From The Answer Desk: Green GDP

Tim Haab asked me to respond to a question by Jonathan Pfeiffer from The Answer Desk:

I'd like to see an overview of ways of measuring economic progress that don't ignore ecological concerns. For example, what alternatives are there to indicators such as gross domestic product? (Alternatives should include indicators that somehow factor environmental data into the equations.)

Jonathan, you are right to point out that the Gross Domestic Product (GDP) almost completely ignores our environment. Even worse, actually, GDP often includes the environment on the wrong side of the balance sheet. If we first pollute and then pay to clean up the mess, both activities add to GDP. Environmental degradation frequently looks good for the economy. In that regard, GDP is a poor welfare measure.

But first, a quick defense of GDP: It does a pretty good job of measuring the size of our economy. Most importantly, it was never intended as a welfare measure. GDP measures market transactions. It does not include the value of your leisure time, the value of taking care of your kids at home, or the value of the oxygen produced by the tree outside your window. In the end, environmental degradation frequently looks good for the economy because it often is good for the economy. It is bad for overall well-being, but it increases GDP.

That said, we — and this includes economists — frequently fall into the trap of using GDP as a measure of how well we are doing as a society. This is often done out of necessity, since we do not have a consistent, alternative measure of true well-being. Up to a point, it is also a pretty good approximation. There is most certainly a correlation between material wealth and well-being. Not eating at all would put a damper on our welfare. Eating too much, however, could actually make us feel worse again. The question is where is the point of inflection. Starting when does one more dollar of GDP decrease well-being? This is where the alternative measures of well-being come in.

Among the first to ask this question were two Yale economists, Bill Nordhaus and the late James Tobin, in a paper titled "Is growth obsolete?" in 1973. They developed the Measure of Economic Welfare, which used GDP (or more accurately NNP, net national product) as the starting point and made some imputations for the value of leisure and the depreciation of natural capital, among others. It turned out that GDP tracked the MEW pretty closely. Their conclusion: "Is growth obsolete? We think not."

Next came Daly, Cobb and Cobb in 1989 with the Index of Sustainable Economic Welfare. They made some further adjustments and concluded that "empirical evidence that GDP growth has increased welfare is very weak."

In the 1990s, Redefining Progress entered the picture. They developed the Genuine Progress Indicator, which makes the most far-reaching adjustments to GDP. They conclude that the growth of well-being has not kept pace with that of economic output. "GPI started declining around 1975, while GDP keeps increasing."

Besides these three alternative measures of well-being, there are efforts underway to amend official GDP statistics. Several countries, including the United States, have attempted to make such calculations at various points in time. The United Nations Statistical Office, which publishes guidelines on how to calculate GDP, also produces a set of rules for environmental or green accounting.

In the end, though, it’s politics, stupid. For all its inglorious number crunching, green accounting tends to be politically loaded. In the United States, it was Congress that stopped any official efforts through one line in an amendment to several appropriations bills. For more on this sorry tale, listen to an NPR story by yours truly.

For an overview of green accounting in general, you may be interested in this green accounting bibliography.

Comments

[Jim Coomes]

Definition
Index of Sustainable Economic Welfare (ISEW) is roughly defined by the following formula.

ISEW = personal consumption
+ non-defensive public expenditures
- defensive private expenditures
+ capital formation
+ services from domestic labour
- costs of environmental degradation
- depreciation of natural capita

Notice that this definition does not include -inflation-.

For argument sake, in terms of salary versus standard of living, America peaked someware between 1965 and 1975. Since that time, inflation has tended to eat away at the avarage working persons standard of living.

"In the 1990s, Redefining Progress entered the picture. They developed the Genuine Progress Indicator, which makes the most far-reaching adjustments to GDP. They conclude that the growth of well-being has not kept pace with that of economic output. The "GPI started declining around 1975, while GDP keeps increasing.""

It would seem, that the culprit here is inflation. This would lead one to conclude that the solution would be "across the board deflation"! Not just commodity deflation.

[Gernot Wagner]

Thank you for your comment, Jim. I have to disagree with you about the role of inflation, though. Whether or not one includes inflation should not figure into any of this.

Inflation enters the picture when comparing nominal versus real prices; i.e. 1975 GDP denominated in 1975 dollars versus in 2005 dollars. When Redefining Progress compares GDP with their GPI and concludes that the GPI has been declining while GDP is increasing, I trust that they compare nominal with nominal measures (or real with real). That is, in fact what they do in this graph. Everything there is denoted in 1996 dollars.

[Jonathan Pfeiffer]

Thanks for the response!

[Tim Haab]

That's what we're here for.

[joshua]

measure happyness...this reminds me of that movie the matrix when morphious is being interigated by Mr smith and Mr Smith brings up the history if the artificial world in which at first the machines tried to make a utopia for the humans but the humans kept rebelling against it so then were forced to a world more similar to the one we live in.

We are still creature of biology and as such our happiness will always be stongly linked to relitive criteria...even though real indicators such as rising life spans, cleaner air, higher education levels, better health, lower infant and child mortality rates, more forests, greater purchasing power we will always be hounded by how it could be better if only we (insert change here).

This is not nesasarily a bad thing but as we get closer and closer to utopia we should keep in mind that by our nature we tend to be pesimistic and our happiness is amoving target.

I remember a term given by an econ prof that mentioned something similar "declining expectations" or something.

[Gernot Wagner]

Joshua, thanks for your comment about happiness. I agree that happiness is in many ways a relative concept, or a "moving target" as you call it. Note, though, that happiness and well-being are not the same, even though many "happiness economists" tend to conflate the two concepts (e.g. this popular book ).

Happiness could be called "subjective well-being," the part of well-being that we consciously experience and would think about if somebody asked us "how happy are you today?"

There is also another component of well-being. The part we get used to, what psychologists call our "adaptation level." When somebody asks me about my happiness, I do not usually think about the comfy bed or my three meals a day, all the creature comforts my mom kept telling me to be grateful for because somebody somewhere does not have them. I simply take them for granted, even though I do derive utility from them. That is the part of well-being/utility not reflected in happiness.

[Jim Coomes]

Gernot,

I'm assuming that you are talking about the standard government definition of inflation, ie, the basket of commodities. Take into account health insurance inflation 5-19% a year, car and home insurance, collage, services/repairs, buying a home etc. Take an old profession, electricion, mechanic, etc who stays in the same type of industry from, lets say 1960 till now. Look at the standard of living that he could afford back then on that salary and compare it to the standard of living that he can afford now.

Subtract the easy access to credit, and you will probably find, in general, that he has a lower standard of living now, (with a higher salary, present day salary), than he did back in 1960.

Ravi Batra, "The Myth Of Free Trade" has a graph on page 45, that shows (real wages, in 1982$) versus years. The graph peaks in 1973. The graph goes from 1950 to 1990.

So, if you were to extrapalate this "total real Inflation" over to the "-this graph-" (your comment graph) it may be possible that my theory could be right.

My actual theory is that "accross the board Deflation" could be the best thing to happen to the avaradge American worker. I just tried to impose my theory on the "GDP versus GPI" theory.

[John Whitehead]

Deflation would increase real wages ... in the short run. In the medium to long run, the expectation of falling prices would provide an incentive to consumers to delay their purchase decisions. The big C, consumption, two-thirds of GDP, would fall and GDP would fall. In Japan, this type of deflation produced a long, long recession and helps explains why the Fed kept interest rates so low for so long.

Bottom line: we want to avoid deflation.

[John Whitehead]

Jim Coomes said "Ravi Batra, 'The Myth Of Free Trade' has a graph on page 45, that shows (real wages, in 1982$) versus years. The graph peaks in 1973. The graph goes from 1950 to 1990."

Hmmm. I just tried to produce this data series through at least 2000 at the BLS and failed (I can get 1995-2003). Can anyone help out?

The reason for the peak of real wages in 1973 is the mysterious tanking of labor productivity (measured as real GDP divided by labor hours worked, I think). Productivity picked up again in the 1990s and I'm sure that real wages have bounced back to the point that the electrician is doing better now than in the past. I don't think the macroeconomists have a very good handle on the sources of productivity.

[Gernot Wagner]

Jim, I have to agree with John Whitehead on this one: deflation is generally bad.

But you raise an interesting point. Inflation is commonly calculated based on a market basket of commodities. There are lots of issues with this measure as a true cost-of-living index.

Most importantly for this discussion, once we ammend GDP to include any kind of environmental considerations, we would also have to adjust the price index. See a recent article by H. Spencer Banzhaf on "Green price indices" (JEEM 49(2), March 2005).

[joshua corning]

"the expectation of falling prices would provide an incentive to consumers to delay their purchase decisions."

hmm this must be the reason i dread buying a new computer....becouse i know a new and better and cheaper one will be for sale in like 6 months...

why has this not harmed the economy...ie the deflation of computer prices?

[Jim Coomes]

Joshua, Thanks.

About Deflation!

Actualy, if you read up on the economical crashes of 1882, 1874, 1929, The anomily is 1987, you will find out that there are good benifits for the common worker caused by deflation. (Japan did most things wrong in how they handled their economical crash of 1990+-).

A. Gary Shilling wrote 2 books, "Deflation;..." and "Deflation:..." . He came to the same basic conclusions as I did. (Patting myself on my back. I love to read my own ideals in print.)

Both of us started out with Nikolai D. Kondratiev and his 60 year cycle. We both ended up predicting the economical crash of 2000. (I found and read his book in 2001). Both of us have been wrong in predicting "across the board deflation" for this decade.

The benifits of deflation can be found in reading the wrong (according to most economists) books on economical history.

According to one of the infamus (now unknown) economist of the 20's and 30's: economical crashes are caused by excessive DEBT.

The capitalistic system is self correcting. So, since 1973 the balance between wages and standard of living has been off. The inbalances will only get worse until the capitalistic system is allowed to self correct. So, in theory, if it self corrects, we will suffer a lot of economical pain. If, on the other hand, we take precausionary measurs before hand, we can aleviate some of that economical pain.

It is in human nature to want something new! After a certain period of denial, people will slowly start to spend again. It basicly boils down to the "way that the government handles the economical crash".

In the 30's, the government drasticly reduced M1, M2, M3. Japan followed the policy of "keep all the institutions alive" with few legaly forced bankruptsies.

There are two types of "across the board deflation". The "good" deflation as happened in 1874 and the "bad" deflation as happened in 1929. Here again, it is "government policy" that dictates the severity of the economical pain.

[Jim Coomes]

There is commodity deflation, computers etc, going down in price. But then service prices tend to go up soon after (service inflation).

Then there is "across the board deflation" where almost all prices tend to go down. Continuing job holders may have a small decrease in salary. New employees will start out with far lower salaries. But eventualy, wages and standard of living will balance out.

[Michael Harris]

For a general deflation to have a real impact, I presume there's some sort of wealth effect being postulated. Otherwise, in "the long run", money neutrality would be expected to apply, with no change in real incomes or relative prices, would it not?

In the short run, as already mentioned, major deflation could have serious adverse consequences, unless we think that negative real interest rates are a good thing all round.

I think relative price changes (rather than increases in the absolute price level) are potentially an important part of the story of standards of living over time. Housing and real estate are often described as the single biggest consumption/investment choice an individual will make in their life time, and there's definitely been an increase in the relative price of urban land and housing in developed countries -- certainly, where I live in Sydney!

That said, whether housing affordability (factoring in interest rates) has changed as much as housing prices is a different question.

[Jeb Archer]

What people dont realise is that green homes and buildings are not only worth more (resale value) but are creating more reveneu as well. Higher occupancy rates paired with higher rental premiums equals more money in VC's pockets.
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