institutions serving households, or NPISH). These two types of output are valued differently. Intermediate consumption is defined as all goods and services used up or transformed in a process of production. This includes raw materials, power and fuel, rental on buildings and business services such as advertising, recruitment consultancy and cleaning. It specifically excludes staff costs and capital investment which are handled elsewhere in the accounts.
The expenditure approach
The income approach
The production approach
Gross value added (GVA) is the sum of all output, less costs of intermediate inputs, or, in national accounts terms, intermediate consumption. There are two main types of output: that produced for the market (mainly by corporations) and services not for market sale (mainly by government and non-profit institutions serving households, or NPISH).
These two types of output are valued differently. Intermediate consumption is defined as all goods and services used up or transformed in a process of production. This includes raw materials, power and fuel, rental on buildings and business services such as advertising, recruitment consultancy and cleaning. It specifically excludes staff costs and capital investment which are handled elsewhere in the accounts.
The expenditure approach
The expenditure approach, or GDP (E), is the sum of all final expenditures within the economy, that is, all expenditure on goods and services which are not used up or transformed in a productive process. In other words, GDP is equal to household (and NPISH) final consumption expenditure plus general government final consumption expenditure plus gross capital formation plus exports less imports. Imports are deducted because GDP refers to goods and services produced within the UK economy and the other components will include items produced elsewhere.
The income approach
The income approach, GDP (I), totals all income generated by production activity, also known as factor incomes. In other words, GVA (I) is equal to the sum of employment income (compensation of employees), self-employment income (mixed income) and profits (gross operating surplus).
Source: Office for National Statistics
All these depend on information on income or on expenditure. But where does this come from? Income comes from the price of a unit sold and the number of units. It is set to be more than costs. Costs come from the costs that an organisation has to meet to acquire the goods and services necessary to produce the units sold. And all this information comes from a set of accounts.
As usual the role of accounting in all this is either ignored, forgotten or not recognised. All these approaches depend on financial accounting. Financial accounting is the bedrock for national accounting and for estimates of GDP, and yet financial accounting is not a science. It’s a social construct.
Financial accounting is the bedrock for GDP estimates, yet financial accounting is not a science. It’s a social construct
Fix accounting to fix GDP
Perhaps the problem isn’t entirely GDP.
GDP depends in large part on the values generated by financial accounting. If we were to change the basis of financial accounting we would change relative prices, the demand for the production and consumption of resources, and the level of GDP being reported.
GDP measures are complex, well-resourced estimates of a consistent approach to production, consumption and income with a long history of both theory and practice. If it is possible the change the underlying data, then the existing infrastructure for calculating GDP could be retained without additional costs or challenges.
Why doesn’t financial accounting account for the things that are missing in GDP?
On first glance, accounting seems simple enough. The costs that are included are the costs of the resources used in creating goods and services, and the value is the price paid for those resources.
However, the decision as to which resources have been used in creating goods and services is actually far from simple. If resources are used that have not been traded then the cost isn’t included, for example, household labour costs where businesses depend on someone somewhere providing these services for free. And if costs have been incurred by other people that a business is not required to compensate then they are not included, for example, the costs incurred by people suffering the effects of climate change.
If they are not in the financial accounts, they won’t be in GDP. But why are they not in the accounts?
The requirement for financial accounts – which are statements of what costs have been included in producing goods and services – is set by legislation and is a matter of public policy. The basis for deciding what should be included is also a matter of public policy and has become the common basis for international standards. The current requirement is to include information that would be useful for investors in making decisions to provide resources to an entity in the expectation of financial returns. The prevalence of this approach to accounting means we have lost sight of the alternatives and of society’s role in deciding which alternative we should use.
In deciding what information is required by investors to make economic decisions, accounting practice over the last nearly 200 years has had to standardise the answer to this question. Accountants don’t go out to all current and potential investors and ask them what information they personally would want; they make an assumption that most investors want the same thing and standardise around that.
Changing financial accounting
So rather than adding new measures, if we can go back to basics and change the basis on which cost is determined, what is being included and how whatever is included is valued, this would change prices. This needs some consideration of what is meant by resources that are being used. If the decision on what to include also factored in the effects on people’s wellbeing and on what are sometimes referred to as externalities, and included the resources on which an enterprise depends, then many of the concerns with GDP would be addressed.
Traditional economics suggests that self-interest is the basis of social value. As Adam Smith wrote in The Wealth of Nations, “By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”
We have lost sight of the alternatives and of society’s role in deciding which alternative we should use
This idea, that self-interest is the best way to help society and create value, is a founding principle of our current world economic system and of liberal economics. Although this is increasingly being questioned as the basis for economic policy, it is still at the heart of the type of accounting that is used all over the world.
Even Adam Smith realised this wouldn’t be the basis for an economic system. He also said, in The Theory of Moral Sentiments, “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.”
What would happen if the basis of accounting was changed?
Investors would actually get the information they need. Businesses would make provisions on their balance sheet for negative impacts and set up deferred assets for positive impacts. A business that had net negative environmental impact would have fewer reserves that could be distributed to shareholders. For some business models the costs would go up, and therefore the prices for its products would have to go up.
One advantage of this approach is that the business would not be asked to directly pay for its impacts. The cost of capital for businesses with higher environmental impacts would increase. Investors still seeking to maximise income, though now within constraint, would move investment to businesses that had net positive impacts and lower levels of dependency.
Some business models would no longer be viable. The increase in prices would not be met by customers. But entrepreneurs would start new businesses responding to a different set of possibilities.
The issue is whether there would be political will to change the requirements for reporting
The net effect of these changes would be to change relative prices. Costs and prices would go up and now be reflected in GDP, within the existing infrastructure for calculating GDP. Where businesses closed as a result of increased costs, GDP would go down.
It wouldn’t be possible to predetermine what these new patterns would look like or the effect on GDP. Certainly the change in basis would have implications for comparability and international comparisons. It may need to be a step-by-step approach.
Is it possible?
The big step would be including this information in financial accounts, and not merely as separate and additional information. This should be a matter for public policy and for investors. No one has asked investors, individual members of pension funds or individuals whose investments are held in trusts or managed by fund managers what they would want to have included in accounts. Accountants would be among those consulted on technical feasibility. The issue is whether there would be political will to change the requirements for reporting and be more specific about the motivation of investors as the basis for financial accounting.
It is time for society to think about the purpose of financial accounting and to recognise its role in deciding what this should be. Changing the basis for financial accounting would be a simple bottom-up solution to pricing in externalities and changing demand, production and investments. In other words, a simple solution to changing GDP. The practical application of this solution may be more complex, but there is a growing body of work that shows this is possible. And certainly necessary.
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