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Mieke Welvaert explains why using GDP is not the problem that some assume; investment in a rebuild also comes with opportunity costs

Mieke Welvaert explains why using GDP is not the problem that some assume; investment in a rebuild also comes with opportunity costs

By Mieke Welvaert*

The Christchurch rebuild is keeping tradesmen busy, Northland's storm clouds gave road workers trees to clear and roads to fix, and if you decided to play cricket against your neighbour's front window, someone will soon be ringing a glazier.

On the face of it, all this work increases GDP.

When trying to tell whether society is making progress, we often use GDP as an indicator of economic wellbeing.

But is it then true that breaking things makes us better off?

Naturally, this seems counterintuitive.

To figure out what's missing we need to look at what GDP is, why disasters are often followed by GDP growth and what this really means about how we’re doing.

Why do we use GDP in the first place?

Gross Domestic Product is often used as an indicator for standard of living.

GDP measures the market value for all final goods and services produced within a geographic entity over a period of time. Final goods and services refer to products at a stage of manufacture where they will no longer be used for any other purpose within that geographic region.

If we extract crude oil in New Zealand and sell it overseas (as we do with most of our oil), GDP increases by the amount for which we sold the crude oil. However, if we were to process the oil before we sold it overseas or consumed it here, we would value the oil at the last stage of production.

One could then consider GDP to be the total of incomes generated from activities which add value to a product.

As we enjoy consuming what our income buys, GDP is used to indicate the extent to which people in a region can satisfy their lifestyle demands.

Where does GDP come from?

We can't conjure goods and services out of thin air; we need resources to produce them. We know that there are benefits from producing goods and services – namely that we get to consume them.

However it is important to remember that the resources used in this process all have a cost.

Say we're fixing you neighbours window, we need glass (a raw input), a glazier (labour supply) tools for the glazier and probably a van to take all this to your house (capital stock).

More generally, it takes some land, labour, and capital to create the goods and services we want to consume.  It is this combination of inputs that creates output/GDP.  If we are thinking about wellbeing, we need to consider how this process ultimately influences the things people value, namely the ability to consume goods and services, and the cost of doing so.

However, there are a couple of areas that we need to think about to avoid simply mixing GDP and wellbeing:

1. GDP measures market transactions, but it does not include non-market transactions (such as when you offer to house sit your neighbour’s house), and it does not count the benefit of leisure (as enjoying your downtime is not always a market transaction).

2. GDP is essentially current consumption plus deferred consumption (investment) – implying that we need to think carefully about where this new post-quake investment is coming from.

Often GDP and general wellbeing are strongly related, but is that really the case when there is a disaster?

Heading back to the disaster zone

An understanding of what constitutes GDP gives us insight into how smashing your neighbour’s window could be perceived as a strategy to help the economy.

Thinking this through, the broken window is unlikely to be left unrepaired. You or your unfortunate neighbour is likely to pay someone to fix it. The amount which the glazier is paid is more or less (taking taxes into account) the amount by which GDP increases.  If you put infuriating people aside, why, then, would you not want to smash windows? And if you could put immense emotional trauma aside, could you then celebrate earthquakes?

As your intuition would hopefully suggest, defenestration (the act of throwing someone or something through a window) is not beneficial to the economy.

The GDP growth that follows, restores the GDP level, making the net effect of the exercise equal zero.

Following the first and second Christchurch earthquakes, GDP for the region dropped.

The (6%pa) GDP growth we are seeing in the region is a sign of a recovery in the level of GDP. This is a positive sign of our ability to regenerate, but it does not mean our standard of living is better than pre-earthquake levels.

Furthermore, the lift in GDP growth is occurring as individuals and households are being convinced to make market transactions they would not have otherwise. A builder may be working longer hours, when he/she previously may have spent time with family or gone fishing.

The lost non-market benefits are a cost to society that is not captured in the GDP figures, even though they are an opportunity cost associated with the rebuild!

Note that when it comes to boosting demand in the economy, a quake may give it a kick however, the Reserve Bank shifts interest rates to cancel this sort of thing out.

Capital costs

The more substantive concern with considering earthquake reconstruction as a booster for growth comes from thinking about investment and capital.  Previously we mentioned that we use land, labour, and capital as inputs to create GDP.  Earthquakes can not only have horrific human costs but, more often, destroy our things (capital).

The lift in GDP growth that occurs is indicative of the fact that we as a society are having to invest a bit more just to have what we had before – we have to sacrifice consumption, and other types of investment, just to rebuild a city that was already there!

This was why the “level” of GDP dropped.

It is also why we currently need stronger growth to rebuild lost capital and get back to where we were before.

Fundamentally, investment in a rebuild has an opportunity cost.

Taking an anecdotal step to the side to illustrate, when I was a first year university student, I crashed my flatmates car into a BMW. I was uninsured and it cost a lot of money. Thankfully no-one was hurt (because that would have made everyone's emotional cost of the experience far greater). I can tell you now that crashing a car did not enhance my standard of living.

The money spent on fixing two cars would have been nice to hold on to as I had planned to use it on my up and coming exchange. In the microcosm that was both car owners and myself once the cars were fixed, no-one was better off than they were before the crash. Furthermore, I incurred the opportunity cost of what I had planned to spend that money on.

As of May this year, the government has reportedly spent $2.45 billion on rebuilding the city. Had there been no earthquakes, we would have had a complete Christchurch and a few billion in the bank to save and spend as we pleased.

In fixing broken things, we use resources that we could have consumed or used to invest in ways we would have preferred.

To summarise:

GDP measures the value produced within a geographic entity.

Although it seems damaging property could increase GDP, this is unlikely – and when it does, it does not do so in a way that increases wellbeing.

In truth, it would be better if we didn't have to repair what we have and could just add to it.

Although this is not possible in the case of natural disasters, it is possible when we can prevent destructive events from happening.

The moral of the story is: If it ain’t broke, don’t break it.

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Mieke Welvaert is a data analyst at Infometrics. You can contact her here »

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11 Comments

If ever there was a clear example of why enonomics should be down-graded as a societal tool, this is it. At least she gets the fact that if it's broken, you've gone backwards. The problem is - I think - that she sees it in $ terms, not physical. Physical is what counts; houses, food, warmth....
 
"More generally, it takes some land, labour, and capital to create the goods and services we want to consume".  
 
No resources in there? No work no energy consumption? Goods and services are actually created from resources, by the doing of work, which required the use of energy. (even labout requires food). Capttal (actually, debt) is the way we track the procedure, but all physical procedures can be done without capital.
 
"As we enjoy consuming what our income buys, GDP is used to indicate the extent to which people in a region can satisfy their lifestyle demands".
 
No it doesn't. If their 'lifestyle demands' include an exponential increase in the consumption of finite physical resources (including the ability of the biosphere to absorb outputs like carbon) and neither are tracked in GDP, then it's a false measure by any measure. Anything that doesn't value Natural Capital and Ultimate Scarcity, is a false measure. Count properly, and we are all going backwards, at an accelerating rate.
 

Yes I noticed all that, all the information is there in front of her but she fails to make the connection. GDP = the consumption of resources......on a finite planet.

A good article in explaining how GDP works, especially in fixing things; or in digging holes and filling them up again.
To be fair to Meike, the headline (which seems to support GDP as a key measure) seems inconsistent with the article, which is somewhat more dismissive of it. Presumably someone else at interest.co.nz might have written the headline. 
Apart from the issue with fixing broken things, my two main issues with an obsession with GDP as almost our only economic measure of note are as follows:
There is no incentive to own the capital; hence our frantic selling of it, even though an increasing share of our GDP now goes in paying interest and dividends for its use.
It is not a per capita measure; so increasing the population is the easiest way to achieve increased GDP.

Except GDP is a "closed system", ie we see GDP as NZ based/conext.  In the case of the rebuild however the re-insurance money is coming from outside the "closed system".  Now is this therefore positive? hard to say yes as the loss of jobs and productivity to Chch and NZ over what must be a decade must be large.  Especially considering the quality of the jobs....so programmers and other highly skilled ppl (earning exprt money I assume) swapped out for "skilled" building trades? which is just churn? got to wonder on that.
Per capita is the most important one IMHO. Indeed even that masks the present "per capita" using up all the resources in 1 generation leaving nothing left....locusts in effect.
I think I read a measure of Saudi's wealth per capita, it was I think $26k in the 1960s and $6k today because of their exploding population...
regards
 

steven,
Am not disagreeing at all. Wealth and income can frequently be confused. As I understand it, GDP more or less measures income before foreign transfers- in our case a net $10 billion or so paid offshore, because we don't own so much any more. Wealth is of course a measure of our assets (which are not all about generating income). Our policy obsession with GDP has ignored the current account effects on net income (after paying international transfers); and on any wealth build up. So predictably enough, net income and wealth build up have been very poor. GDP has been okay.
We should in my view want a reasonable national net income; and a good build up of wealth- something like our personal financial planning.

No, i dont think we were...
Yes its a wierd obsession with GDP.....
regards

Except GDP is a "closed system", ie we see GDP as NZ based/conext.
 
Not that discontinued, but revealing measure previously known as Gross National Product?

It did seem a better measure to me; one suspects capture by foreign vested interests in its demise. Add a per capita measure, and we would have a more useful measure in my view.
 

No I dont like GNP either, I prefer per capita....but that then measures natural wealth as an asset and that one generation thinks of it as all theirs.....hence the pickle we are in.
regards

yes and No,
 GDP is a pointless measure as its essentially current consumption plus deferred consumption (investment)
but no - minus natural resources consumed.
regards

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