Janan Ganesh, an often original if not iconoclastic columnist, asked why bad governments such as populist ones don’t seem to undermine economic growth, at least in the short run (“Why Hasn’t Populism Done More Economic Harm,” Financial Times, January 23, 2024). This provides us with a good opportunity to review what GDP numbers cannot prove.
For seven or eight decades, it has been known to economists (at least to those who studied the issue) that, if GDP might help those who get more of it, it does not measure “social welfare” (sometimes called “aggregate utility”). There is much welfare-economics theory behind the reasons for this, but they can be intuitively rendered in a few more or less equivalent ways, or at least that’s what I will attempt to do. (The basic theory can be found in Paul A. Samuelson’s “Evaluation of Real National Income [Oxford Economic Papers, 1950] and Francis M. Bator’s “The Simple Analytics of Welfare Maximization” [American Economic Review March 1957].) Consider different descriptions of what happens after the government forces the economy to move on the production possibility frontier (PPF) by authoritatively deciding that more of something and less than something else will be produced:
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Some consumers and possibly some workers and owners of capital are harmed. In economic jargon, the move is not a Pareto improvement. Since some gain and others lose, there is no social-scientific (economic) way to tell if “social welfare” has increased or decreased, whatever the GDP figures show. There is typically no practical way, nor even (as shown in the Samuelson article cited above) theoretical formulas, to compensate those who are harmed. Ultimately, the cause lies in the impossibility of interpersonal comparisons of utility. (Of course, if everyone gets a higher real income with nothing else changed, we would know that everyone’s utility, or individual welfare, has increased, and thus “social welfare” too.)
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Prices, which serve to add apples and oranges to make up GDP, lose their previous correspondence with consumer valuations.
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It is not consumer sovereignty that determines what will be produced in the economy, but government rulers or some majority. Imagine, for example, that real GDP grows at 10% and that all the growth accrues to the king, all other individuals being impoverished: “the economy” has improved, but there is no scientific way to establish that welfare has increased.
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The free interaction between demanders and suppliers is prevented from determining what “economic growth” is made of or what it is used for. To see this in a slightly different way, imagine that as the year 2023 progressed, the state continuously seized all its subjects’ incomes over subsistence level and invested the proceeds in a portfolio mirroring the S&P 500. Given that the latter increased by 24% during the year and assuming that the government invested the money as it seized it regularly (linearly) during the year, the investment portfolio would have yielded a return of 12%. Even if the government paid this gain back to its subjects, it makes no sense to say that “the economy” grew at 12%.
To summarize: If, and to the extent that, producers are not at liberty to make money by producing what consumers demand on free markets (what is called consumer sovereignty), the configuration of the number of units of goods and services produced and their prices (GDP is the name of this configuration) is basically meaningless; or, if you will, it represents what the rulers want to be produced at prices that represent the trade-offs they make.
In economic jargon, a government-dictated increase in GDP does not signal a Pareto improvement, that is, an increase in the welfare of some individuals without a decrease in the welfare of anybody else. Most economists, however, would view as Pareto improvements the production or financing of “public goods” wanted by everybody but not excludable to non-payers (such as territorial defense), as well as the reduction of “externalities.”
Thus, if a ruler’s dirigiste policies result in the production of, say, more steel and less wheat, an increase in GDP does not imply that the economy has grown in the sense of increasing the value of consumption as evaluated by the consumers themselves. It is only in the longer run and mainly negatively that the evolution of GDP (per capita) can lead to some conclusion: if it plunges or stagnates (as it did in Argentina for long periods), we may, especially if other indicators confirm the trend, consider that as a refutation of the ruler’s beneficial contribution to economic efficiency.
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Featured image: Busts of Juan and Evita Peron covered with snow.
