25 April 2017

The trouble with GDP


The key claim of free-market capitalism is that it makes us all richer over time. If it doesn’t, there’s not much point to it. So, logically enough, people ask: well, where’s all that getting richer then? Because if we look at GDP, at wages adjusted for inflation and so on, then we don’t seem to be getting much richer. Median incomes in the US, for example, are said to have stagnated for 40 years now. So, Whassup?

What’s up is that we’re badly  measuring the economy – so badly as to be doing it the wrong way. We should not be using GDP as the sole determinant of how well we’re doing and the two major reasons we shouldn’t are not those usually talked about.

We usually hear how it doesn’t measure pollution, doesn’t measure the distribution of incomes, takes no account of unpaid work in the household; these are all perfectly reasonable critiques. But GDP doesn’t really tell us how well we’re doing when it tells us how rich we are.

The first reason it doesn’t is because we’re not measuring inflation properly. Any of us rich in maturity can look around the world and see that everyone’s vastly richer today, in our dotage, than they were in our early years.

But that’s not something that really comes through in the economic numbers. And a new paper, by Bruce Sacerdote, tells us why. Those low end American wages apparently haven’t improved after we account for inflation. Yet American low earners have twice as many cars as they used to, more bedrooms for smaller families and so on.

It’s our inflation adjustment that is wrong. For, of course, we’re not all that interested in how well people are doing in nominal money, we want to know what their real incomes are, how are their living standards changing – not how many notes they have in their wallets.

This latest paper, though, is just another confirmation of something we’ve known for a long time. The CPI overstates inflation – and thus understates how quickly real incomes are rising. We even know the cause, or at least a major part of it. We measure inflation using a basket of goods and services. What does the average person buy, we check how those prices are changing, average them and that’s the inflation rate.

But new products usually start out being available only to the rich. Then they decline in price and only then do they start turning up in the shopping baskets of Mr and Mrs You and Me, the average. Since our inflation rate is driven by what we buy the major price declines of these new things never make it into the inflation numbers.

A smartphone wasn’t in that inflation basket when Apple was the only game in town, we all started buying them en masse only after they had halved, quartered, in price from there. The same was true of ABS turning up first on executive saloons, of the mobile phone itself 35 years ago and so on. Of course the ONS and others do the best they can but the current estimate is that inflation is overstated by 1 per cent a year. Or real income rises understated by it of course.

The second problem is that, as Google’s Hal Varian points out: “GDP has a very hard time with free.” Because GDP only records transactions at market prices it’s completely silent on what we might be getting for free.

The value of Google’s search engine in the national accounts is the advertising it sells, the same with Facebook. Or as Mark Perry has just pointed out, the rise on streaming music is supposed to have made us poorer. US music spending declined from $20.9 billion in 1999 to $7.57 billion last year. GDP accounting says we’re poorer from this. Everyone else says getting the near entirety of accumulated recorded music online for perhaps $10 a month makes us richer. And everyone is right here, not GDP.

Just to show quite how odd this is, consider WhatsApp. For a while it carried no ads and had no price at all. GDP can be calculated as either income, or production, or consumption, all at market prices. Because no one was paying, even indirectly, the app appeared as a nice round $0 in both production and consumption versions of GDP. There would be a bit in the income part, as the engineers were being paid. That this was the case, and yet there was nothing in the other two versions, turns up as a fall in productivity.

So, conventional national accounts would show that WhatsApp increases living standards not at all and also reduces productivity levels. At the same time as 800 million people are getting much of their telecoms needs for free, we’re made no richer?

GDP isn’t a good measure of the economy, those complaining have been entirely correct. But it’s not even a good method of telling us how rich we are. So we shouldn’t be using it as a measure of how well we’ve done over recent decades either, should we? For it’s obvious to our own eyes, and when properly adjusted GDP shows it once again, that we’ve all got much richer these recent decades. There has been no failure of that free market capitalism to deliver, we’re just not measuring it right.

Tim Worstall is senior fellow at the Adam Smith Institute