In times of increased risks of economic recession and the inability of welfare states to meet the needs of their citizens, the questioning of our economic system has been brought back to light. Currently, about 1/5 of all EU citizens are at risk of poverty, where the young are especially vulnerable. A situation that hasn’t changed much in the last decade. It is not new criticism; the environmental movement has, for a long time, raised warnings about the coupled relationship between environmental destruction and climate change with GDP growth. A criticism that has been met with the idea of Green Growth is that modern technology and the efficiency of the market can solve the problem, even though the scientific evidence points to the opposite. Current criticism, however, brings up the social factor too because what is the point then with GDP growth if livelihoods don’t get any better and citizens are struggling? Wasn’t that what we sacrificed the environment for in the first place?
Photo: Adam Smith Institute
What is GDP?
The concept of GDP has its roots in the aftermath of the Great Depression. In the 1930s, economists were searching for a reliable measure to assess economic activity and guide policymakers in responding to economic challenges. Simon Kuznets, an American economist, is often credited with developing the first comprehensive system for measuring national income and output, laying the groundwork for what would later become GDP. However, the term "Gross Domestic Product" itself was not widely used until the 1940s.
GDP is calculated using three different approaches, each providing a slightly different perspective on economic activity:
Production approach (or Output method): This approach calculates GDP by adding up the value of all goods and services produced in the country during a specific period.
Income approach: GDP can also be measured by summing up all incomes earned by individuals and businesses in the country, including wages, profits, and taxes.
Expenditure approach: This approach calculates GDP by adding up all expenditures made in the economy, including consumption, investment, government spending, and net exports (exports minus imports).
GDP growth indicates that the economically measured monetary output is increasing. Real GDP means that it has been adjusted based on inflation, as increased activities typically coincide with inflation. Regardless of which method one is using, some factors added percentage change can result in GDP growth. The factors include consumption, investment, government spending, exports, and imports. Increased consumption, investment, government spending, and exports normally contribute to GDP growth, while increased imports decrease GDP.
You will find surprising little literature that goes more into detail about how these calculations are done and if you want to understand GDP better, I would highly recommend Diane Coyle's book "GDP: A Brief but Affectionate History", which you can find in my book list at Educate Yourself.
What it measures and not
Despite being celebrated as a good indicator of a country’s economic activity it is not a good indicator of a country’s development. Already when created Kuznets warned US Congress not to focus too narrowly on GNP or GDP: “The welfare of a nation can scarcely be inferred from a measure of national income,”.
Here’s a list of what GDP does not measure.
Quality of life: GDP does not account for the overall well-being or quality of life of a population. It provides no information about factors such as education, healthcare, life expectancy, or access to social services, which are crucial components of a society's standard of living.
Income inequality: GDP does not reflect the distribution of income within a population. A country with a high GDP may still have significant income disparities, and this inequality is not captured by the GDP figure.
Non-Market transactions: GDP focuses on market transactions and excludes non-market activities such as household work, volunteerism, and other unpaid contributions. This omission leads to an incomplete understanding of a nation's economic activity.
Environmental sustainability: GDP does not consider the environmental impact of economic activities. While economic growth may contribute to a higher GDP, it may (or has) come at the cost of environmental degradation, resource depletion, and pollution.
Quality and innovation: GDP measures the quantity of goods and services produced but does not account for their quality, innovation, or technological advancements. A focus on GDP alone does not capture improvements in products or services that enhance the overall well-being of the population. Ever heard of planned obsolescence?
Informal economy: GDP may not accurately represent economic activities in the informal sector, where transactions are often unrecorded. This is particularly relevant in developing countries where a significant portion of economic activity occurs outside formal channels.
Health and education: GDP does not provide insights into the health and education status of a population. Health outcomes, educational attainment, and access to healthcare are critical factors influencing a nation's human capital, but they are not reflected in GDP figures.
Social and political stability: GDP does not measure social or political stability. Even in economically prosperous countries, social or political unrest can prevail, affecting the overall well-being of the population.
In other words, GDP increases when more jails are built and after a natural crisis, when cities are rebuilt. GDP increases when people spend more money on medication (which might not always cure the root cause of the symptom), and if mines are built exploiting humans and nature. It does not increase when a parent decides to work less and stay home more with their children when people choose to eat less unhealthy food and go for a run outside more (maybe indirectly if they live longer lives and stay in the workforce), or if people decide to consume fewer new things in general. When a country exports weapons, it is good for GDP growth. When households share cars, and household gear, and exchange second-hand clothing, GDP does not go up; it’s better for GDP if each household buys a new item.
You may have heard of the quote “You get what you measure,” a company would never apply a Key Performance Indicator that does not help facilitate expected results. However, our states are presently relying on an indicator that fails to deliver the anticipated results citizens are seeking in their lives.
Photo: QCostaRica
GDP and human progress
There is little doubt that in a post-war scenario, GDP also reflect improvements in livelihood, schools are built, hospitals are built, trade starts, people get jobs, and income and can start consuming the necessities it need. There is strong evidence that a higher GDP also results in higher life expectancy and more years of schooling. Further, a study from 2017 looking at welfare in terms of consumption means, leisure and life expectancy subtracted by inequality shows a correlation between welfare and higher income per capita. However, a large part of that is related to consumption (which is in high-income countries, a huge environmental issue). Looking at the largest economy in the World, the USA compared to Costa Rica, Costa Rica outperforms the USA in life expectancy, wellbeing and environmental sustainability. Costa Rica’s environmental footprint is just 1/3 of the USA’s and the Costa Ricans experience a higher sense of wellbeing than the Americans. It truly shows that GDP needs to be complemented, adjusted or replaced. Costa Rica seems to have a more efficient economy than the USA, but that is not how we build policies in the world.
What to measure instead
The academic literature on measures beyond GDP is well-explored. WISE lists more than 300 well-being measures on its platform. By researching and mapping measures myself for more than 6 months, I can however say that the categorization of measures is not standardized in the literature. However one can view the measures as adjusting GDP (where negative costs are subtracted and positive values added), complementing GDP (such as a well-being index), or an alternative to GDP (which seeks to replace GDP). Some of these measures result in one single index (but categories can still be weighted), one single number, and others have categories where certain areas are not tradable with others. To give an example of the latter would be some measure that puts environmental and social performance separately since an increase in social performance could overshadow a possible decline in environmental performance.
If you want to explore some of the measures, check out the list here! If you want to get notified about articles and insights related to economics, make sure you subscribe to my newsletter, and you can always invite me to learn more about welfare measures. Contact me for keynote details.
It’s time to have a look at our economic system.