GDP as Standard of Living

Part Of: Economics sequence
Content Summary: 2500 words, 25 min read

This will be an (embarrassingly high-level) overview of macroeconomics. This post is intended as a framework, a jumping-off point for more detailed analyses.

Introduction

During the Great Depression, Americans had a vague sense that it was harder to keep a job, and harder to pay your bills. But no one really knew how long it would last, or if it could be brought to a merciful end. Governments tried several policy solutions, but it was very hard to tell whether their policies were helping or hurting. Governments were making decisions on the basis of such sketchy data as stock price indices, freight car loading, and incomplete indices of industrial production. 

As the problem worsened, it weighed increasingly on the public mind. For the first time, the economy entered the public lexicon as a noun. And the situation prompted governments to get more serious about economic data collection. In order to forecast economic outcomes, it pays to get quantitative about the present. What is the state of the economy?

To answer this, we might endeavor to calculate the value of all the stuff in the United States. 

Imagine going through your living space, taking every possession and entering its value into a spreadsheet. Imagine doing this, but for all goods in every house, every apartment, every place of business, every square meter of pavement (and services too, like your last haircut). 

The calculation sounds daunting. So, why not just keep track of the stuff you bought this year? Rather than calculating wealth (net worth), it’s often simpler to calculate spending. Just as a wealthier person spends more, a wealthier nation (like the US) most plausibly produces more every year.

The formal definition:

Gross Domestic Product (GDP) is the market value of all finished goods and services produced within a country in a year. 

Now, three aspects facets of this definition are worth keeping in mind:

  • finished: A finished good is a good that will not be sold again as part of another good. Steel, engines, and flour often serve as examples of intermediate goods: raw materials that are repackaged into final goods like bicycles, cars, and bread. But if a customer buys eggs to make an omelette, those eggs still count as final goods, since the omelette will not be again put up for sale. 
  • produced: GDP only counts new goods and services. A used car sold this year does not count towards GDP; but a new car does. 
  • within a country: exports count, imports count against.

GDP is how economists measure three very important aspects of human societies:

  • Standard of living is GDP per capita. 
  • Productivity is GDP per hour worked.
  • Growth is GDP change over time.

Standard of living matters. In the DR Congo, people earn on average $500 per year. That’s only six baskets of stuff… for an entire year. In Mexico, $21,000 or 178 baskets. In the United States, it’s $67,000 or 545 baskets worth of stuff.

GDP Categories

In a personal budget, it often helps to group your spending habits by categories – so too for nations. GDP is often decomposed into four components: consumption,

  1. Consumption. Private expenditures, including durable goods, non-durable goods, and services.
  2. Investment. Does not include financial products (which is instead considered saving).
  3. Government Consumption. All government expenditures on final goods/services, and also its investments
  4. Net Exports. Exports have outbound value, imports have inbound value. Imports detracts from export receipt; Net Exports = Exports – Imports. 

To understand what drives changes in GDP, other disaggregations are possible. For example,

  • Partitioning by State or Province is useful in interrogating geographical information.
  • Partitioning by Industry is useful to flagging problematic industries. 

There is a related notion of Gross National Income (GNI). The relationship between expenditures and income is something like Newton’s Third Law: “for every action, there is an equal and opposite reaction”. In theory, GDP and GNI should be equivalent; in practice they sometimes slightly come apart (for complicated reasons). GNI thus provides a complementary way of measuring changes in wealth.

There are many ways to disaggregate GNI; one of the more popular operationalizations is to consider four factors: { employee compensation, rent, interest, and profit }.

Towards Real GDP

During the hyperinflation era of Zimbabwe, the price of a sheet of toilet paper went to 417 Z-dollars. Surely, we don’t want to confuse the act of printing more money, with producing more valuable goods and services. 

We’ve all heard our grandparents say, “when I was a kid, that cost a quarter”. But such memories conflate nominal versus real prices. If you control for inflation, some goods (e.g. movie tickets) have kept roughly the same price; other goods (e.g. electricity) have become easier to purchase. Yet inflation makes both feel more expensive.

In general, money illusion denotes our predisposition to focus on nominal rather than real prices. People positively revolt when their nominal salary is cut, but rarely notice if their real salary is cut (eg if inflation increases more than your raise).

To compute real GDP over time, simply fix your dollar value to a single year (eg 2020 dollars). This allows for comparison between real GDP versus nominal GDP. In the United States before 1980, nominal growth has been about 7.5% per year; whereas real growth has been about 3.5%.

Economic data like this also showcases two important facts: when Real GDP is negative for two consecutive quarters, that is the definition of a recession (you can’t see that as clearly in this dataset, which aggregates growth by year).

The cost of an iPhone is $700 USD in the United States, and $700 in India. The cost of a haircut is $20 in the United States, and $1 in India. This is the Balassa-Samuelson effect. Why should it exist?

If iPhones were sold for less in India, more people would purchase iPhones from India & have them shipped to their house. This process is called arbitrage, and it guarantees the Law of One Price. However, Law of One Price only applies to tradable goods: you cannot ship a haircut overseas.

Before adjusting for this effect, you might conclude that the average income of a person living in India is 33 times smaller than someone living in the United States. After the adjustment, the actual number becomes visible: only 10 times less purchasing power. 

The Significance of Growth

For most developed nations, GDP doesn’t increase linearly (say, an addition $10b per year), but exponentially (e.g. 2% more per year). Just as exponential growth in epidemics can lead to surprisingly horrendous outcomes, exponential growth in economies can lead to surprisingly affluent outcomes. 

The economically naive think to themselves, “previous lives were similar to mine, except with different ideas and older technologies.” But consider that, for the entirety of human history, our predecessors lived as close to starvation as the modern-day poorest nations. After controlling for inflation – with today’s dollars – almost everyone made less than $1 per day. 

Jesus once said, “The poor will always be with you”. And yes, a person living in the 1st century would have good reason to believe our species is eternally doomed to absolute poverty. But then the industrial revolution happened!

Take a moment to get your head around this. Extreme poverty has been the fate of 90% of the world’s population since our species emerged on the world scene some 270,000 years ago. Only two centuries ago did this state of affairs change.

Prior to the industrial revolution, all human beings were subject to the Malthusian trap, where resources were a zero-sum game. Wealth temporarily increased during the Black Death, simply because there were fewer people to “share the pie” with.

Another way to view this same data is by looking at land fertility (since agriculture used to be the only significant economic sector). Ever since the first agricultural revolution in 10,000 BCE, productivity has produced people, not prosperity. 

This was the state of affairs for 99.925% of human history. You are living in a very unusual time.

The Causes of Growth

So… how did our species escape the Malthusian trap?

Escape is not a guarantee. It didn’t happen before 1800. And it also didn’t happen uniformly; it began as a phenomenon of the West.

Why is there “divergence, big time”? What causes growth to succeed or fail? To answer this, we need a theory of the causes of growth. 

As a first pass, people use cultural knowledge and physical tools to produce goods and services. The Solow Model is used to model these immediate causes of growth. But as we arguably learned from communism, bad institutions can impeded incentives to produce. While harder to measure, institutional structure orchestrates economic production. Finally, institutions do not derive ex nihilo; rather, they too are (slowly) molded by the forces of history, geography, etc etc. Our account of growth thus features three tiers of causes.

You can see the effect of institutions clearly, by satellite photos of the Korea peninsula:

Most people see this picture and think, “wow, communism really made its citizenry poor”. But that is fuzzy thinking. In 1945, Korea was a single country, with the same (quite impoverished) economy. Sure, North Korea did become somewhat more poor, but the much larger effect was – South Korea became prosperous. 

The field of development economics studies what causes some nations to catch the growth train, and others to miss it (and what can be done).

GDP vs Wealth

If you could only choose two economic measures to track, which would they be?

  • A person’s finances cannot be completely described by income; it also helps to know your net worth
  • A company’s finances cannot be completely described by profits; it also helps to know your balance sheet
  • A country’s finances cannot be completely described by GDP; it also helps to know your total wealth.

Imagine a partially-full bathtub, with some water entering and some leaving. In system dynamics jargon of stocks and flows: GDP is an inflow, wealth is a stock.

After it has been bombed, a city’s GDP often increases. Why? The damage sustained during warfare is destruction of wealth: a large outflow. Yet by the law of diminishing marginal utility, it is often easier to replace capital rather than make even more stuff. While GDP gives you a rosy picture, if you also track wealth you will have an easier time grasping the true cost of war. 

It is often useful to extend our mental model to include the environment. In this sense, GDP relies on extraction of (often non-renewable) resources from the Earth. In this sense, GDP is not just an inflow to wealth, but also an outflow of natural resources.

Exactly how large is the stock of natural resources? Your answer will likely affect your judgment of the morality of the capitalistic enterprise. 

GDP vs Welfare

One way of interpreting policy decisions is that they ought to maximize a single variable: societal welfare. But what is this variable sensitive to?

Welfare is a multidimensional measure. Other dimensions arguably should be included in any final analysis:

Importantly, GDP tends to correlate with immaterial factors of welfare. As countries become more affluent, for example, they tend to invest more in health care (and vice versa). The correlation (bidirectional causal link) between GDP and life expectancy is very strong.

Positive psychology has been directly measuring subjective life satisfaction for many years now. Enduring low standards of living is unpleasant! 

In the above, GDP per capita has been log-transformed. When you are very poor, becoming more wealthy matters a lot; when you are rich, less so. 

I used to think consequentialist thinking was confined to 19th century philosophical traditions… and then I learned economics.

Five Concerns

I’ll mention five concerns often levied against free-market economics generally, and productivity specifically.

  1. Unsustainability. Exponential growth means exponential depletion. It cannot be sustained.
  2. Materialism. Developed nations produce much more than they need; so we lionize gratuitous consumption to increase demand. 
  3. Specialization. Division of labor produces more wealth. Yet as this process intensifies, our mental lives become increasingly banal.
  4. Inequality. Capitalism is extinguishing absolute poverty, but at the same time exacerbating relative inequality. This is unfair, and socially toxic.
  5. Monoculture. The West got rich first, and abused its power first by direct colonialist enslavement, and later by sneakily-abstract trade deals.

I will defer an evaluation of these charges for now; I simply felt it useful to present this incomplete list. 

Takeaways

This post discussed eight topics:

  1. GDP is “the market value of all finished goods and services produced within a country in a year”
  2. There are many ways to disaggregate GDP, including looks at GNI (the equivalent, income-based variant)
  3. After you adjust for inflation, Nominal GDP becomes Real GDP. After you adjust for the Balassa-Samuelson effect, Real GDP can facilitate between-country comparisons.
  4. Before the industrial revolution, our species was stuck in a Malthusian trap, where productivity produced people not prosperity.
  5. Physical capital, human capital, and ideas conspire to create wealth. More distal influences include institutions, including property rights, reliable courts, etc…
  6. Growth is an inflow into a country’s wealth. It is important to recognize that growth depletes natural resources.  
  7. Welfare (aggregate life satisfaction) requires more than material comfort. But note! GDP strongly correlates with life expectancy and happiness.
  8. There are five concerns often voiced towards GDP talk. They are unsustainability, materialism, specialization, inequality, and monoculture.

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