Measuring the Economy with a Broken Ruler

The problem with many popular economic measures is that they are like the drunk looking for his key near the light-post. The measures are used because they are near the source of light (government data), not because they will help reveal what is happening.

The two biggest offenders are GDP and CPI (gross national product and consumer price index).

GDP measures economic activity without any regard to whether this activity is socially valuable or not. That's why we keep hearing about digging holes and filling them up as a way to provide stimulation. This is said in jest, but we really have many such programs in existence. Building useless, and redundant, military hardware (more F22's, new nuclear subs and aircraft carriers just being the most prominent right now) does not add to the social welfare. Favoring a "strong" military when the term is undefined and the goals shift allows for no measure of what is appropriate or sufficient.

Repairing the Gulf Coast also adds to the GDP, but when it is done we will have an area which is still blighted and the fixed capital will be worth less than before the storms. GDP doesn't reflect this. In fact the destruction from the storms shows up in no statistics because we don't have a measure of fixed capital. Companies keep track of the value of their plant and equipment and even use something called "good will" to reflect the value of their intellectual capital and brands. They then apply depreciation formulas to account for wear and tear. Why don't we do the same thing for the economy as a whole?

Then there is inflation. There have been many attempts to measure this more accurately, with things like hedonic adjustments being tried. This is an attempt to adjust for products getting "better" while the price stays the same or goes down. A modern computer may cost $1000, but is is much more powerful than a $1000 computer of five years ago, so by this measure it is "cheaper". But if one still has to lay out the $1000 is there "deflation"?

The current rapidly deflating asset bubble in housing and stocks was a form of inflation, but was not treated as such, except to the extent that inferred rents were considered. Most measures don't treat stocks as a factor in the market basket of purchases. The nominal value is treated when calculating people's net worth, however. This is illogical.

Then there is the issue of how to weight the market basket. Elizabeth Warren has shown that the proportion of household spending for services like education, health care and transportation has increased while the traditionally measured items like hard goods has declined. There have been adjustments to the market basket over time, but this has been highly imperfect. What inflation looks like to a young family with kids planning to go to college is much different than that for retirees on a fixed income and facing probable rising health costs.

Families have had to borrow to compensate for this unacknowledged inflation. Their net worth has decline or has been masked by the inflation in home values. But having higher debt and a variably valued asset is not the same as having no debt and a paid off home. There is a difference in risk which also doesn't show up in economic statistics.

Finally there is the use of spending as a percentage of GDP to measure future crises. Right now it is health care that is seen as being the biggest worry, but if GDP is a poor measure than using it as the denominator in a ratio is also misleading.

Along with the failure to measure capital investment there is a failure to account for the depletion of natural resources. The world has been eating its seed corn, in the form of fossil fuels and minerals, since the beginning of the industrial revolution. These can never be replaced, but their consumption is not accounted for in national or international balance sheets.

The biggest crisis in terms of the US federal budget is runaway militarism, which now accounts for 54% of discretionary spending. This is a much more accurate measure than using the percent of GDP. If half of the government spending is going to militarism then the rest of the needed services are being starved of funds, and there are just some things that only government can do. So no matter how big the GDP looks these functions will still be shortchanged.

In Europe the biggest crisis is the lack of a sustainable industrial and energy policy. The panics over fuel supplies from the east should have been a wakeup call, but apparently not yet. In Asia the biggest crisis is population growth, increasing use of raw materials with a rising standard of living, and the lack of any pollution policy

We need better measures of social health, such attempts as "gross national happiness" are novel, but still don't capture the complexity of the real world. Others like the Genuine Progress Indicator aren't widely noticed and thus have little policy impact.

If policy makers focus on maximizing the measures they have (like GDP) or minimizing the "bad" ones, like inflation, they will end up making bad policy. Perhaps the world could get by with some mistakes like this when it was mostly empty and still had lots of undeveloped resources. It is now full and resources are running short. There is no margin for error anymore.


Click here to see all my essays in context.

If you have any comments or for further discussions email me at robert.feinman@gmail.com
Copyright © 2009 Robert D Feinman
Feel free to use the ideas, but the words are mine.