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Nobel Prize-winning economist Joseph Stiglitz explains why our reliance on the GDP metric masked the economy's ill health before the credit crisis hit.
Marie Leone, CFO.com | US
September 29, 2009
One of the reasons the global financial crisis took the world by surprise may be that our measurement system failed. That is, market participants and government officials were not focused on the right set of statistical indicators, claims a report from a panel of top economists led by Nobel Prize winners Joseph Stiglitz and Amartya Sen.
One of the main culprits, according to the research, which was commissioned by President Nicolas Sarkozy of France, is that the classic and widely referenced gross domestic product metric is no longer a good measure of general well-being — and, in fact, has not been for some time
Simply put, the GDP is a measure of economic performance that represents the value of all the goods and services in an economy based on prices being charged. But there has long been discussion of the metric's alleged deficiencies; namely, that it does not take into account factors such as disparity in the distribution of wealth, depletion of natural resources, underground economies, and the quality of goods and services.
Stiglitz, Sen, and their colleagues say that such deficiencies helped portray the U.S. economy, and to a larger extent the global economy, as being in better shape than it actually was before the credit crisis hit. "In a performance-oriented society, what you measure affects what you do. If you have the wrong measures, you can wind up doing the wrong thing," asserted Stiglitz at a seminar last Friday sponsored by law firm Labaton Sucharow.
A key problem, according to Stiglitz, was that faux profits were factored into GDP calculations. He noted that, for example, 41% of all corporate profits in 2007 were generated in the financial sector and tied to debt. In other words, the gains were "borrowed from the future," he said.
As a result, the massive subprime-related losses that financial institutions booked in 2008 wiped out not only the profits from 2007 but also those from the preceding five years. "They were not really profits, but we recorded them as fantastic years," asserted Stiglitz.
Further, during the bubble-based run-up to the economic crisis, prices of output or capital were much higher than they should have been — 30% or more higher in the case of real estate. So the value of all goods and services being used to calculate the GDP "overestimated output," he concluded.
The GDP also fell short as a measure of sustainable growth, because the U.S. consumption boom between 2003 and 2007 was based on debt, and borrowing to generate consumption is unsustainable, added Stiglitz.
Another fundamental measuring mistake relates to household income. Adjusted for inflation, median household income in 2008 fell to $50,303, which was 4% below its 2000 level and continued a downward trend that had been accelerating for some time. That's "a striking statistic," said Stiglitz, because the GDP per capita for the same period climbed from $33,700 in 2000 to $38,100 in 2008 (adjusted for inflation).
The counterintuitive trend is explained by the increasing financial inequality within American society, which allows the two measures to go in absolutely different directions. The implication, according to Stiglitz, is that most citizens' standard of living goes down while the GDP goes up.
Another problem with the metric is that in some sectors, such as health care, GDP calculations take into consideration input but ignore output. So as an economy becomes less efficient, input and the GDP increase because of higher spending, "but things you care about actually go down," including citizens' health, opined Stiglitz.
Health-care spending currently accounts for 16% of the U.S. GDP, and that percentage is rising steadily. Yet "health outcomes in the U.S. are not commensurate with spending," he said. That means other countries are spending less and getting better results — witness France, which spends 11% of its GDP on health care and is ahead of the United States in life expectancy and other health metrics.
Stiglitz also addressed the issue of sustainability with respect to climate change, in particular the "false prices" that the United States and other countries use when valuing natural resources. "Our price system is based on the assumption that one of the scarcest resources we have has a zero price, and we know that can't be right," he said.
That scarce asset is clean air. Stiglitz's reasoning is that the Earth has a limited amount of capacity in its atmosphere to absorb the CO2 emissions that are spewed into the air by factories and cars, and are believed to be the main contributor to global warming.
He noted that many experts believe CO2 emissions should be priced at around $80 to $100 per ton. When the United States eventually factors the cost of carbon into its economy in that way, it will affect everything that emanates from fossil-fired energy production. Until then, prices will remain distorted.
"Our accounting framework affects how you see the world, and our accounting framework is flawed," said Stiglitz, who as a member of the Council of Economic Advisors under President Clinton lobbied for the United States to use metrics incorporating the effects of natural-resource depletion. "I knew we were on to something important when Congress said that if we did this, our funding would be cut. The coal industry was very adamant that we not [put a price on carbon]."
After the Great Depression, the GDP was used to take the stock market's temperature. But over the years, it increasingly became a measure of how well society was doing, "and those are two very different things," noted Stiglitz. In fact, he also counsels market participants to avoid using the stock market as a measure of economic health, especially now in the midst of the downturn. "The stock market is a very bad measure of how the overall economy is doing," he explained.
For one thing, said Stiglitz, the stock market could be bolstered by falling wages. Consider the current situation: it is likely that the true U.S. unemployment rate is much higher than the official 9.7%, putting extra downward pressure on wages. Sinking wages can boost short-term profitability for individual companies but ultimately diminish aggregate demand, stifling a strong economic recovery.
Today's stock market prices also may appear high because the Fed is keeping interest rates low, realizing that the economy is not yet in a robust recovery. Low interest is a natural deterrent for investors looking for a decent return. "Would you rather get zero on your bank deposits or put your money in the stock market — even with the risk?" Stiglitz asked the crowd.