Policymakers around the world have used Gross Domestic Product as the main gauge of economic performance – and have often adopted policies that aim to maximise its rate of growth. Generation after generation of economists have committed significant time and effort to thinking about the factors that influence GDP growth, on the premise that an expanding and healthy economy is one that sees its GDP increasing every year at a sufficient rate.
But is economic output a good enough indicator of national economic wellbeing? Costanza et al (2014) (see link below) argue that, despite its merits, GDP can be a ‘misleading measure of national success’:
GDP measures mainly market transactions. It ignores social costs, environmental impacts and income inequality. If a business used GDP-style accounting, it would aim to maximize gross revenue — even at the expense of profitability, efficiency, sustainability or flexibility. That is hardly smart or sustainable (think Enron). Yet since the end of the Second World War, promoting GDP growth has remained the primary national policy goal in almost every country. Meanwhile, researchers have become much better at measuring what actually does make life worthwhile. The environmental and social effects of GDP growth is a misleading measure of national success. Countries should act now to embrace new metrics.
The limitations of GDP growth as a measure of economic wellbeing and national strength are becoming increasingly clear in today’s world. Some of the world’s wealthiest countries are plagued by discontent, with a growth in populism and social discontent – attitudes which are often fuelled by high rates of poverty and economic hardship. In a recent report titled ‘The Living Standards Audit 2018’ published by the Resolution Foundation, a UK economic thinktank (see link below), the authors found that child poverty rose in 2016–17 as a result of declining incomes of the poorest third of UK households:
While the economic profile of UK households has changed, living standards – with the exception of pensioner households – have mostly stagnated since the mid-2000s. Typical household incomes are not much higher than they were in 2003–04. This stagnation in living standards for many has brought with it a rise in poverty rates for low to middle income families. Over a third of low to middle income families with children are in poverty, up from a quarter in the mid-2000s, and nearly two-fifths say that they can’t afford a holiday away for their children once a year. On the other hand, the share of non-working families in poverty has fallen, though not by enough to prevent an overall rise in poverty since 2010.
Their projections also show that this rise in poverty was likely to have continued in 2017–18:
Although the increase in broad measures of inequality were relatively muted last year, our nowcast suggests that there was a pronounced rise in poverty (measured after housing costs[…]. The increase in overall poverty (from 22.1 to 23.2 per cent) was the largest since 1988. But this was dwarfed by the increase in child poverty, which rose from 30.3 per cent to 33.4 per cent. […]The fortunes of middle-income households diverged from those towards the bottom of the distribution and so a greater share of households, and children, found themselves below the poverty threshold.
A simple literature search on Scope (or even Google Scholar) shows that there has been a significant increase in the number of journal articles and reports in the last 10 years on this topic. We do talk more about the limitations of GDP, but we are still using it as the main measure of national economic performance.
Is it then time to stop focusing our attention on GDP growth exclusively and start considering broader metrics of social development? And what would such metrics look like? Both interesting questions that we will try to address in coming blogs.
- What are the main strengths and weakness of using GDP as measure of economic performance?
- Is high GDP growth alone enough to foster economic and social wellbeing? Explain your answer using examples.
- Write a list of alternative measures that could be used alongside GDP-based metrics to measure economic and social progress. Explain your answer.
Ten years ago, the financial crisis deepened and stock markets around the world plummeted. The trigger was the collapse of Lehman Brothers, the fourth-largest US investment bank. It filed for bankruptcy on September 15, 2008. This was not the first bank failure around that time. In 2007, Northern Rock in the UK (Aug/Sept 2007) had collapsed and so too had Bear Stearns in the USA (Mar 2008).
Initially there was some hope that the US government would bail out Lehmans. But when Congress rejected the Bank Bailout Bill on September 29, the US stock market fell sharply, with the Dow Jones falling by 7% the same day. This was mirrored in other countries: the FTSE 100 fell by 15%.
At the core of the problem was excessive lending by banks with too little capital. What is more, much of the capital was of poor quality. Many of the banks held securitised assets containing ‘sub-prime mortgage debt’. The assets, known as collateralised debt obligations (CDOs), were bundles of other assets, including mortgages. US homeowners had been lent money based on the assumption that their houses would increase in value. When house prices fell, homeowners were left in a position of negative equity – owing more than the value of their house. With many people forced to sell their houses, prices fell further. Mortgage debt held by banks could not be redeemed: it was ‘sub-prime’ or ‘toxic debt’.
Response to the crisis
The outcome of the financial crash was a series of bailouts of banks around the world. Banks cut back on lending and the world headed for a major recession.
Initially, the response of governments and central banks was to stimulate their economies through fiscal and monetary policies. Government spending was increased; taxes were cut; interest rates were cut to near zero. By 2010, the global economy seemed to be pulling out of recession.
However, the expansionary fiscal policy, plus the bailing out of banks, had led to large public-sector deficits and growing public-sector debt. Although a return of economic growth would help to increase revenues, many governments felt that the size of the public-sector deficits was too large to rely on economic growth.
As a result, many governments embarked on a period of austerity – tight fiscal policy, involving cutting government expenditure and raising taxes. Although this might slowly bring the deficit down, it slowed down growth and caused major hardships for people who relied on benefits and who saw their benefits cut. It also led to a cut in public services.
Expanding the economy was left to central banks, which kept monetary policy very loose. Rock-bottom interest rates were then accompanied by quantitative easing. This was the expansion of the money supply by central-bank purchases of assets, largely government bonds. A massive amount of extra liquidity was pumped into economies. But with confidence still low, much of this ended up in other asset purchases, such as stocks and shares, rather than being spent on goods and services. The effect was a limited stimulation of the economy, but a surge in stock market prices.
With wages rising slowly, or even falling in real terms, and with credit easy to obtain at record low interest rates, so consumer debt increased.
So have the lessons of the financial crash been learned? Would we ever have a repeat of 2007–9?
On the positive side, financial regulators are more aware of the dangers of under capitalisation. Banks’ capital requirements have increased, overseen by the Bank for International Settlements. Under its Basel II and then Basel III regulations (see link below), banks are required to hold much more capital (‘capital buffers’). Some countries’ regulators (normally the central bank), depending on their specific conditions, exceed these the Basel requirements.
But substantial risks remain and many of the lessons have not been learnt from the financial crisis and its aftermath.
There has been a large expansion of household debt, fuelled by low interest rates. This constrains central banks’ ability to raise interest rates without causing financial distress to people with large debts. It also makes it more likely that there will be a Minsky moment, when a trigger, such as a trade war (e.g. between the USA and China), causes banks to curb lending and consumers to rein in debt. This can then lead to a fall in aggregate demand and a recession.
Total debt of the private and public sectors now amounts to $164 trillion, or 225% of world GDP – 12 percentage points higher than in 2009.
China poses a considerable risk, as well as being a driver of global growth. China has very high levels of consumer debt and many of its banks are undercapitalised. It has already experienced one stock market crash. From mid-June 2015, there was a three-week fall in share prices, knocking about 30% off their value. Previously the Chinese stock market had soared, with many people borrowing to buy shares. But this was a classic bubble, with share prices reflecting exuberance, not economic fundamentals.
Although Chinese government purchases of shares and tighter regulation helped to stabilise the market, it is possible that there may be another crash, especially if the trade war with the USA escalates even further. The Chinese stock market has already lost 20% of its value this year.
Then there is the problem with shadow banking. This is the provision of loans by non-bank financial institutions, such as insurance companies or hedge funds. As the International Business Times article linked below states:
A mind-boggling study from the US last year, for example, found that the market share of shadow banking in residential mortgages had rocketed from 15% in 2007 to 38% in 2015. This also represents a staggering 75% of all loans to low-income borrowers and risky borrowers. China’s shadow banking is another major concern, amounting to US$15 trillion, or about 130% of GDP. Meanwhile, fears are mounting that many shadow banks around the world are relaxing their underwriting standards.
Another issue is whether emerging markets can sustain their continued growth, or whether troubles in the more vulnerable emerging-market economies could trigger contagion across the more exposed parts of the developing world and possibly across the whole global economy. The recent crises in Turkey and Argentina may be a portent of this.
Then there is a risk of a cyber-attack by a rogue government or criminals on key financial insitutions, such as central banks or major international banks. Despite investing large amounts of money in cyber-security, financial institutions worry about their vulnerability to an attack.
Any of these triggers could cause a crisis of confidence, which, in turn, could lead to a fall in stock markets, a fall in aggregate demand and a recession.
Finally there is the question of the deep and prolonged crisis in capitalism itself – a crisis that manifests itself, not in a sudden recession, but in a long-term stagnation of the living standards of the poor and ‘just about managing’. Average real weekly earnings in many countries today are still below those in 2008, before the crash. In Great Britain, real weekly earnings in July 2018 were still some 6% lower than in early 2008.
- The Lehman Brothers Crash And The Chaos That Followed – Everything You Need To Know
HuffPost, Isabel Togoh (15/9/18)
- Ten years after the crash: have the lessons of Lehman been learned?
The Guardian, Yanis Varoufakis, Ann Pettifor, Mark Littlewood, David Blanchflower, Olli Rehn, Nicky Morgan and Micah White (14/9/18)
- Financial crisis 10 years on: Who are the winners and losers?
Independent, Kate Hughes (14/9/18)
- Investment winners and losers 10 years after the crash
Financial Times, Kate Beioley (14/9/18)
- Nine Lessons From the Global Financial Crisis
Bloomberg, Mohamed A. El-Erian (13/9/18)
- Lehman — why we need a change of mindset
Deutsche Welle, Thomas Straubhaar (14/9/18)
- ‘The world is sleepwalking into a financial crisis’ – Gordon Brown
The Guardian, Larry Elliott (12/9/18)
- Economists warn of new financial crisis on anniversary of 2008 crash
Channel 4 news, Helia Ebrahimi (15/9/18)
- Financial crisis 2008: Five biggest risks of a new crash
International Business Times, Nafis Alam (14/9/18)
- Carney warns against complacency on 10th anniversary of financial crisis
BBC News, Kamal Ahmed (12/9/18)
- A cyberattack could trigger the next financial crisis, new report says
CNBC, Bob Pisani (13/9/18)
Information and data
- Explain the major causes of the financial market crash in 2008.
- Would it have been a good idea to have continued with expansionary fiscal policy beyond 2009?
- Summarise the Basel III banking regulations.
- How could quantitative easing have been differently designed so as to have injected more money into the real sector of the economy?
- What are the main threats to the global economy at the current time? Are any of these a ‘hangover’ from the 2007–8 financial crisis?
- What is meant by ‘shadow banking’ and how might this be a threat to the future stability of the global economy?
- Find data on household debt in two developed countries from 2000 to the present day. Chart the figures. Explain the pattern that emerges and discuss whether there are any dangers for the two economies from the levels of debt.
The last two weeks have been quite busy for macroeconomists, HM Treasury staff and statisticians in the UK. The Chancellor of the Exchequer, Mr Phillip Hammond, delivered his (fairly upbeat) Spring Budget Statement on 13 March, highlighting among other things the ‘stellar performance’ of UK labour markets. According to a Treasury Press Release:
Employment has increased by 3 million since 2010, which is the equivalent of 1,000 people finding work every day. The unemployment rate is close to a 40-year low. There is also a joint record number of women in work – 15.1 million. The OBR predict there will be over 500,000 more people in work by 2022.
To put these figures in perspective, according to recent ONS estimates, in January 2018 the rate of UK unemployment was 4.3 per cent – down from 4.4 per cent in December 2017. This is the lowest it has been since 1975. This is of course good news: a thriving labour market is a prerequisite for a healthy economy and a good sign that the UK is on track to full recovery from its 2008 woes.
The Bank of England welcomed the news with a mixture of optimism and relief, and signalled that the time for the next interest rate hike is nigh: most likely at the next MPC meeting in May.
But what is the practical implication of all this for UK consumers and workers?
For workers it means it’s a ‘sellers’ market’: as more people get into employment, it becomes increasingly difficult for certain sectors to fill new vacancies. This is pushing nominal wages up. Indeed, UK wages increased on average by 2.6 per cent year-to-year.
In real terms, however, wage growth has not been high enough to outpace inflation: real wages have fallen by 0.2 per cent compared to last year. Britain has received a pay rise, but not high enough to compensate for rising prices. To quote Matt Hughes, a senior ONS statistician:
Employment and unemployment levels were both up on the quarter, with the employment rate returning to its joint highest ever. ‘Economically inactive’ people — those who are neither working nor looking for a job — fell by their largest amount in almost five and a half years, however. Total earnings growth continues to nudge upwards in cash terms. However, earnings are still failing to outpace inflation.
An increase in interest rates is likely to put further pressure on indebted households. Even more so as it coincides with the end of the five-year grace period since the launch of the 2013 Help-to-Buy scheme, which means that many new homeowners who come to the end of their five year fixed rate deals, will soon find themselves paying more for their mortgage, while also starting to pay interest on their Help-to-buy government loan.
Will wages grow fast enough in 2018 to outpace inflation (and despite Brexit, which is now only 12 months away)? We shall see.
Data, Reports and Analysis
- What is monetary policy, and how is it used to fine tune the economy?
- What is the effect of an increase in interest rates on aggregate demand?
- How optimistic (or pessimistic) are you about the UK’s economic outlook in 2018? Explain your reasoning.
In delivering his Budget on 22 November, Philip Hammond reported that the independent Office for Budget Responsibility had revised down its forecasts of growth in productivity and real GDP, and hence of earnings growth.
Today, median earnings are £23,000 per annum. This is £1500 less than the £24,500 that the median worker earned in 2008 in today’s prices. The OBR forecasts a growth in real household disposable income of just 0.35% per annum for the next four years.
With lower growth in earnings would come a lower growth in tax revenues. With his desire to cut the budget deficit and start eventually reducing government debt, this would give the government less scope for spending on infrastructure, training and other public-sector investment; less scope to support public services, such as health and education; less scope for increasing benefits and public-sector wages.
The normal measure of productivity, and the one used by the OBR, is the value of output produced per hour worked. This has hardly increased at all since the financial crisis of 2008. It now takes an average worker in the UK approximately five days to produce the same amount as it takes an average worker in Germany four days. Although other countries’ productivity growth has also slowed since the financial crisis, it has slowed more in the UK and from a lower base – and is now forecast to rebound less quickly.
For the past few years the OBR has been forecasting that productivity growth would return to the trend rate of just over 2% that the UK achieved prior to 2008. For example, the forecasts it made in June 2010 are shown by the grey line in the chart, which were based on the pre-crash trend rate of growth in productivity (click on chart to enlarge). And the forecasts it made in November 2016 are shown by the pale green line. Yet each year productivity has hardly changed at all. Today output per hour is less than 1% above its level in 2008.
Now the OBR believes that poorer productivity growth will persist. It is still forecasting an increase (the blue line in the chart) – but by 0.7 of a percentage point less than it was forecasting a year ago (the pale green line): click here for a PowerPoint of the chart.
We have assumed that productivity growth will pick up a little, but remain significantly lower than its pre-crisis trend rate throughout the next five years. On average, we have revised trend productivity growth down by 0.7 percentage points a year. It now rises from 0.9 per cent this year to 1.2 per cent in 2022. This reduces potential output in 2021-22 by 3.0 per cent. The ONS estimates that output per hour is currently 21 per cent below an extrapolation of its pre-crisis trend. By the beginning of 2023 we expect this to have risen to 27 per cent.
Why has there been such weak productivity growth?
Weak productivity growth has been caused by a mixture of factors.
Perhaps the most important is that investment as a percentage of GDP has been lower than before the financial crisis and lower than in other countries. Partly this has been caused by a lack of funding for investment as banks have sought to rebuild their capital and have cut down on riskier loans. Partly it has been caused by a lack of demand for investment, given sluggish rates of economic growth and the belief that austerity will continue.
And it is not just private investment. Public-sector investment in transport infrastructure, housing and education and training has been lower than in other countries. Indeed, the poor training record and low skill levels in the UK are main contributors to low productivity.
The fall in the pound since the Brexit vote has raised business costs and further dampened demand as incomes have been squeezed.
Another reason for low productivity growth has been that employers have responded to weak demand, not by laying off workers and thereby raising unemployment, but by retaining low-productivity workers on low wages. Another has been the survival of ‘zombie’ firms, which, by paying low wages and facing ultra-low interest rates, are able to survive competition from firms that do invest.
Why is weak productivity growth forecast to continue?
Looking forward, the nature of the Brexit deal will impact on confidence, investment, wages and growth. If the deal is bad for the UK, the OBR’s forecasts are likely to be too optimistic. As it is, uncertainty over the nature of the post-Brexit world is weighing heavily on investment as some businesses choose to wait before committing to new investment.
On the other hand, exports may rise faster as firms respond to the depreciation of the pound and this may stimulate investment, thereby boosting productivity.
Another factor is the effect of continuing tight Budgets. There was some easing of austerity in this Budget, as the Chancellor accepted a slower reduction in the deficit, but government spending will remain tight and this is likely to weigh on growth and investment and hence productivity.
But this may all be too gloomy. It is very difficult to forecast productivity growth, especially as it is hard to measure output in much of the service sector. It may be that the productivity growth forecasts will be revised up before too long. For example, the benefits from new technologies, such as AI, may flow through more quickly than anticipated. But they may flow through more slowly and the productivity forecasts may have to be revised down even further!
The OBR’s productivity “forecast” Financial Times, Kadhim Shubber
U.K. Faces Longest Fall in Living Standards on Record Bloomberg, Simon Kennedy and Thomas Penny (23/11/17)
Britain’s Productivity Pain Costs Hammond $120 Billion Bloomberg, Fergal O’Brien (22/11/17)
OBR slashes Britain’s growth forecast on sluggish productivity and miserly pay The Telegraph, Tim Wallace (22/11/17)
Budget 2017: Stagnant earnings forecast ‘astonishing’ BBC News (23/11/17)
Economists warn Budget measures to lift productivity fall short Financial Times, Gavin Jackson and Gill Plimmer (22/11/17)
Why the economic forecasts for Britain are so apocalyptic – and how much Brexit is to blame Independent, Ben Chu (24/11/17)
Growth holds steady as economists doubt OBR’s gloom The Telegraph, Tim Wallace (23/11/17)
Britain’s debt will not fall to 2008 levels until 2060s, IFS says in startling warning Independent, Lizzy Buchan (23/11/17)
Philip Hammond’s budget spots Britain’s problems but fails to fix them The Economist (22/11/17)
Debunking the UK’s productivity problem The Conversation, Paul Lewis (24/11/17)
Budget 2017: experts respond The Conversation (22/11/17)
Autumn Budget 2017 Forecasts Mean ‘Longest Ever Fall In Living Standards’, Says Resolution Foundation Huffington Post, Jack Sommers (23/11/17)
It May Just Sound Like A Statistic, But Productivity Growth Matters For All Of Us Huffington Post, Thomas Pope (24/11/17) (see also)
UK prospects for growth far weaker than first predicted, says OBR The Guardian, Angela Monaghan (22/11/17)
UK faces two decades of no earnings growth and more austerity, says IFS The Guardian, Phillip Inman (23/11/17)
Age of austerity isn’t over yet, says IFS budget analysis The Guardian, Larry Elliott (23/11/17)
Summary of Budget measures
Budget 2017: FT experts look at what it means for you Financial Times (24/11/17)
Autumn Budget 2017 HM Treasury (22/11/17)
Economic and fiscal outlook – November 2017 Office for Budget Responsibility (22/11/17)
Autumn Budget 2017 Institute for Fiscal Studies (23/11/17)
- What measures of productivity are there other than output per hour? Why is output per hour normally the preferred measure of productivity?
- What factors determine output per hour?
- Why have forecasts of productivity growth rates been revised downwards?
- What are the implications of lower productivity growth for government finances?
- What could cause an increase in output per hour? Would there be any negative effects from these causes?
- What policies could the government pursue to increase productivity? How feasible are these policies? Explain.
- Would it matter if the government increased borrowing substantially to fund a large programme of public investment?
The latest edition of the IMF’s Fiscal Monitor, ‘Tackling Inequality’ challenges conventional wisdom that policies to reduce inequality will also reduce economic growth.
While some inequality is inevitable in a market-based economic system, excessive inequality can erode social cohesion, lead to political polarization, and ultimately lower economic growth.
The IMF looks at three possible policy alternatives to reduce inequality without damaging economic growth
The first is a rise in personal income tax rates for top earners. Since top rates have been cut in most countries, with the OECD average falling from 62% to 35% over the past 30 years, the IMF maintains that there is considerable scope of raising top rates, with the optimum being around 44%. Evidence suggests that income tax elasticity is low at most countries’ current top rates, meaning that a rise in top income tax rates would only have a small disincentive effect on earnings.
An increased progressiveness of income tax should be backed by sufficient taxes on capital to prevent income being reclassified as capital. Different types of wealth tax, such as inheritance tax, could also be considered. Countries should also reduce the opportunities for tax evasion.
The second policy alternative is a universal basic income for all people. This could be achieved by various means, such as tax credits, child benefits and other cash benefits, or minimum wages plus benefits for the unemployed or non-employed.
The third is better access to health and education, both for their direct effect on reducing inequality and for improving productivity and hence people’s earning potential.
In all three cases, fiscal policy can help through a combination of taxes, benefits and public expenditure on social infrastructure and human capital.
But a major problem with using increased tax rates is international competition, especially with corporation tax rates. Countries are keen to attract international investment by having corporation tax rates lower than their rivals. But, of course, countries cannot all have a lower rate than each other. The attempt to do so simply leads to a general lowering of corporation tax rates (see chart in The Economist article) – to a race to the bottom. The Nash equilibrium rate of such a game is zero!
Raising Taxes on the Rich Won’t Necessarily Curb Growth, IMF Says Bloomberg, Ben Holland and Andrew Mayeda (11/10/17)
The Fiscal Monitor, Introduction IMF (October 2017)
Transcript of the Press Conference on the Release of the October 2017 Fiscal Monitor IMF (12/10/17)
Higher taxes can lower inequality without denting economic growth The Economist, Buttonwood (19/10/17)
Trump says the US has the highest corporate tax rate in the world. He’s wrong. Vox, Zeeshan Aleem (31/8/17)
Reducing inequality need not hurt growth Livemint, Ajit Ranade (18/10/17)
IMF: higher taxes for rich will cut inequality without hitting growth The Guardian, Larry Elliott and Heather Stewart (12/10/17)
IMF Fiscal Monitor
IMF Fiscal Monitor: Tackling Inequality – Landing Page IMF (October 2017)
Opening Remarks of Vitor Gaspar, Director of the Fiscal Affairs Department at a Press Conference Presenting the Fall 2017 Fiscal Monitor: Tackling Inequality IMF (11/10/17)
Fiscal Monitor, Tackling Inequality – Full Text IMF (October 2017)
- Referring to the October 2017 Fiscal Monitor, linked above, what arguments does the IMF use for suggesting that the optimal top rate of income tax is considerably higher than the current OECD average?
- What are the arguments for introducing a universal basic income? Should this depend on people’s circumstances, such as the number of their children, assets, such as savings or property, and housing costs?
- Find out the details of the UK government’s Universal Credit. Does this classify as a universal basic income?
- Why may governments reject the IMF’s policy recommendations to tackle inequality?
- In what sense can better access to health and education be seen as a means of reducing inequality? How is inequality being defined in this case?
- Find out what the UK Labour Party’s policy is on rates of income tax for top earners. Is this consistent with the IMF’s policy recommendations?
- What does the IMF report suggest about the shape of the Laffer curve?
- Explain what is meant by tax elasticity and how it relates to the Laffer curve?