EKIP– Expert Club for Economics and Politics A Different Opinion
Author: Steven Horwitz, FEE.org
Even the smartest economists can make the simplest mistake. Two recent books— Violence and Social Order by Douglas North, Barry Weigast, and John Joseph Wallis (not to be confused with John Wallis, the 17th-century mathematician) and Why Nations Fail by Daron Acemoglu and James Robinson—suffer from a misunderstanding of the concept of economic growth. Both books discuss the high rates of growth in the socialist economy of the USSR in the mid-20th century. While the authors correctly note that such rates of growth could not be sustained, they nevertheless assume that the aggregate measures used to demonstrate growth, such as gross domestic product (GDP), reflect actual improvements in the living standards of Soviet citizens. However, it is not certain that these statistical aggregates are a good indicator of true economic growth.
Misunderstanding what constitutes economic growth takes two forms. One is to assume that the traditional measures we use to track economic activity also describe economic growth, and the other is to assume that the production of material things constitutes economic growth.
GDP growth does not necessarily mean an improvement in living standards
The first confusion often stems from the concept of gross domestic product (GDP). Although it is the most commonly used measure of economic growth, GDP actually measures economic activity. GDP is a calculation of the market value of final goods and services produced in a given geographic area during a given period of time. “Final” goods and services refer to goods and services purchased by the final consumer, which means removing all costs of their production from the equation. It takes into account the market price (value) of the bread you buy for your sandwiches, but not the cost of buying flour from the company that makes the bread.
What GDP cannot distinguish is whether the exchange of goods and services - even taking into account absolutely all final goods - actually improves people's lives.
It is this improvement that should be considered economic growth. Two quick examples can illustrate this statement.
First, nations that devote a large portion of their resources to building huge monuments to their leaders will experience GDP growth. The purchase of final goods and services, as well as the labor costs (for example, wages, which are included in GDP) to build these monuments will increase the level of GDP, but will this improve people's lives? Should this then be considered economic growth? GDP does not tell us whether the final goods and services in question are more useful than their alternatives.
GDP measures economic activity, not economic growth.
Second, consider how often people focus on the supposed silver lining of natural disasters: all the jobs that will be created in the recovery process. I’m writing this from the airport in New Orleans, where the unemployment rate was very low and the GDP was high after Hurricane Katrina. The cleanup and rebuilding effort counts toward GDP, but I don’t think rebuilding a devastated city represents real economic growth—or any growth at all. At best, we’re back to where we were before the disaster, using resources that could have been used to improve living standards.
GDP measures economic activity, which may not necessarily represent economic growth. It is a bit like body mass. Let's imagine two men, both weighing 100 kg. One could be a muscular professional athlete with very low body fat, and the other could be eating an unhealthy diet and just being fat. Knowing only someone's weight doesn't tell us how much of them are muscle or fat, and we can't judge their health. GDP tells us that people are producing, but it doesn't tell us whether that production is improving their lives.
The Soviet Union could indeed produce, but when you look at the life of the average citizen, all that production doesn't really have a positive impact on him. When we talk about economic growth, we should be interested in improving the standard of living.
Human wealth is not measured (only) in material goods
The second confusion is very similar in meaning to the first. Too often we think of economic growth as being solely about the production of material goods. But if by economic growth we mean the accumulation of wealth– which in turn means people acquiring the things they value most – then material goods are not the answer. An increase in their quantity does not necessarily mean an improvement in the quality of life.
More importantly, and what really matters, is subjective value. A service is no less capable of improving our lives, and thus of being a source of economic growth, than the production and purchase of a material good. What we really want when we buy material goods is not the goods themselves, but the stream of services they can provide. The laptop I use at work is valuable to me because it brings me a bunch of other services (word processing, games, Internet access, etc.) that I value highly. This is the subjective satisfaction of our desires, and whether they arise from a material good or from human labor is irrelevant. Only the ultimate goal matters – the satisfaction of a particular need of mine.
This point is especially evident in the digital and sharing economies, where so much value is created not by producing things, but by using what is already produced more efficiently. Uber does not require the production of more cars, or Airbnb more homes. By using the resources already available more efficiently, we create value – and that means economic growth.
Let's focus on changes in living standards
If not GDP, then what measure shows economic growth? Look at the standard of living: of ordinary people, and especially of the poor. How easily can they satisfy their basic needs? How many hours do they have to work to satisfy them? Look at the division of labor. How well developed is it? Can people specialize in narrow areas, and despite this extremely narrow specialization, are their products and services in sufficient demand?
Economic growth is not the same as economic activity, that is, growth is not the process of creating more things or increasing their exchange, but the process by which people get the things they want at lower and lower prices and therefore improve their well-being. This is exactly what markets have achieved at certain times in certain territories over the past two centuries. For those who understand this, it is important not to equate higher rates of GDP growth (or increased production per se) with economic growth.
True economic growth is a process in which there is an improvement in the subjective well-being of the individual, but this improvement is often difficult to notice, even when the evidence of it is all around us.
