Sunday, January 4, 2009

GDP as a welfare proxy

GDP growth is popularly spoken of as though it were the ne plus ultra of economic policy; if growth is high, policy is succeeding, and if it's low, it's failing. Exogenous effects aside, GDP is not a perfect proxy for what economists call "welfare", namely how well off everyone is. One illustration of the discrepancy was recently given by Mankiw; longer ago the misuse of GDP was decried by Bobby Kennedy*. The best defense of the use of GDP in these ways has been that, while it doesn't conceptually capture everything it should, it's likely to correlate with welfare, and that eras of high GDP growth tend to be better for welfare growth than other eras. (I've made this argument myself.)

As Robert Lucas noted, though, correlations can be true under certain policy regimes but not others; in particular, policy tailored to a historical correlation, by creating an incentive by policy-makers to optimize a single (imperfect) measure of welfare rather than (unmeasurable) welfare itself, is likely to reduce that measure's correlation with welfare. Just as a chandelier factory in the USSR, told it would be paid by weight for its product, produced the heaviest chandeliers in the world, the focus on a particular measure will optimize that measure, both in ways that optimize what it should be measuring, and in ways that do not. As Mankiw pointed out, it's possible to design stimulus that increases GDP but not welfare. If GDP is being optimized, those forms of stimulus will look like a good idea.

In every popular, simple, short-term policy model of the economy — I'm thinking in particular of a sticky-wages model for the effects of unexpected inflation, but I've also thought in the last couple days that this is likely true of a simple microeconomic analysis of Keynesian demand-pumping — a boost in GDP comes at the expense of welfare. Unexpected inflation reduces real wages, so that workers work more than they would prefer at that wage; a deficit reduces savings, boosting consumption at the expense of capital accumulation. Other sticky prices or other mechanisms that these models leave out might change things, and certainly a good argument for boosting GDP is the psychological effect it has — the recession-as-a-coordination-problem model — and I'm pretty sure that in both cases I give above, the GDP boost is first-order while the welfare loss is second-order, so that a small error of analysis is likely to change the qualitative outcome. Still, it seems worth remembering that there is a distinction, and worth occasionally asking whether something targeted at GDP as a proxy for welfare is actually welfare-enhancing or not. I'm not sure Keynesian stimulus usually or always is.

* I would quibble with some of what Kennedy says, e.g. that GDP counts "destruction of our redwoods and the loss of our natural wonder". A better welfare measure would subtract environmental losses; GDP does not include additions for them, but does include additions for products that entail those losses. In any case, his broad thesis is correct.

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