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Fooled by GDP: Economic Activity versus Economic Growth – Article by Steven Horwitz

Fooled by GDP: Economic Activity versus Economic Growth – Article by Steven Horwitz

The New Renaissance Hat
Steven Horwitz
May 4, 2015

Even the smartest of economists can make the simplest of mistakes. Two recent books, Violence and Social Orders by Douglass North, John Wallis, and Barry Weingast and Why Nations Fail by Daron Acemoglu and James Robinson both suffer from misunderstanding the concept of economic growth. Both books speak of the high growth rates in the Soviet economy in the mid-20th century. Even if the authors rightly note that such rates could not be sustained, they are still assuming that the aggregate measures they rely on as evidence of growth, such as GDP, really did reflect improvements in the lives of Soviet citizens. It is not clear that such aggregates are good indicators of genuine economic growth.

These misunderstandings of economic growth take two forms. One form is to assume that the traditional measurements we use to track economic activity also describe economic growth, and the other form is to mistake the production of material things for economic growth.

Often at the core of this confusion is the concept of gross domestic product (GDP). Although it is the most frequently used indicator of economic growth, what it really measures is economic activity. GDP is calculated by attempting to measure the market value of final goods and services produced in a particular geographic area over a specific period. By “final” goods and services, we mean the goods and services purchased by the end consumer, and that means excluding the various exchanges of inputs that went into making them. We count the loaf of bread you buy for sandwiches, but not the purchase of flour by the firm that produced the bread.

What GDP does not distinguish, however, is whether the exchanges that are taking place — even the total quantity of final goods — actually improve human lives.

That improvement is what we should be counting as economic growth. Two quick examples can illustrate this point.

First, nations that devote a great deal of resources to building enormous monuments to their leaders will see their GDP rise as a result. The purchase of the final goods and labor services to make such monuments will add to GDP, but whether they improve human lives and should genuinely constitute “economic growth” is much less obvious. GDP tells us nothing about whether the uses of the final goods and services that it measures are better than their alternative uses.

Second, consider how often people point to the supposed silver lining of natural disasters: all the jobs that will be created in the recovery process. I am writing this column at the airport in New Orleans, where, after Katrina, unemployment was very low and GDP measures were high. All of that cleanup activity counted as part of GDP, but I don’t think we want to say that rebuilding a devastated city is “economic growth” — or even that it’s any kind of silver lining. At best, such activity just returns us to where we were before the disaster, having used up in the process resources that could have been devoted to improving lives.

GDP measures economic activity, which may or may not constitute economic growth. In this way, it is like body weight. We can imagine two men who both weigh 250 pounds. One could be a muscular, fit professional athlete with very low body fat, and the other might be on the all-Cheetos diet. Knowing what someone weighs doesn’t tell us if it’s fat or muscle. GDP tells us that people are producing things but says nothing about whether those things are genuinely improving people’s lives.

The Soviet Union could indeed produce “stuff,” but when you look at the actual lives of the typical citizen, the stuff being produced did not translate into meaningful improvements in those lives.

Improving lives is what we really care about when we talk about economic growth.

The second confusion is a particular version of the first one. Too often, we think that economic growth is all about the production of material goods. We see this in discussions of the US economy, where the (supposed) decline of manufacturing is pointed to as a symptom of a poorly growing economy. But if economic growth is really about the accumulation of wealth — which is, in turn, about people acquiring things they value more — then material goods alone aren’t the issue. More physical stuff doesn’t mean that the stuff is improving lives.

More important, though, is that what really matters is subjective value. The purchase of a service is no less able to improve our lives, and thereby be a source of economic growth, than are the production and purchase of material goods. In fact, what we really care about when we purchase a material good is not the thing itself, but the stream of services it can provide us. The laptop I’m working on is valuable because it provides me with a whole bunch of services (word processing, games, Internet access, etc.) that I value highly. It is the subjective satisfaction of wants that we really care about, and whether that comes from a physical good or from human labor does not matter.

This point is particularly obvious in the digital and sharing economies, where so much value is created not through the production of stuff, but by using the things we have more efficiently and precisely. Uber doesn’t require the production of more cars, and Airbnb doesn’t require the production of more dwellings. But by using existing resources better, we create value — and that is what we mean by economic growth.

So what should we look at instead of GDP as we try to ascertain whether we are experiencing economic growth? Look at living standards: of average people, and especially of poor people. How easily can they obtain the basics of life? How many hours do they have to work to do so? Look at the division of labor. How fine is it? Are people able to specialize in narrow areas and still find demand for their products and services?

Economic growth is not the same as economic activity. It’s not about just making more exchanges or producing more stuff. It’s ultimately about getting people the things they want at progressively lower cost, and thereby improving their well-being. That’s what markets have done for the last two centuries. For those of us who understand this point, it’s important not to assume that higher rates of GDP growth or the increased production of physical stuff automatically means we are seeing growth.

Real economic growth is about improving people’s subjective well-being, and that is sometimes harder to see even as the evidence for it is all around us.

Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution 4.0 International License, which requires that credit be given to the author.

TANSTAAFL and Saving: Not the Whole Story – Article by Sanford Ikeda

TANSTAAFL and Saving: Not the Whole Story – Article by Sanford Ikeda

The New Renaissance Hat
Sanford Ikeda
October 3, 2012

How often have you heard someone say, “There ain’t no such thing as a free lunch,” or, “Saving is the path to economic development”?  Many treat these statements as the alpha and omega of economic common sense.

The problem is they are myths.

Or, at least, popular half-truths.  And they aren’t your garden-variety myths because people who favor the free market tend to say them all the time.  I’ve said them myself, because they do contain more than a grain of truth.

“There ain’t no such thing as a free lunch” (or TANSTAAFL) means that, with a limited budget, choosing one thing means sacrificing something else.  Scarcity entails tradeoffs.  It also implies that efficiency means using any resource so that no other use will give a higher reward for the risk involved.

That saving is necessary for rising labor productivity and prosperity also contains an economic truth.  No less an authority than the great Austrian economist Ludwig von Mises has stated this many times.  In an article published in The Freeman in 1981, for example, he said:

The fact that the standard of living of the average American worker is incomparably more satisfactory than that of the average [Indian] worker, that in the United States hours of work are shorter and children sent to school and not to the factories, is not an achievement of the government and the laws of the country. It is the outcome of the fact that the capital invested per head of the employees is much greater than in India and that consequently the marginal productivity of labor is much higher.

The Catalyst

But the statement is true in much the same way that saying breathable air is necessary for economic development is true.  Saving and rising capital accumulation per head do accompany significant economic development, and if we expect it to continue, people need to keep doing those activities.  But they are not the source–the catalyst, if you will–of the prosperity most of the world has seen in the past 200 years.

What am I talking about?  Deirdre McCloskey tells us in her 2010 book, Bourgeois Dignity: Why Economics Can’t Explain the World:

Two centuries ago the world’s economy stood at the present level of Bangladesh. . . .  In 1800 the average human consumed and expected her children and grandchildren and great-grandchildren to go on consuming a mere $3 a day, give or take a dollar or two [in today’s dollars]. . . .

By contrast, if you live nowadays in a thoroughly bourgeois country such as Japan or France you probably spend about $100 a day.  One hundred dollars as against three: such is the magnitude of modern economic growth.

(Hans Rosling illustrates this brilliantly in this viral video.)

That is unprecedented, historic, even miraculous growth, especially when you consider that $3 (or less) a day per person has been the norm for most of human history.  What is the sine qua non of explosive economic development and accelerating material prosperity?  What was missing for millennia that prevented the unbelievable takeoff that began about 200 years ago?

A More Complete Story

Economics teaches us the importance of TANSTAAFL and capital investment.  Again, the trouble is they are not the whole truth.

As I’ve written before, however, there is such a thing as a free lunch, and I don’t want to repeat that argument in its entirety.  The basic idea is that what Israel M. Kirzner calls “the driving force of the market” is entrepreneurship.  Entrepreneurship goes beyond working within a budget–it’s the discovery of novel opportunities that increase the wealth and raises the budgets of everyone in society, much as the late Steve Jobs or Thomas Edison or Madam C.J. Walker (probably the first African-American millionaire) did.  Yes, those innovators needed saving and capital investment by someone–most innovators were debtors at first–but note: Those savings could have been and were invested in less productive investments before these guys came along.

As McCloskey, as well as Rosenberg and Birdzell, have argued, it isn’t saving, capital investment per se, and certainly not colonialism, income inequality, capitalist exploitation, or even hard work that is responsible for the tremendous rise in economic development, especially since 1800.

It is innovation.

And, McCloskey adds, it is crucially the ideas and words that we use to think and talk about the people who innovate–the chance takers, the rebels, the individualists, the game changers–and that reflect a respect for and acceptance of the very concept of progress.  Innovation blasts the doors off budget constraints and swamps current rates of savings.

Doom to the Old Ways

Innovation can also spell doom to the old ways of doing things and, in the short run at least, create hardship for the people wedded to them.  Not everyone unambiguously gains from innovation at first, but in time we all do, though not at the same rate.

So for McCloskey, “The leading ideas were two: that the liberty to hope was a good idea and that a faithful economic life should give dignity and even honor to ordinary people. . . .”

There’s a lot in this assertion that I’ll need to think through.  But I do accept the idea that innovation, however it arises, trumps efficiency and it trumps mere savings.  Innovation discovers free lunches; it dramatically reduces scarcity.

Indeed, innovation is perhaps what enables the market economy to stay ahead of, for the time being at least, the interventionist shackles that increasingly hamper it.  You want to regulate landline telephones?  I’ll invent the mobile phone!  You make mail delivery a legal monopoly?  I’ll invent email!  You want to impose fixed-rail transport on our cities?  I’ll invent the driverless car!

These aren’t myths. They’re reality.

Sanford Ikeda is an associate professor of economics at Purchase College, SUNY, and the author of The Dynamics of the Mixed Economy: Toward a Theory of Interventionism.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Automation, Jobs, and Human Prosperity – Video by G. Stolyarov II

Automation, Jobs, and Human Prosperity – Video by G. Stolyarov II

Contrary to popular belief, automation does not lead to the loss of jobs. Automation is humankind’s best friend in terms of raising standards of living and freeing up human efforts to be devoted to truly creative and innovative tasks. Furthermore, Mr. Stolyarov argues that jobs are not in themselves a desirable goal; higher prosperity is – and higher prosperity allows humans to enjoy greater leisure while producing more than their ancestors could with more primitive tools.

Remember to LIKE, FAVORITE, and SHARE this video in order to spread rational discourse on this issue.