Friday Chart(s): Economy contracts, slow growth persists. Does it matter?

THE Bureau of Economic Analysis released its second estimate of economic growth in the U.S. for the first quarter, revealing that GDP was down 1%.  This latest release comports with the anemic economic recovery as well as the decade and a half of tepid economic growth:

And of course, most of the responses both to the BEA’s release this morning as well as the longer trends suggest that this is bad for the U.S.  But is it?  To answer we need to understand how economic growth is measure.

Gross Domestic Product (GDP) is the standard measure of economic growth.  As Mijin Cha at Demos wrote:

GDP measures the output of goods and services produced by labor and property located within the U.S. during a given time period. It was developed in the 1930s as a way for policymakers to gauge the recovery from the Great Depression. Reported quarterly, GDP has become the metric economists and policymakers primarily look to for analyzing the health of our economy and setting economic policy. For instance, the White House and Congress use GDP numbers to prepare the federal budget, the federal reserve uses GDP to formulate monetary policy, and business interests look to GDP as an indicator of economic activity and performance.

While GDP serves as the standard measure of economic growth, it is also imperfect.  First, while GDP measures economic activity in the aggregate, it does not measure what that activity is.  So, for instance, GDP would measure economic activity similarly whether an economy produces $10 billion on infrastructure, or $10 billion on financial products.  Whether these goods or services are beneficial to society as a whole are not captured by the GDP statistic.  To further highlight the inability of GDP to measure the value (not price) of economic growth is a natural disaster such as hurricane.  The hurricane destroys buildings and property, which require reconstruction, which increases economic activity.  Lastly, the driver of consumption, and thus economic activity, is also hidden from GDP.  There is no decoupling economic activity spurred on by household debt vs economic activity spurred on by expenditure of incomes.  While the former is not sustainable, both will be measured equally by GDP.

Second, GDP does not account for all economic activity, and at times can indicate higher economic activity even though the same good or service is being provided.  As to the former, parents who stay home and care for their children in lieu of paying a daycare, growing their own food for self-consumption, or other tasks that do not require the exchange of money for goods or services are not counted.

Third, GDP does not measure the distribution of economic activity or wealth throughout an economy.  So, economic activity for an economy could drastically increase, as indicated by GDP, but the product of that activity (wealth) could accumulate with a minority while the wealth of the majority declines.   In short, GDP cannot measure income inequality.

Akin to the inability of GDP capture the distribution of income and wealth is the inability of GDP to capture social well-being.  For instance, the internet has resulted in an enormous amount of information available to users free of charge.  Because there isn’t a financial transaction occurring between the consumer and producer of the information (think, Wikipedia, WebMD, etc.), there is no economic activity to measure even though people are deriving a benefit from those services.  Recently, Ed Dolan wrote about the failings of GDP to measure social well-being and whether slowing economic growth is a problem:

The first point is that real GDP per capita, or per worker, is the wrong indicator. As DeLong puts it, “What we are really interested in is material well-being, what people want and need, and whether they actually obtain it. We are interested in material production as a springboard to human flourishing.”

The point is hardly original, but it is important. Let me show why by using data from the Social Progress Index (SPI), which is the latest and most ambitious effort to attach specific numbers to the concept of “human flourishing.” The SPI is especially appropriate for our purposes because it explicitly treats GDP as an input to human welfare and asks how well various economies transform raw GDP into outputs such as health, education, rights, and opportunities.

Our first chart plots GDP per capita against the SPI for two measures of GDP per capita, one stated in U.S. dollars at market exchange rates and the other  in dollars that are adjusted for purchasing power parity (PPP), using the newest data from the World Bank’s International Comparison Program. The PPP adjustment takes into account differences in the cost of living among countries, so we might expect PPP-adjusted GDP per capita to correlate more strongly with the SPI than GDP measured at market rates. In practice, though, the difference in fit is small. The point that represents the United States is close to the trend line for both measures.

Three features stand out.

  • First, the positive slope of the scatter plots shows that material production, as measured by GDP per capita, really is a springboard to human flourishing, as measured by the SPI. The overall correlation between the SPI and the log of GDP per capita is .88 for market exchange rates and 0.91 for purchasing power parity. The biggest outliers on the downside—wealthy countries with SPI scores far below the trendline—are Kuwait, the United Arab Emirates, and Saudi Arabia. (I discussed some possible reasons in an earlier post on the curse of riches.) The biggest outlier on the upside is New Zealand, which manages to achieve the top SPI score even though its PPP-adjusted real GDP per capita of $31,000 is only twenty-fourth in the world and just two-thirds that of the United States.
  • Second, the relationship of GDP to the SPI is far from linear. For poor countries, even modest gains in GDP have a big payoff in terms of the quality of life. As income increases, the curve flattens out. After reaching a GDP per capita of $25,000 measured by PPP, improvements in the SPI from further GDP growth alone are modest. (Portugal and Slovakia are just above the $25,000 line, Estonia and Russia just below it.)
  • Third, the relationship of GDP to SPI not only flattens as countries grow wealthier, it becomes significantly less tight. For countries below the $25,000 threshold, the correlation between GDP and the SPI is .83 but it is just .60 for countries above it. If we interpret those correlation coefficients in terms of R2s, we could say that for the poorer countries, GDP “explains” about two-thirds of differences in SPIs, but for the wealthier countries, only about one third.

 . . . 

The bottom line is that policies that improve human welfare always make sense. Policies that sacrifice human welfare to achieve growth for its own sake never do. Yes, there is a positive correlation between growth of real GDP per capita and broad measures of human welfare, but the relationship is much weaker for rich countries than for poor ones. For high-income countries, strategies that focus on improving the efficiency of transformation of GDP into wellbeing are far more attractive than policies that focus on growth and hope that wellbeing will take care of itself. So, I say, go for welfare-enhancing policies and let growth come out however it may.

In other words, GDP fetishism is not be the best economic policy objective.  Slow(ing) economic growth can be problematic when it results from slowing productivity or unemployment.  Given the weak state of the nation’s labor market, there are reasons to be concerned about the anemic growth the country has experienced since 2008.  However, in general, slowing economic growth is not per se problematic, like when there is a decline in the labor force.  As such, the issue isn’t whether economic growth is slowing, but rather, why it’s slowing.

[EDIT:  The following is from economist Dietz Volrath writing in response to Dolan’s post]:

The ultimate point of Ed Dolan’s post, and this one, is that there is nothing inherently desirable about rising GDP. It is simply a statistical construct capturing the total value of currently produced goods and services. If we prefer things that are not currently produced goods and services, then who cares if GDP rises or falls?

John Haskell

About John Haskell

John graduated from the University of Southern Maine with a degree in Political Science, and from the University of Maine School of Law. He has worked in both the public and private sectors, and currently, works with a small business services company in the Mid-Coast area.