Sunday 23 September 2012

The Perils of Relying on GDP in the Information Age

“What gets measured gets managed” is one of the fundamental principles of management. What would a business do if they realised that their one critical measurement tool was broken? If their primary performance indicator was found to be unfit for purpose?

What about a country? When it comes to measuring the health of an economy, the received wisdom is that Gross Domestic Product is the best measure we’ve got. It’s widely acknowledged to be imperfect, but is measured anyway, and used as a yard-stick for government competence almost everywhere.

There are two flaws with GDP that are usually cited in economics textbooks.

Firstly, GDP leaves out certain things that have economic value. It leaves out value-creating work that is unpaid, such as volunteer work and domestic care that parents provide to children or relatives to relatives. It leaves out the value of leisure time spent doing nothing but relaxing.

Secondly, GDP includes certain things that have no economic value (or negative value). Products that are bought then never used are one example. ‘White Elephant’ vanity projects, like the ones described here by the BBC’s Paul Mason, fall into this category.

Industrial activity that creates pollution and products that are harmful to health are often put in the second category: they add to GDP but have negative ‘externality’ effects for society. I would suggest treat these differently. They reveal another, deeper, flaw with GDP, which is that it ignores the ‘balance sheet’ effects of economic activity.  This is a major area of interest to environmental economists, but it has yet to make it into the mainstream of policy creation and debate.

Why do balance sheet effects matter? Because there are a range of economic activities that deplete our ‘stocks’ of natural capital (e.g. mining, oil extraction, fishing and some farming) and there are a range of activities that generate future economic liabilities (e.g. pollution, health deterioration). When economics was born hundreds of years ago, humanity’s impact on the environment was sufficiently small that balance sheet effects could be ignored. Now that the human race has grown to over 7 billion we are having a profound effect on our environment, and we can no longer ignore these effects. Just as it would be inconceivable to manage a business based solely on its profit and loss account, it is a fallacy for governments to concentrate so much on GDP, which measures only flows.

If this is not enough to convince you that GDP is a fatally flawed metric, consider another sort of good that it ignores: Free goods. GDP was developed in an age when most goods produced by businesses were products you could hold in your hand or services delivered face to face. Computing, software and the internet has changed all that. If I consider the most important services I use, most of them are information services, and most of them are provided to me for free by companies such as Google, Facebook and Skype, NFPs such as Wikipedia and the BBC, and individuals who share their thoughts through blogs. Advertising aside, none of this activity is captured by GDP, and yet lives all over the world have been made much richer by the easy availability of information and social contact for free.

GDP has been used consistently since WW2 because it has been a reasonable proxy for quality of life. But in the Information Age, the fundamental linkage between GDP and quality of life is broken (see also this HBR article). Infinitely scalable services with no marginal cost, given away for free, have changed the ball game and now we need a better stick with which to measure economic success.

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