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Measuring the Economy with a Broken Ruler

by rdf Thu Feb 26th, 2009 at 07:21:25 AM EST

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). I explain their defects below.

Promoted by Colman


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.

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.

Display:
to go beyond GDP

See the recent diary by Melanchton FT: Is GDP the wrong indicator?

And earlier diaries:

LQD - James Speth (Yale University) on "happiness"
Beyond GDP - Day 2 (afternoon) Summary
Beyond GDP - Day 1 Summary
Minor Errors
Anyone attending "Beyond GDP"?
Measuring Progress (pt. 1)
Happiness and Economics
Regrettables
Socratic Economics I: Why GDP growth above all else?
Let's Ban the GDP

The most difficult problem, I think, is the level of entanglement between governments and large corporations. That's not just an issue of government spending priorities.

But maybe we are entering into a new era of possibility...

by nanne (zwaerdenmaecker@gmail.com) on Wed Feb 25th, 2009 at 02:01:06 PM EST
I found this site after I wrote the diary. Clifford Cobb has long been associated with ecological economist Herman Daly.

Their latest report on something they call genuine progress indicator:

http://www.rprogress.org/publications/2007/GPI%202006.pdf

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Wed Feb 25th, 2009 at 03:00:33 PM EST
[ Parent ]
See also the following discussion threads (more even than the diaries themselves)


Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Thu Feb 26th, 2009 at 09:00:58 AM EST
[ Parent ]
Whoops, I duplicated "minor errors".

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Thu Feb 26th, 2009 at 09:01:42 AM EST
[ Parent ]
... what's broken is people trying to use a ruler to measure mass, or volume.

It measures what it measures, and what it measures is something that bears measuring. Its those who treat it as if it was a measure of standard of living who are in error ... so what is broken are the (social) institutions governing the use of GDP in public discourse.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Feb 25th, 2009 at 04:43:07 PM EST
The fundamental problem seems, to me, to be that any effort to encapsulate the state of a system as complex as an economy in one or two or half a dozen figures is badly flawed.
by Colman (colman at eurotrib.com) on Thu Feb 26th, 2009 at 07:23:01 AM EST
I think if you had some nominal metric of environmental health - unsustainable resources used and destroyed - and also median+average disposable income you'd get a fairly useful broad-brush picture.

People need simple numbers - hardly anyone has the patience to read through a two hundred page report, and probably only around 10-20% of the population would be able to understand it anyway.

But even if they're not comprehensive, some simpler numbers are more revealing and useful than others.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Thu Feb 26th, 2009 at 08:25:35 AM EST
[ Parent ]
No, propagandists need simple numbers. Headline writers need simple numbers. People need to understand the issues.

A qualitative description would be considerably more useful to most people than focusing on a handful of numbers that hide all the details and act merely to obscure the truth.

by Colman (colman at eurotrib.com) on Thu Feb 26th, 2009 at 08:30:08 AM EST
[ Parent ]
Should we have a debate on the theory of index numbers?
There is a substantial body of economic analysis concerning the construction of index numbers, desirable properties of index numbers and the relationship between index numbers and economic theory.


Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Thu Feb 26th, 2009 at 08:44:14 AM EST
[ Parent ]
Yes, please?
by Colman (colman at eurotrib.com) on Thu Feb 26th, 2009 at 08:45:14 AM EST
[ Parent ]
It is nonsense?

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Thu Feb 26th, 2009 at 09:07:26 AM EST
[ Parent ]
Let me start with this:
Basically I've managed to convince myself that there isn't a sensible mathematical definition of "real GDP" or the "price level" (also known as "GDP deflator"). Which means you can talk about nominal GDP and about growth rates and inflation rates, but you cannot really compare real GDP across countries or across  time. And it casts serious doubts on PPP. And this is in principle, without even going into the practical difficulties of gathering real data, or the fishiness of arbitrary "baskets of goods", "hedonic pricing", and other assorted suspicious stuffnonsense.

I have hinted at it here and here. There's also Keynes:

That the units, in terms of which economists commonly work, are unsatisfactory can be illustrated by the concepts of the national dividend, the stock of real capital and the general price-level:

...

Thirdly, the well-known, but unavoidable, element of vagueness which admittedly attends the concept of the general price-level makes this term very unsatisfactory for the purposes of causal analysis, which ought to be exact.

Nevertheless these difficulties are rightly regarded as 'conundrums'. They are 'purely theoretical' in the sense that they never perplex, or indeed enter in any way into, business decisions and have no relevance to the causal sequence of economic events, which are clear-cut and determinate in spite of the quantitative indeterminacy of these concepts. It is natural, therefore, to conclude that they not only lack precision but are unnecessary. Obviously our quantitative analysis must be expressed without using any quantitatively vague expressions. And, indeed, as soon as one makes the attempt, it becomes clear, as I hope to show, that one can get on much better without them.

The fact that two incommensurable collections of miscellaneous objects cannot in themselves provide the material for quantitative analysis need not, of course, prevent us from making approximate statistical comparisons, depending on some broad element of judgement rather than of strict calculation, which may possess significance and validity within certain limits.

But the proper place for such things as net real output and the general level of prices lies within the field of historical and statistical description, and their purpose should be to satisfy historical or social curiosity, a purpose for which perfect precision--such as our causal analysis requires, whether or not our knowledge of the actual values of the relevant quantities is complete or exact--is neither usual nor necessary. To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to the statement that Queen Victoria was a better Queen but not a happier woman than Queen Elizabeth--a proposition not without meaning and not without interest, but unsuitable material for the differential calculus. Our precision will be a mock precision if we try to use such partly vague and non-quantitative concepts as the basis of our quantitative analysis.

-- John M. Keynes in The General Theory of Employment, Interest and Money

(my emphasis)

The "general price level" is the "GDP deflator".

I don't know whether Keynes was thinking about the mathematical reasons I'm thinking about, but it sounds like he knew this stuff was nonsense already.

BruceMcF:

Keynes' basic argument for working in terms of nominal amounts and employment was that the ability of a person to work as unskilled labor if need be provided a connection between various specialized and more restricted skilled labor markets in terms of their renumeration as a multiple of the wage of unskilled labor, providing a quantity that could be aggregated with greater justification than the vector of the amount produced of each and every different type of final product for sale in the economy.
And now for the IM:
Colman: Is the underlying model even faintly relevant to the real world here?
Migeru: maybe what I'm doing is reducing GDP to absurdity
Colman: That's my immediate thought. ... Not that it needs much help.
Migeru: hmm. It is king of policy right now. It might be absurd but that matters little. The thing is if REAL GDP is not a state function then you CANNOT compare it across countries or across times.
Colman: Well, that's obvious to start with. In fact, most of these sumamry statistics are incomparable.
Migeru: not obvious to economic policy makers. ... So in economics what you can measure is meaningless and hwat is meaningful is unmeasurable?
Colman: I don't know about that - though it may be true - but what is measured is not comparable. Unemployment, gdp, military spend, research spending, health spending etc.
...
Migeru: apparently keynes wanted to use only nominal GDP but I don't know why other than some qualitative statements
Colman: Because real GDP is made up? Measurement errors on top of measurement errors on top of biases. Inflation is affected by political and technical choices in what is measured, GDP is "corrected" for various factors - hedonistic pricing among them, and so on.
Migeru: well, that just makes matters even worse
Colman: Absurd on the face of it.
Migeru: my argument doesn't involve arbitrary choices of baskets, or hedonic pricing or anything like that
Colman: I know.
Migeru: so that, plus practical issues of measurement just make matters worse.
Colman: GDP is, on many levels, a shit measure of anything. That it has appalling technical problems is hardly surprising.
Migeru: but it doesn't even make mathematical sense in a perfect world.
Colman: Frankly, I think it harks back to a time when it was the best they could do. GDP is easy to measure. Or approximate. From tax records.
Migere: sure, what else is the government going to use for policy? (by way of quantitative information)
Colman: The problem is that the number is, again, only slightly meaningful. So that, all things being equal (hah!) and with a sensible choice of basket, real GDP growth tells you that your economy is producing wealth faster than it was. ... Colman: But comparing 3% for one country vs 5% for another doesn't make much sense. And comparing GDP/head is meaningless. Especially since the policy discussions generally take place on the basis of provisional figures which are then revised. And US figures (broadly) are revised down, while European figures are (broadly) revised up.
Migeru: so it's all bullshit.
Colman: The way it is used is bullshit. Like unemployment.
Migeru: I'm beginning to think economics really is not at all a quantitative subject
Colman: Well, it has severe measurement problems. Rather like doing physics with only a metre stick, and without standardised metre sticks in different countries.
Migeru: no, I think it's not rather like doing physics. At all. Or maybe it's like Aristotelian physics: with entirely the wrong concepts.
(A comment to Minor errors by Colman on November 15th, 2007.

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Thu Feb 26th, 2009 at 09:29:05 AM EST
[ Parent ]
To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to

This is simply not true. Real GDP change for existing goods is usually measured by amount. If I produce today 1000 screws and nexy year 1050, I have 5% real GDP growth. The price of a single screw may change, that is the price change.

As well, that Basically I've managed to convince myself that there isn't a sensible mathematical definition of "real GDP" or the "price level" (also known as "GDP deflator")
is not a great intellectual achievment. GDP isn't well defined in infinitesimal small time intervals, or at least it will wiggle extremely around - e.g. on the day scale, GDP at night is much lower than in the morning. Therefore usually the smalles time unit in which GDP is published are months. This doesn't mean that you can't reasonably parametrise real GDP growth with analytical functions to make an economic theory.

"price level" (also known as "GDP deflator")
Be careful! You may mean the right thing, but many people don't get immediately, that CPI and GDP deflator aren't the same. Terms of trade shocks happen in the real world, even to quite big players.

Der Amerikaner ist die Orchidee unter den Menschen
Volker Pispers

by Martin (weiser.mensch(at)googlemail.com) on Thu Feb 26th, 2009 at 09:02:32 PM EST
[ Parent ]
Real GDP change for existing goods is usually measured by amount.

But the basket of goods and services produced by an economy changes over time. And it is not necessarily meaningful to compare screws with ball bearings, or integrated circuits with railroad cars. So as a macroeconomic figure, real GDP does not necessarily make sense, even when defined in terms of real goods and services.

This doesn't mean that you can't reasonably parametrise real GDP growth with analytical functions to make an economic theory.

Who promised you that it's an analytical function? For that matter, who promised you that it's a function at all of the variables it's usually expressed in terms of?

(You can always make it a function by parametrising it in time, but as Keynes notes in the paragraphs above, that's not terribly interesting in terms of predictive power...)

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri Feb 27th, 2009 at 03:00:16 AM EST
[ Parent ]
real GDP does not necessarily make sense

Yes, but real GDP growth makes a sense, as the portion of fundamentally different products is rather small. Such new products are than at some point pegged in their relation to other products by their nominal value. Comparing the absolute value of GDP of two countries is indeed not that much helpful.

Of course there is some arbitraryness in real GDP, as one has to define the hedonistic factor. Is a computer with double the CPU power and disk space double as good as the other computer?
But I do think that often such questions can be answered in a reasonable way.

Of course without an underlying theory a parametrisation has no (or very little, when you make the theory of 'some smoothness') predictive power. That is true for easy to define state variables, too.

Der Amerikaner ist die Orchidee unter den Menschen
Volker Pispers

by Martin (weiser.mensch(at)googlemail.com) on Fri Feb 27th, 2009 at 10:43:03 AM EST
[ Parent ]
Martin:
As well, that Basically I've managed to convince myself that there isn't a sensible mathematical definition of "real GDP" or the "price level" (also known as "GDP deflator")
is not a great intellectual achievment. GDP isn't well defined in infinitesimal small time intervals, or at least it will wiggle extremely around - e.g. on the day scale, GDP at night is much lower than in the morning. Therefore usually the smalles time unit in which GDP is published are months. This doesn't mean that you can't reasonably parametrise real GDP growth with analytical functions to make an economic theory.
The point is that as long as you have more than one product in your economy the (real gdp growth rate) and (inflation rate) are inexact differentials so they are path-dependent. Nominal gdp change is an exact differential.

If you have two collections of prices and volumes that are exactly the same 10 years apart, you have the same (nominal gdp change) but if the evolution of the economy took two sufficiently disparate paths over those 10 years you could have two very different (real gdp change) and (inflation).

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith

by Migeru (migeru at eurotrib dot com) on Fri Feb 27th, 2009 at 03:49:43 AM EST
[ Parent ]
If you have two collections of prices and volumes that are exactly the same 10 years apart, you have the same (nominal gdp change) but if the evolution of the economy took two sufficiently disparate paths over those 10 years you could have two very different (real gdp change) and (inflation).

Well, the change is still simply the difference. The accumulated real GDP can be different. But why would that mean that real GDP isn't properly defined. Your link to thermodynamic; in thermodynamics the values that are path dependent are as well properly defined. In the real world, the economy has taken one path.

And it is very clear, that Zimbabwe isn't the richest country in the world, despite for sure by far the largest nominal increase in GDP.

Der Amerikaner ist die Orchidee unter den Menschen
Volker Pispers

by Martin (weiser.mensch(at)googlemail.com) on Fri Feb 27th, 2009 at 10:33:07 AM EST
[ Parent ]
All I'm saying is that nominal GDP is a state quantity but that real GDP change is a path quantity (and so is inflation). Maybe this is obvious, to you, but it wasn't to me, especially not from reading about economics.

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
by Migeru (migeru at eurotrib dot com) on Fri Feb 27th, 2009 at 10:40:38 AM EST
[ Parent ]
No, it wasn't clear to me.

But I don't see the relation with

there isn't a sensible mathematical definition of "real GDP" or the "price level"

from that observation.

Der Amerikaner ist die Orchidee unter den Menschen
Volker Pispers
by Martin (weiser.mensch(at)googlemail.com) on Fri Feb 27th, 2009 at 10:45:39 AM EST
[ Parent ]
You can't get "real GDP" from just enumerating the goods and services traded and their prices at any one time. Thus, "real GDP" is not comparable across time or across countries.

Moreover, you can't get "real GDP change" from just enumerating the goods and services traded and their prices at the initial and final times, if these are far away enough to have encompass at least one business cycle.

So you have to fall back on "real GDP change" as a feature of a history of economic development.

By there isn't a sensible mathematical definition of "real GDP" or the "price level" I mean you can't meaningfully compare the "real GDP" or the "price level" between two points.

Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith

by Migeru (migeru at eurotrib dot com) on Fri Feb 27th, 2009 at 10:56:52 AM EST
[ Parent ]
Therefore you usually keep one variable fixed. E.g. the real GDP in prices of 2000. Or the inflation on this basket of products. This are both reasonable quantities.

Der Amerikaner ist die Orchidee unter den Menschen
Volker Pispers
by Martin (weiser.mensch(at)googlemail.com) on Sat Feb 28th, 2009 at 09:35:44 PM EST
[ Parent ]
In fact, the less you understand the more misleading a simple summary number is. If you come to most ETers and tell them that GDP is up, unemployment is down and that the CPI is stable, they should know to start asking a pile of questions about the details and the income distribution and changes in employment participation and so on, or at least to be profoundly suspicious. On the other hand, the papers in Ireland could spout on for ages about how Ireland was the wealthiest country in Europe in the face of all the evidence and every possible sensible definition of wealth without being laughed off the news-stands precisely because almost nobody understands what the simple numbers being reported actually mean.
by Colman (colman at eurotrib.com) on Thu Feb 26th, 2009 at 08:48:55 AM EST
[ Parent ]
Out of the all of the people I know, I'm almost the only one who would be thinking like that.

The political environment is independent of economic reporting. Why do you think that propaganda would be any less effective with huge ring-bound reports than it would be summary reporting?

Surely it's even easier to hide lies and misdirections inside a mountain of data and concepts which most people don't understand at all.

If people don't understand simple numbers - which empirically they don't - how can it make sense to to suggest they should be trying to understand complicated numbers instead?

But - if there's a tradition of reporting numbers which are at least a little bit useful, rather than not useful at all, you're in with a chance of keeping them informed.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Thu Feb 26th, 2009 at 09:18:07 AM EST
[ Parent ]
Actually, I'm suggesting that they shouldn't have the numbers dumped on their heads at all and that the idea that reporting that Ireland's GDP per head rose by 0.1% at PPP equivalence stoat-belly wombat botherer is the slightest bit meaningful or useful to the body politic is gibbering nonsense. Replacing it with more meaningless numbers is not going to help: we'll just be told that Ireland's Guinness Quotient is higher than the UK's and aren't we great? It still hides what needs to be discussed.
by Colman (colman at eurotrib.com) on Thu Feb 26th, 2009 at 09:29:48 AM EST
[ Parent ]
There are of course  reports [pdf] that discuss important stuff with more than a number. That German report e.g. does contain:
  • ressource conservation
  • climate change
  • renewable energies
  • area usage
  • state debt
  • economic future provision
  • innovation
  • education
  • economic wealth
  • mobility
  • farming
  • air quality
  • health and nutrition
  • criminality
  • employment
  • perspectives for families
  • equality of men and women
  • integration of immigrants
  • development aid
  • open markets

Similar reports probably exists for Ireland. But who reads 80 pages, when he can have a number?

Der Amerikaner ist die Orchidee unter den Menschen
Volker Pispers
by Martin (weiser.mensch(at)googlemail.com) on Sat Feb 28th, 2009 at 09:44:53 PM EST
[ Parent ]
Ecological footprint is an attempt at an environmental index (though it would be better with a positive then a negative one).

WWF - Living Planet Report

Living Planet Report 2008 - Full report [pdf, 4.35 MB]

Living planet report has an nice attempts. Living planet index etc. Those numbers just needs to be re-told and re-told to form a ever-present narrative.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Thu Feb 26th, 2009 at 08:04:18 PM EST
[ Parent ]
But a simple number that measures someone's temperature is of very little use if the question is whether they should increase or reduce their caloric intake.

That's the situation here.

The human development index composed of average Rank in terms of Purchasing Power Parity GDP per capita, Rank in terms of Life Expectancy, and Rank in terms of Adult Literacy is an example of combining three simple numbers in a quite arbitrary, ad hoc, and certainly imprecise way, which despite that provides a more robust measure of relative standard of living than any of them individually would do.

GDP per capita measures capacity to provide material support to individual needs at most ... but comparing a society that gives a hundred and one people $1,000 a month and a society that gives a hundred people $100 month and one person $91,000 a month would yield the same $12,000/capita.

But you cannot "store" a thousand years of lifespan in one wealthy person to make up for ten years of lifespan lost by a hundred poorer people ... life expectancy track strongly to how well a society distributes its ability to meet basic needs. And adult literacy tracks as well as any readily available number to measure distribution of access to social participation.

Its got a gaping hole in terms of sustainability, but the way to fill that would be to add a sustainability rank, such as the rank in terms of excess (or deficit) biocapacity per capita in hectares.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Sat Feb 28th, 2009 at 10:30:22 PM EST
[ Parent ]


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