The April 30 issue of The Economist includes a special briefing on The Prosperity Puzzle. The briefing highlights how tricky it is to compare living standards across countries, across economic classes within a country, and, - arguably hardest of all, - across time.
“Which would you prefer to be: a medieval monarch or a modern office-worker?,” it glibly asks. “The king has armies of servants. He wears the finest silks and eats the richest foods. But he is also a martyr to toothache. He is prone to fatal infections. It takes him a week by carriage to travel between palaces. And he is tired of listening to the same jesters. Life as a 21st-century office drone looks more appealing once you think about modern dentistry, antibiotics, air travel, smartphones and YouTube.”
The point is further illustrated by referencing the research of Yale economist William Nordhaus. In the mid 1990s, Nordhaus looked at the evolution of the price of light over the past two centuries in Do Real-Output and Real-Wage Measures Capture Reality? The History of Lighting Suggests Not.
He first calculated the price of light by adding up the prices of the things people bought over the years to make light, - from candles in 1800 to compact fluorescent light bulbs in 1992. This is the traditional way that prices are calculated using GDP, - “a measure of the value of all final goods and services produced in a period (quarterly or yearly).” By this GDP-like measure, the price of light rose by a factor of between three and five over the past two centuries. Next he calculated the change in the true price of light, by estimating the price in cents per lumen-hours, a measure that would quantify the considerable innovations in generating light over the same time period. By this measure, the true price of light has plummeted by considerably more than a hundredfold since the early 1800s.
Nordhaus’ research implies that the true price of light “has been underestimated by a factor of between nine hundred and sixteen hundred since the beginning of the industrial age. If the case of light is representative of those products that have caused tectonic shifts in output and consumption, then this raises the question of whether the conventional measures of real-output and real-wage growth over the last two centuries come close to capturing the true growth.”
According to The Economist, not only is GDP a poor measure of material well-being and prosperity, but it’s not even a reliable gauge of production. Our heavy reliance on such a deeply flawed measure may account for our prosperity puzzle, “distorting levels of anxiety in the rich world about everything from stagnant incomes to disappointing productivity growth.”
GDP was first developed in the 1930s at the request of the US Congress to quantify the full economic impact of the Depression. In the 1940s it was used in the US and the UK to help estimate their economies’ capacities to make guns, tanks, airplanes and everything necessary for the second world war. Since then, GDP has become the key measure of a country’s production capacity, while GDP per capita is generally viewed as an indicator of a country’s standard of living.
Most measures of economic performance used by government officials to inform their policies and decisions are based on GDP figures, including setting taxes, fixing unemployment and managing inflation. But, many concerns have been raised about the adequacy of GDP-based measurements given the major structural changes that economies around the world have been experiencing over the past few decades.
GDP does not adequately capture the growing share of services and complex system infrastructures that characterize advanced economies. In the 1950s, the industrial sector made up more that a third of GDP, and the service sector was a bit over 50% in the US and the UK. Today, services account for close to 80% of of their economies, while manufacturing has significantly declined.
GDP is a relic of a time dominated by manufacturing, where the production of physical goods was easier to measure. But it’s a less reliable measure of services, where there is much more variation in quality and value. Services are increasingly tailored to individual tastes, with user experience being a growing portion of the value of a service, - be it a meal in a restaurant or an online purchase.
This is a particular concern in our increasing digital economy. How do you measure the value of the explosive amount of free goods available over the Internet, including Wikipedia articles, Facebook social interactions, Linux open source software and You Tube videos? Since all these services are free, they are excluded from GDP. In addition, many new services we used to pay for are now also free, including long-distance calls, newspaper articles, maps and recorded music.
“We know less about the sources of value in the economy than we did 25 years ago,” wrote economists Erik Brynjolfsson and Adam Saunders in a 2009 article. “We see the influence of the information age everywhere, except in the GDP statistics. More people than ever are using Wikipedia, Facebook, Craigslist, Pandora, Hulu and Google. Thousands of new information goods and services are introduced each year. Yet, according to the official GDP statistics, the information sector (software, publishing, motion picture and sound recording, broadcasting, telecom, and information and data processing services) is about the same share of the economy as it was 25 years ago - about 4%. How is this possible? Don’t we have access to more information than ever before?”
Moreover, GDP does not reflect important economic activity beyond production, such as income, consumption and living standards. A few years ago, a Commission on the Measurement of Economic Performance and Social Progress, - led by Nobel-prize winning economists Joseph Stiglitz and Amartya Sen, - was convened to look at the limits of GDP as an indicator of economic performance and social progress.
“What we measure affects what we do; and if our measurements are flawed, decisions may be distorted…” it noted in its report issued in September, 2009. “So too, we often draw inferences about what are good policies by looking at what policies have promoted economic growth; but if our metrics of performance are flawed, so too may be the inferences that we draw.”
The Commission recommended measuring economic activity beyond GDP, looking at income and consumption rather than production because they more closely reflect economic well being, that is, how well off people are. To better track living standards, it called for tracking household income and consumption in addition to aggregated measure of the economy, as well as measuring not just the averages, but also the distribution of income, consumption and wealth. It also called for factoring in measurements of sustainability to help reflect the evolution of the economy into the future.
“Quality of life depends on people’s objective conditions and capabilities,” noted the report. “Steps should be taken to improve measures of people’s health, education, personal activities and environmental conditions. In particular, substantial effort should be devoted to developing and implementing robust, reliable measures of social connections, political voice, and insecurity that can be shown to predict life satisfaction.”
According to The Economist, measuring prosperity better calls for three key changes:
- Improve GDP as a gauge of production. “Junking it altogether is no answer: GDP’s enduring appeal is that it offers, or seems to, a summary statistic that tells people how well an economy is doing. Instead, statisticians should improve how GDP data are collected and presented… they should rely more on tax records, internet searches and other troves of contemporaneous statistics, such as credit-card transactions, than on the standard surveys of businesses or consumers.”
- Pioneer a new, broader annual measure, that would aim to capture production and living standards more accurately. This is particularly important in services-dominated advanced economies. “This new metric - call it GDP-plus - would begin with a long-overdue conceptual change: the inclusion in GDP of unpaid work in the home, such as caring for relatives. GDP-plus would also measure changes in the quality of services by, for instance, recognising increased longevity in estimates of health care’s output. It would also take greater account of the benefits of brand-new products and of increased choice.”
- Take stock of a country’s overall prosperity and wealth each decade. “This balance-sheet would include government assets such as roads and parks as well as private wealth. Intangible capital - skills, brands, designs, scientific ideas and online networks - would all be valued. The ledger should also account for the depletion of capital: the wear-and-tear of machinery, the deterioration of roads and public spaces, and damage to the environment.”
“Building these benchmarks will demand a revolution in national statistical agencies as bold as the one that created GDP in the first place,” notes The Economist in conclusion. “Even then, since so much of what people value is a matter of judgment, no reckoning can be perfect. But the current measurement of prosperity is riddled with errors and omissions. Better to embrace a new approach than to ignore the progress that pervades modern life.”