By Ayan Banerjee
Ever since GDP was adopted as the main metric of wealth during the 1944 Bretton Woods conference, it has been used as an indicator of growth. However, many economists argue that it fails to capture a significant range of important factors that contribute to a country’s wealth. Wealth has a wide range of definitions depending on the discipline but is consistently agreed upon to include anything of value. The frequent publishing of GDP figures hugely influences the health of an economy through informing international trade, investment, political and financial decisions. Therefore, it is vital to have an accurate measuring system otherwise it could have far-reaching economic consequences. Here we'll have a look into the flaws of GDP, why it has been widely criticised, its alternative measures and their effectiveness and finally determine which of these is the best substitution for GDP.
GDP or Gross Domestic Product is the most widely used indicator of wealth in the world. To ensure that its calculation is carried out fairly across countries to allow comparison, a System of National Accounts (SNA) is used to analyse statistics. Although it aims to allow comparisons by formalising markets and extending accounting, it fails to capture numerous aspects of a country’s economy. The SNA often creates miscalculations resulting from causes such as the exclusion of non-market transactions; the failure to account for inequality, the sustainability of growth, environmental and health externalities and also through considering the replacement of depreciated capital as introducing new capital. An example of this is that mass deforestation would contribute to GDP growth due to the introduction of timber but doesn’t account for the environmental and social effects of losing forests. Its many flaws and failure to capture several aspects of wealth incentivise the search for more suitable alternatives.
One alternative is the Fordham Index of Social Health (FISH). Formed in 1987 by the Fordham Institute for Innovation in Social Policy as an indicator for ‘social well-being,’ its premise is that the index is based on the combined effect of numerous social factors and issues. These issues are spread across four stages of life: childhood, youth, adulthood and old age. 16 indicators are identified including infant mortality, housing and income inequality. These can capture the overall effect of how some areas have improved and others worsened over time. For example, infant mortality has improved whereas child poverty has worsened since 1970 in the US. By considering a wider range of social factors, the FISH can capture a better picture of changes in wealth. The FISH index has decreased in the US whilst GDP has grown illustrating the potential discrepancies.
Another substitute is the Genuine Progress Indicator (GPI) outlined in 1994. Designed to involve aspects missed by GDP to better represent the well-being of a nation, it involves aspects of the environment and social factors such as poverty rate. Considered to be a great improvement over GDP by most environmental economists, it places more emphasis on the functions of communities and households. Most notably, the replacement of these functions would not be considered as growth as it would be using GDP. Like FISH, GPI uses numerous socio-economic factors such as crime rate but also considers environmental factors such as pollution and more abstract unquantifiable socio-economic factors such as ‘family breakdown’. The total of 18 indicators thus provides a fuller picture by adding environmental factors and using more complex socio-economic measures. However, there are still some drawbacks; GPI fails to measure a few other key influential factors such as human capital, diversity and lifestyle-related diseases. Overall, GPI improves over FISH by increasing the range of indicators and considering more pertinent environmental factors. However, still suffers drawbacks by excluding several important metrics.
Another indicator formulated to replace GDP is the Gross Sustainable Development Product (GSDP). Defined as the total value of production within a region over time, it uses GDP as a foundation but builds upon it by measuring the costs of development and growth to society. This is quantified through the analysis of the prices of goods and services in markets within a country. Furthermore, it also considers the impact on people activity due to environment, resource availability and development; biodiversity and environmental effects as well as the impact on future generations. The main aim of this metric is representing the concerns around sustainability. Ever since the beginning of our current modern growth epoch in the 1870s, there has been a constant evaluation of how sustainable our growth can be. GSDP aids with this whilst also capturing some environmental and social factors. However, this metric fails to consider as large a range of social and environmental changes as GPI achieves, therefore, unlikely to fully represent a nation’s wealth.
The final alternative this article will explore is Gross Environmental Sustainable Development Index (GESDI). Used to measure the quality of growth and development over its quantity, it involves over 200 indicators spread across four areas. The first main one being people and their social, economic, psychological, physical and spiritual aspects. The others being available resources, environment and economic development. This metric builds upon GSDP by also considering a far wider range of more holistic measures and in-turn, capturing far more non-monetary measures.
An effective indicator of wealth needs to capture an extremely wide range socio-economic, environmental and intangible factors. Most recently, there has been a shift in economics to consider peoples’ well-being constituting wealth rather than their material possessions. These alternatives outlined above illustrate this shift by building upon GDP and capturing more non-metric factors that make up most aspects of peoples’ wealth. The most effective at these are GESDI, GPI and FISH as GSDP still suffers from too many of the limitations that GDP experiences. Out of these three remaining indexes, I believe GESDI is the most effective alternative. This is because FISH does not capture enough aspects of the environment as its importance wasn’t as well known when it was first formulated in the 1980s. Furthermore, GPI lags behind GESDI in the number of indicators used which help provide GESDI with a far more detailed picture of a nation’s wealth.
GDP has many drawbacks that contribute to its inability to act as an indicator of wealth. Alternative indicators aim to capture the more intangible aspects of wealth found in social and environmental areas. The most effective of these being GESDI which uses over 200 indicators to form a far more detailed picture of nations' wealth. This indicator could be used to measure and compare countries’ wealth growth more fairly. It is also a better indicator of an elected political party’s success over their elected period. Over time, economists are outlining increasingly accurate measures of wealth. Despite these continuous incremental improvements, we also need to decide on an effective measure for semi-long-term use, so that countries can allocate resources knowing that their expected benefits would still be observed in future published results. In spite of all this, decision-makers need to also consider the monetary and time cost of calculating a chosen metric. High costs of calculation may encourage short-cutting and miscalculations, all of which makes an alternative’s benefits redundant.
By Adam Perkins, Ayan Banerjee
Up to this point mainstream economic thought has been divided in three eras. Starting with the publication of the General Theory in 1936, the Keynesian era saw the economy being perceived as a beast that needed to be tamed with state intervention, as opposed to a self-correcting organism. Stagflation in the 1970s dismantled Keynesian theory, with high inflation and low growth revealing flaws in the paradigm. Milton Freidman’s monetarism took its place and provided solutions to problems Keynesianism could not explain. By the 2000s economists were drawing on a synthesis of Keynesian and Monetarist princples to answer policy questions. This period is also marked by central bank independence and flexible inflation targeting. Coronavirus presents another threat that will inevitably disrupt conventional economic policy. Traditional policy was already looking tired pre-corona. 2010s recovery was notoriously slow and both inflation and unemployment were inexplicably low. Two concerns that conventional economic wisdom had no answer for. Furthermore, monetary policy was facing the issue that rate of interest needed to generate enough demand was below zero or ‘reaching the zero-lower bound’. Quantitative easing (QE) was the solution to this, but its efficacy and viability as a long-term option are both in question. By far the biggest problem policymakers face is distribution. Many argued that the maldistribution of income was the root of stagnant economic growth. Pointing out that the rich have a higher marginal propensity to save and therefore as their share of income grows so will national saving. Simultaneously, Antitrust policy is in upheaval with the dominance of tech giants prompting a rethink. This made the standard economic paradigm increasingly fragile throughout the 2010s, so it shouldn’t be surprising that a once in a lifetime type event like coronavirus created the urgent need for a change in economic policy strategy. The virus created issues such as disrupted supply chains causing a price level surge and a sharp decrease in aggregate investment. Most concerning was that the job losses were not only significant in number but mainly focused on the hospitality sector where women, minorities and low skilled workers are overrepresented. Therefore, this crisis was unique in that the poorest in society were being affected the worst. This created a sense of urgency amongst policymakers and economists alike to find a new approach.
Modern Economists attitude to recovery policy can be sorted in three groups from most to least radical. Firstly, there are those that believe that monetary policy alone has enough firepower to reliably stimulate the economy. Many economists, including Ben Bernanke, state there is enough scope for further asset purchases and that consequently monetary policy alone would be sufficent to fight a recession. However, nowadays many doubt that asset purchases have the reach to deliver unlimited stimulus. Leading us to the second school, who believe that budget deficits and fiscal stimulus are a more effective way to recovery. The more radical members of this group believe that central banks should act as enablers of public debt by allowing for cheap public borrowing. This idea is being pushed (particularly by Adair Turner former regulator) as a mainstream policy termed ‘helicopter money’. In traditional economic theory running such a high and prolonged deficit would cause serious public debt issues. But with this new attitude, relying on central banks to backstop debt, high public debts become a less signifcant problem. This does challenge the idea of central bank independence and may compromise inflation targeting. Furthermore, the success of fiscal stimulus is almost completely dependent on how well it is targeted as too extensive a package could keep business’s alive that are meant to fail. Therefore, this route is effective in theory but is at the mercy of how it is executed.
What both of these approaches have in common is that they leave a bill to be paid in the future and have both been explored before. This combined with the aforementioned ‘urgency to find a new approach’ has led to the exploration of an approach that 10-15 years ago would’ve been considered very radical. Negative interest rates. Not that negative interest rates have never been considered and are even in place in some countries (Switzerland’s current bank rate is -0.75%) but they are still considered fringe by the mainstream. The notion of a negative bank rate is gradually becoming more appealing as the global public debt crisis grows. Furthermore, central banks extensive use of QE over the last decade has somewhat immobilized them as they cannot raise rates without paying interest on the ‘huge bill parked on it’ (The Economist, 2020). The classic criticism of negative interest rates is that customers will simply withdraw all their money and hide them under mattresses. Although this is still valid, the movement towards a cashless society means this problem is much closer to being solved now than it ever has been. One suggestion is to eliminate large denomination notes making storing large quantities of cash impractical. This kind of reform would need to sweeping as it the bank rate takes too long to transmit to real rates it will be ineffective. The proponents of negative interest rates say that experimental rates such as Switzerland’s are not radical enough and that negative rates of -3% are what is needed for benefit to be felt.
This does however bring into question the reversal interest rate.
This is the point at which rates become so low they actually deter lending and are therefore counter-intuitive to growth. The reversal rate is dependent on a number of factors such as strictness of capital constraints and bank holdings, so an actual figure is not known. One thing that is known QE use raises the reversal rate which does not bode well for the current economy. It is entirely possible that a more aggressive negative rate such as -3% could very well surpass the reversal rate and cause the policy to be counter-productive but this is not a certainty. One thing that is certain is that a change of perspective is needed. Inequality issues will only be exacerbated as dominant incumbent companies increase automation and workers bargaining power is diminished. Public debt is already at an all-time high and QE is showing its limitations. Perhaps negative interest rates are the new shiny weapon policymakers are looking for.