What GDP can't tell us

The 1870s and 1880s were a period of rapid industrialisation and innovation. Alexander Graham Bell’s telephone, Nikola Tesla’s twophase induction motor, Herman Hollerith’s punched cards, the electric fan, the seismograph, the motorcycle—all of these advances were made in this period.

So presumably the “new economy” that these inventions helped bring about can be seen in the economic statistics of the 19th century. But no: the Statistical Abstract of the United Kingdom for 1871-1885 contains just a few pages of figures on the new technologies of the period—textile factories, railways and so on. In contrast, there are almost 200 pages of the finest detail on the traditional economy: agricultural production and trade. In other words, economic progress has always outstripped our ability to measure it.

Today’s principal economic indicator, Gross Domestic Product (GDP), was invented to serve a specific purpose, namely measuring the production available for the war effort and the sacrifice required of consumers at a time of real scarcity. The man often thought to be the inventor of GDP, Simon Kuznets, had in fact argued against it. He would have preferred the government to measure economic well-being.

The exigencies of the time meant Kuznets lost that argument, but the debate over the precise determinants of GDP has been revived. Critics of the metric point out that it does not take account of the many adverse consequences of some forms of economic activity. It does not account for the effects of pollution, of urban traffic congestion, or of crime. On the other hand, neither does it take account of the huge benefits of innovation and the sheer variety of goods and services in a modern economy. It was designed specifically not to incorporate any effects on well-being, but simply to measure the monetary, market-based economy.

This does not mean that GDP should either be retired or fundamentally changed. Having a measure of economic activity is essential for setting fiscal and monetary policy, and GDP is the product of 70 years of research and development. Of course it will need further improvements. National statisticians should be looking urgently at how the financial sector is measured. An adjustment to the way in which finance was measured, made just before the financial crisis, resulted in the sector’s biggest ever contribution to UK GDP growth in the last three months of 2008. This is absurd; the definition overstates true financial sector economic activity. (Adam Smith would have excluded banking as a productive activity altogether.)

GDP is useful. However, politicians and commentators pay it too much attention. They pounce on small quarterly changes that are well within the normal margin of statistical error as evidence of whatever they want it to mean. Economic growth is important but other indicators of well-being are important too. The gap between GDP and well-being is increasing as the character of the economy changes. In the post-war economy, mass produced goods and standardisation drove growth.

Now, growth depends on services and intangibles, variety and customisation. There is good evidence that consumers greatly value innovation and variety, even if it consists of something apparently trivial like a new flavour of breakfast cereal. Yet GDP will not count genetically-targeted cancer drugs any differently than the molecules devised in the 1970s and 80s. And the concept of production makes little sense for services, where the quality of service and human engagement is so important.

Rather than trying to merge into one indicator the wide variety of factors influencing our well-being, from poor air quality and long commutes to the benefits of innovation, a better approach is a “dashboard” of indicators. Some already exist, such as the OECD’s Better Life Index. This has the merit of revealing the unavoidable trade-offs—live in the city and have a lower standard of living, or move to the country but have much greater commuter time. Dashboards monitor these conundrums.

The other dimension that can’t be captured by GDP is the sustainability of growth. It is impossible to know whether future living standards will match or exceed today’s without measuring the change in the economy’s assets, of all kinds, from natural resources to infrastructure to the level of “human capital” or skill. The national accounts statistics can be used as the foundations for an indicator of net national investment in the future.

GDP is still useful, but it deserves less attention. We should be looking as well at the different dimensions of well-being and at what we are investing in tomorrow’s economy.