Limitations of GDP as Welfare Indicator

GDP (and its derivatives) is a measure of economic activity, actually. Narrowly understood economic activity, one should add. However, this does not prevent economists and policy makers from making welfare comparisons across countries and across time on its basis. The argument goes as follows: GDP is a good proxy of the consumption possibilities people have, and consumption is a good proxy of well-being/welfare. Therefore, we allegedly can use GDP per capita for comparing welfare between countries and GDP growth as an indicator of social progress within a society. This may sound compelling to many and, indeed, we are used to this rhetoric from authorities and the media. But it is wrong to assume that GDP or any of its common derivatives provides a measure of social welfare, for a number of reasons.

Let us begin with some basic definitions. GDP (gross domestic product) is computed as the sum of all end-use goods and services produced in an economy during a period of time, weighted by their market prices. There are at least two derivatives of GDP that are in usage, too: GNP and NNP. GNP (gross national product) is GDP plus income earned by inlanders abroad minus income earned by foreigners in the inland. For most economies, the difference between these two is small, but it can be significant in some cases (e.g. in Ireland before the crisis, where much of the GDP was owned by foreign corporations). NNP (net national product) is GNP minus depreciation of capital, sometimes including estimates of natural capital depreciation (“green NNP”).

From the definitions it is clear that these accounting quantities measure primarily the economic activity and, in the case of the NNP, the sustainability thereof (although in a very limited sense only). They could potentially be used as welfare indicators under some ideal conditions. But these conditions are nonexistent. To use GDP and its derivatives as a welfare indicator means to ignore its limitations, and there are many of them:

• First of all, GDP (I will stick to this base measure, but I mean its derivatives as well, if not else indicated) is computed at market prices – which means that it ignores externalities, particularly (but not only) environmental ones. To a limited extent, this limitation can be overcome by computing the measure using “accounting prices”, which try to correct for market externalities. However, this is a difficult procedure, since many accounting prices are more or less best guesses with limited reliability. In most cases, market prices are used.
• As pointed out by Richard Easterlin, who conducted extensive research from the 1970’s through 2000’s, people do not become happier when they grow richer if they crossed some rather low threshold in terms of income (the so-called Easterlin Paradox). There are many possible explanations of why this is so – e.g. the fact that there is some threshold beyond which we have no more time to enjoy the fruits of our affluence (as suggested by Staffan Linder) or the correlation between increasing affluence and increasing competition for “positional goods” that can be attained by anyone, but not by everyone (this theory was suggested by Fred Hirsch). Both effects make the pursuit of ever-increasing affluence (in terms of GDP) sisyphean and interpretations of the gross domestic product as a welfare indicator flawed.
• Another argument against using GDP as a welfare indicator is its treatment of “defensive expenditures”: a category that includes items from expenditures on the military, through money spent on building dams to protect human settlements from flooding, to clean-up costs after, say, an oil-spill in the Gulf of Mexico. These expenditures contribute positively to the GDP, but they clearly do not contribute to well-being. Therefore GDP overestimates what it is thought to approximate, i.e. social welfare.
• Also, GDP does not include a meaningful part of the economy – household work -, as was pointed out by William Nordhaus and James Tobin in their famous paper Is Growth Obsolete?. Beside of its importance for the proper functioning of the economy and society, unaccounted for household work makes welfare comparisons based on GDP both across time and across countries difficult. E.g., the US is known for its culture of “outsourcing” of household work (which may at least partly explain why US-Americans work more hours and why the US unemployment rates are systematically lower than in Europe) – many things that Europeans do on their own, outside of the market (and therefore unnoticed by GDP statistics), e.g. cooking, washing etc., an average US-Americans lets do others against payment. This makes the US-American GDP higher by trend – but it is very difficult to interpret the welfare consequences of these differences, especially because they root deeply in cultural specifics. Also, the tendency toward household work changes within societies over time – how should the resulting change in GDP be interpreted in welfare terms?
• A similar point to the one made above can be made about the “shadow” or informal economy, which is especially important in developing countries (but also in many developed ones, particularly in Southern Europe) – being informal, its activities are not included in GDP statistics, even though they may have a tremendous influence on the welfare specifically of the poorer parts of the society.
• A subject that this blog is often concerned about is that GDP does not include any measures of changes in natural capital. Nor does the “normal” NNP. Since natural capital and ecosystem services (including renewable and nonrenewable natural resources, water purification, climate regulation, pollination, flood protection and many, many more) more often than not has no market prices, it is not included in GDP-like statistics that deal with marketed goods and services only. Also, the already mentioned environmental external effects remain unaccounted for (and, furthermore, there is evidence suggesting that rapid GDP growth is correlated with environmental destruction). However, ecosystem services are tremendously important for the well-being of people in developing and developed countries alike (although in the short term the former depend relatively more on them). Or could you get by without clean water, a stable climate or pollinated fruits? These things have to be included in any meaningful measure of social welfare, even though their valuation may be problematic.
• GDP and its derivatives are measures of the total output of the economy – they do not in any way account for distributional or equity effects of it. However, as suggested among others by Fred Hirsch and Richard Easterlin (see above), people evaluate their lives not in absolute terms, but rather in comparison with those whom they live among. So, the distribution of wealth is very important, in many cases (particularly when basic needs of the population are satisfied, as is the case in most developed countries) it may be more important than the general (average) level of wealth. GDP does not capture this crucial aspect of human well-being at all. Unless one believes in some kind of “trickle-down”, this is a serious limitation of GDP as a welfare indicator.
• A more general point was made by Partha Dasgupta and Karl-Göran Mäler, who analysed formally the ability of NNP (including “green NNP”) to provide a glimpse at changes in social well-being across time and differences across countries. Their result was that NNP can only help evaluate the welfare effects of policy changes in the short-term within an economy, but not in the long-term and across countries. The reason is quite simple, actually – GDP and its derivatives are all measures of income, not of wealth. The difference between these two terms that are often used interchangeably in everyday speech is significant. If our income is high, it may be due to the fact that we live “on tick”: after having accumulated some wealth in the past, we are consuming (producing) unsustainably, i.e., in a way that cannot be sustained over a longer period of time. Unless income is defined in Hicksian terms (i.e., as the amount of money that can be consumed within a period of time without compromising the ability to consume at least as much in the next) – and GDP is not -, it cannot be used as a true, sustainable measure of welfare.
• Many of the points made above can be summarized within the notion of capabilities, which goes back to Amartya Sen. He and other researchers dealing with this subject pointed out that human (or social) well-being does not depend solely on commodities (as captured by the GDP statistics), but on the capability of people to actually use them in a way they wish to. This understanding of welfare requires much more than just a simple statistic of economic activity – GDP leaves too much of the “good” things out and includes too much of the “bad” ones.

Given all the limitations of GDP and related measures as welfare indicators (as listed above), it is clear that the practice of (implicitly or explicitly) using GDP statistics as a welfare proxy is deeply flawed and should be abandoned. There is no ready-made alternative that would give us a glimpse at social well-being and require just one single number. Most likely, it is impossible to create such a simple indicator. Instead, welfare has to be assessed on the basis of many different indicators, as I suggested recently. GDP may have the attracting characteristic of being relatively simple, but it is also flawed in the role as a welfare indicator. We should, using a quote attributed to Albert Einstein, “make things as simple as possible, but not simpler”.

• capability
• GDP
• growth
• positional goods
• well-being