Rethinking GDP

• Author: Diane Coyle

Rethinking GDP Finance & Development, March 2017, Vol. 54, No. 1

Diane Coyle

It may be time to devise a new measure of economic welfare with fewer flaws

Why does economic growth matter? The answer for economists is that it measures an important component of social progress—namely, economic welfare, or how much benefit members of society get from the way resources are used and allocated. A look at GDP per capita over the long haul tells the story of innovation and escape from the Malthusian trap of improvement in living standards that is inevitably limited by population growth.

GDP growth is instrumentally important as well. It is closely correlated with the availability of jobs and income, which are in themselves vital to people’s standard of living and underpin their ability to achieve the kind of life they value (Sen 1999).

However, GDP is not a natural object, although it is now everyday shorthand for economic performance. It cannot be measured in any precise way, unlike phenomena in the physical world. Economists and statisticians understand, when they stop to think about it, that it is an imperfect measure of economic welfare, with well-known drawbacks. Indeed, early pioneers of national accounting, such as Simon Kuznets and Colin Clark, would have preferred to measure economic welfare. But GDP prevailed because the demands of wartime called for a measure of total activity. So from the very start, the concept of GDP has long had its critics. But coming up with a better gauge of welfare is easier said than done.

Short-term measureGDP measures the monetary value of final goods and services—that is, those that are bought by the final user—produced and consumed in a country in a given period of time. The limit of GDP as a measure of economic welfare is that it records, largely, monetary transactions at their market prices. This measure does not include, for example, environmental externalities such as pollution or damage to species, since nobody pays a price for them. Nor does it incorporate changes in the value of assets, such as the depletion of resources or loss of biodiversity: GDP does not net these off the flow of transactions during the period it covers.

The environmental price of economic growth is becoming clearer—and higher. The smog over Beijing or New Delhi, the impact of pollution on public health and productivity in any major city, and the costs of more frequent flooding for which countries are still ill-prepared are all illustrations of the gap between GDP growth and economic welfare. This is why economists and statisticians have been working to introduce estimates of natural capital and its rate of loss (World Bank 2016). When they do, it will be clear that sustainable GDP growth (that enables future generations to consume at least as much as people today) is lower than GDP growth recorded over many years. Getting these new measurements into the mainstream policy debate and reflected in political choices, however, is another matter.

Indeed, GDP ignores capital assets of all kinds, including infrastructure and human capital; it is an inherently short-term measure. Economic policies aimed at delivering growth have demonstrated the validity of the famous comment of their intellectual architect, John Maynard Keynes: “In the long run we are all dead.”

Seventy years on, the long run is upon us. A broad measure of the sustainability of economic growth, and thus long-term economic welfare, would take account of economic assets as well as the flows counted in GDP: the need to maintain infrastructure or record its depreciation as bridges crumble and roads develop potholes. A true national balance sheet would account for future financial liabilities, such as state pensions. It would also include increases in human capital as more people attain greater education and skill. Economic welfare must be calculated net of such...