The growing divorce between GDP and the 'real' economy

There is now a large literature highlighting the inadequacy of GDP growth as a useful measure of overall societal progress. But even if we narrow the focus to just the economy there are powerful reasons to think GDP growth is a poor indicator of real economic expansion. What I mean by "real economic expansion" is the ability of the economy to deliver additional goods & services on a per capita basis in a way that is affordable over time. In what follows I will highlight three fundamental trends that indicate very little, if any, of today's GDP growth meets this definition. We will look at each in turn, before reflecting on the significance.

Financialisation

Over the last 40 years, we have witnessed the rise of 'financialisation' defined as the growth in scale and profitability of the finance sector. In OECD countries it estimated that the financial services typically makes up about 20% of GDP, whereas for the global economy it might be between 12 to 19.5% of global GDP.

Much of the growth in this sector, however, has nothing to do with the generation of additional goods & services. A large portion of income in the sector is derived from investments made in already existing assets i.e. the stock market and housing. Many of these investments are simply wild speculation – in the form of currency trading, credit default swaps and mortgage-backed securities – which are essentially risky attempts by investors to make money from money. By acting as middle men banks and finance mangers are able to make income of these activities through fees, commissions and interest. Far from the creation of new real wealth, this sector is in the business of creating unstable financial bubbles – mostly for the benefit of the already wealthy – that will someday burst.

Compensatory Costs

A second reason for the divorce between GDP and the real economy has long been recognised by ecological economists. The point was well made at a conference I recently attended. One of the speakers pointed out that, according to the official GDP figures, the catastrophic Black Saturday Bushfires actually helped to stimulate the Victorian economy. How could this be? After all, areport commissioned by the Australian Business Roundtable for Disaster Resilience and Safer Communities, foundthe bushfire created $3.1 billion in direct financial damages, and an additional $3.7 billion in social costs (i.e. job losses, psychological trauma etc.). But, of course, all this expenditure created economic turnover which was included in the official GDP figures. But it is obvious that this had nothing to do with creating additional prosperity for these townships, or the state of Victoria. The economic activity was simply compensating for the previous damage caused. Also, in the future, Victoria will generate additional GDP through expenditure designed to better defend against future bushfires.

The point is, as critics have long pointed out, GDP is an indiscriminate measure of economic activity, that fails to deduct these compensatory and defensive costs from the accounts. Moreover, many of these costs are directly or indirectly caused by the economic process itself. The GDP generated by the repair works needed to fix a damaged car, or the occupational health costs incurred by people in the workplace are obvious examples. Even in the case of natural disasters, such as the Victorian Bushfire, climate scientist pointed out that severe weather events like this will become more common in the future due to human induced climate change which, as we know, is caused by the greenhouse gas emissions released via the economic process.

Importantly, these defensive and compensatory costs are rising, both in absolute terms and as proportion of GDP. While it is very difficult to estimate such costs, and evidence seems sparse, one German study found these costs had risen from 7% of GDP in 1970s to 11% of GDP in 1988. It is very likely that since that time, and increasingly in the future, these costs will rise particularly given the intensifying ecological crisis as well as increasing social breakdown, necessitating additional compensatory and defensive expenditure.

The Growth in Debt

The third reason why GDP growth is unreliable, is that today economic growth is becoming ever more dependent on higher accumulations of both public and private debt. Here, of course, there is a direct link between debt and financialisation because whenpeople borrow the finance industry makes more money by collecting interest, and also by charging middleman fees on lending transactions.

Financial analyst Tim Morgan argues that in recent times we have been "faking growth by borrowing". This is reflected in the growing debt to GDP ratio. Morgan estimates, for example, that over the ten years from 2005 to 2015 Global GDP increased by an aggregate of $20.1 trillion (all figures here use "constant" numbers, stated at 2015 values, adjusted for inflation, and use U.S PPP methodology), but, over the same period world debt increased by $76.5 trillion. That is, over this period, for every $1 of GDP growth, an additional $3.81 had to be borrowed. And the ratio appears to be increasing all the time. In other words, by 2015almost one quarter of all global debt represents excess claims on credit beyond what the real economy produced. Much of it will very likely never be repaid but instead will be written off.

It's true, of course, that within our modern monetary system borrowing is necessary to necessary to provide funds for productive investments, that drive growth. But as Morgan points out, it is not the case that all that rising debt is being used to fund productive investment. Not only is much of it invested, as explained above, in non-productive and risky financial services, in addition a significant proportion – Morgan estimates $12 trillion of the $76 trillion in debt accumulated between 2005-2015 – has been used to fund immediate consumption. But, as he points out, this merely "brings forward consumption at the cost of increased liabilities in the future."

It is revealing what happens to the GDP figures when the portion of debt used to fund immediate consumption is deducted from the GDP accounts. If this is done 2015 Global GDP should be reduced from $114 trillion to $102 trillion, and Morgan estimates trend growth over the period would be reduced from about 3-4% in conventional estimates to about $1.2% per annum.

Why have we seen an explosion in debt to GDP? There could be several factors at play, but the most important it seems to me, is related to the increasing cost of oil. As biophysical economists argue, economic growth crucially depends on additional inputs of energy. But from 2005 to 2014, following the peak in conventional oil, the global economy had to withstand very high oil prices. Across this period, consumers and investors took on ever greater levels of debt in order to maintain spending in the face of rising costs induced by the higher oil price. Of course, the high oil price incentivised additional oil supply, and we are consequently now experiencing an oil supply glut and relatively 'low' prices (though still double the adjusted for inflation price of oil in the 1990s). But the debt hang-over remains. And, while the low oil price relieves consumers, the debt problem is being transferred to oil producers, who are now rapidly accumulating debt, as they struggle to remain profitable at today's low oil price, especially given their increasing extraction costs of unconventional sources.

Implications:

If we consider these three trends together – financialisation, growing compensatory & defensive costs, and the increasing dependence on debt – we can see that GDP figures are a very unreliable indicator of the real state of the economy. These trends help explain why people today feel less prosperous, irrespective of rising GDP. But the reality is beginning to be revealed in the hard data. In Britain, Morgan points out that the cost of basic goods such as food & housing has risen faster than real wages. When one factors in population growth, he estimates that in terms of discretionary income (i.e. real wages, minus costs of essentials) Britain reached peak prosperity in 2003 and since then most people have become poorer. The trend is similar across the OECD. One study found that since 2005, real wage growth for the bottom 70% of households had stagnated or fallen, whereas before that time they had enjoyed at least some growth.

But none of this should be taken to mean the sensible path lies in, somehow, cranking up (real) growth and expanding the economy, as most policy makers and indeed ordinary people seem to want. A hard reality must eventually be faced. Even if we put aside the fact that GDP figures inflate the true size and "health" of the economy, still, in global terms the average western citizen has a material footprint that would be impossible to extend to all 9 billion people expected to inhabit the earth by 2050. The trends above should rather shake us out of our slumber, and waken us up to the fact that, whatever the GDP figures tell us, we face ecological, social and energy limits to growth. We need to take our collective eyes off the GDP, and develop alternative indicators of progress but, more importantly, new ways of living involving much lighter footprints but which still enable a good quality of life for all.