One of Pigou’s most prominent disciples was the first person to provide an estimate of the fall in national income of the United States during the Great Depression. The Belarusian-born Simon Kuznets (1901–85), a Professor of Economics at Harvard, won the Nobel Prize in Economics in 1971 for his work on national accounts. Believing that they incurred costs without adding to final economic output, Kuznets, unlike Pigou, excluded from the production boundary all government activities that did not immediately result in a flow of goods or services to households – public administration, defence, justice, international relations, provision of infrastructure and so on.9
Kuznets also believed that some household expenditure did not increase the material standard of living, but simply paid for the cost of modern life – in particular the ‘inflated costs of urban civilization’, such as having to maintain a bank account, pay trade union dues or the social obligation to be a member of a club. Kuznets estimated that between 20 and 30 per cent of consumer expenditure went on such services.10 However, he did argue that unpaid housework should be included, because it clearly improves economic welfare. Kuznets, then, drew the production boundary according to what he believed improved the material standard of living and what did not.
Perhaps Kuznets’s view would have had more traction in a peaceful world. But the exigencies of the Second World War, which forced governments to focus on the war effort, took economists down a different path: estimating output rather than concerning themselves with welfare. As a result, economists who believed that national product is the sum total of market prices prevailed.
The resulting ways in which estimates of output were used to calculate GDP appeared to follow marginal utility theory, but were in fact doubly out of sync with it. First, they ignored the idea of value as utility – the benefit it provided to the consumer – and included items that the Pigou–Kuznets welfare concept would have seen as ‘necessary’ for the creation of value. Rather than assess whether final consumption increased utility, they added any final consumption to national income. In Kuznets’s own words: ‘Many foods and drugs are worthless by scientific standards of nutrition and medication; many household appurtenances are irrelevant to any scientifically established needs for shelter and comfort; many service activities as well as commodities are desired for the sake of impressing foreigners or our fellow countrymen and could hardly measure up to ethical principles of behaviour in relation to the rest of mankind.’11 From that perspective, the new national accounts overstated welfare.
Second, competition in economies is generally imperfect – a reality that has proven distinctively uncomfortable for national accountants trained in the neoclassical ideas of perfect competition and ‘equilibria’. By simply adding up market prices they ignored the fact that those prices would not always produce an equilibrium and be compatible with ‘perfect competition’; prices could therefore be higher or lower than if equilibrium prevailed, thereby giving a distorted impression of value creation. In short, during the war years practice became significantly detached from the prevailing theory – or, seen another way, the utility theory of value did not solve the urgent war-related problems of the time.
In many ways, the national accounts as we know them today stem from the trauma of the Great Depression of the 1930s, and the needs of the Second World War war effort. In this, as in so much else, the British economist John Maynard Keynes (1883–1946) was a pivotal figure. In his 1936 masterpiece The General Theory of Employment, Interest and Money, written during the Great Depression, Keynes assumed that workers would underestimate the purchasing power of their wages, and would therefore be willing to produce more than they needed to. In this way, workers’ involuntary overproduction would in turn create involuntary unemployment – fewer workers being needed to do the same amount of work – and the economy could find itself in a low-output equilibrium. This is a state in which forces in the economy, such as supply and demand, are in balance and there is no incentive to change them, even though the total output of the economy is low and wages and employment are depressed. Keynes used this idea to develop a theory of the macroeconomy – the economy as a whole – in which government spending could stabilize the business cycle when business was investing too little, and even raise the economy’s output.
In order to lift the economy out of the depression, governments needed information to measure how their policies were working. Up until then, they had flown mostly blind: they had no need for detailed statistics because the economy was supposed to be self-regulating. Keynes’s book How to Pay for the War, published in 1940, introduced the idea of recording national income in a set of accounts and completely changed the way in which governments used that data.
In the late 1930s and the 1940s national accountants took up Keynes’s ideas about how government could invigorate an economy, and came to view government spending as directly increasing output. For the first time in the history of modern economic thought, government spending became important – in stark contrast to Kuznets’s omission of many government services from the national income. This redefinition of government as a contributor to national product was a decisive development in value theory. Keynes’s ideas quickly gained acceptance and were among the main influences behind the publication of the first handbook to calculate GDP, the United Nations’ System of National Accounts (SNA): a monumental work that in its fourth edition now runs to 662 pages.
THE SYSTEM OF NATIONAL ACCOUNTS COMES INTO BEING
After the Second World War, formal international rules were drawn up, standardizing national accounting for production, income and expenditure. The first version of the SNA, compiled by the United Nations, appeared in 1953.12 The SNA describes itself as ‘a statistical framework that provides a comprehensive, consistent and flexible set of macroeconomic accounts for policymaking, analysis and research purposes’.13 It defines national accounting as measuring ‘what takes place in the economy, between which agents, and for what purpose’; at its heart ‘is the production of goods and services’.14 GDP is ‘[i]n simple terms, the amount of value added generated by production’.15 It is defined explicitly as a measure of value creation. It can therefore be said that the national accounts, too, have a production boundary.
The SNA’s emergence in the early post-war years owed much to recent economic, political and intellectual developments. The experience of depression and war weighed heavily on policymakers’ minds. Many countries saw wartime planning, which was based on unprecedented amounts of economic information, as a success. Political pressures were important too. In the US, the New Deal of the 1930s and full employment during the war led many voters to believe that government could intervene benignly and progressively in the economy. In Europe, the strength of left-wing parties after the war – exemplified by the Labour Party’s 1945 election victory in the UK – also changed, and marked a change in, people’s attitudes, and made fuller and more accurate national accounts essential. The crucial question was, and remains: on what theory of value were they based?
‘Simple’ national income estimates had to add up the price of production (minus intermediate goods) in the economy, or incomes, or the expenditure of all economic actors on final goods: National Production = National Income = National Expenditure. In order to carry out this estimate, we might have expected the SNA’s authors to use as their methodology the prevailing economic theory of value, marginal utility. But they didn’t – or, at least, not fully. In fact, the resulting model was, and is, a strange muddle in which utility is the major, but not the only, ingredient.
The SNA brings together various different ways of assessing the national income that had developed over centuries of economic thinking. Decisions about what gets included in the production boundary have been described as ‘ad hoc’,16 while national accountants admit that the SNA rules on production are ‘a mix of convention, judgment about data adequacy, and consensus about economic theory’.17 These include devising solutions based on ‘common sense’; making a
ssumptions in the name of ‘computational convenience’ – which has important consequences for the actual numbers we come up with when assessing economic growth; and lobbying by particular economic interests.
In fairness, there have always been practical reasons for this ad hoc approach. Aspects of the economy, from R&D and housework to the environment and the black economy, proved difficult to assess using marginal utility. It was clear that a comprehensive national accounting system would have to include incomes from both market exchange and non-market exchange – in particular, government. With market-mediated activity lying at the heart of the marginalist concept of value, most estimators of national income wanted to adopt a broader approach.18
National Income Accounting Gets it All Together
National income accounting, then, incorporates many different accounting methods. The system simultaneously allows an integrated view of the different aspects of the economy – both production (output) and distribution of income – and obliges national income accountants to link each commodity produced with someone’s income, thereby ensuring consistency. To maintain consistency between production, income and expenditure, the national accounts must record all value produced, income received, money paid for intermediate and finished goods and so on as transactions between actors in the economy – the government, or households or a particular sector – in which each actor has an account. This helps provide a detailed picture of the economy as a whole.
Expenditure on final goods must add up to GDP (as the price of intermediate goods goes into the price of the final goods). So it is possible to compute GDP from the expenditure side and, as we saw in Chapter 1, Petty used this method to estimate national output as early as the seventeenth century. Modern national accounts divide expenditure into the following categories:
GDP = Consumption by households (C) + Investment by companies and by residential investment in housing (I) + Government spending (G).
This can be expressed as: GDP = C + I + G.
For simplicity’s sake we will ignore the contribution of net exports. Two observations are in order: first, on the expenditure side, companies only appear as investors (demanding final investment goods from other companies). The remainder of spending (aggregate demand) is split between households and the government. Government expenditure is only what it spends itself; that is, excluding the transfers it makes to households (such as pensions or unemployment benefits). It is its collective consumption expenditure on behalf of the community. By focusing on government only in terms of the spending, it is by definition assumed to be ‘unproductive’ – outside the production boundary.
MEASURING GOVERNMENT VALUE ADDED IN GDP
In Chapter 8 we will see that government is rarely acknowledged as a creator of value – indeed, quite the reverse. Yet national accounting conventions have in fact been quietly tracking its value-added contribution for the last half century—and it’s not small! While Chapter 8 is fully dedicated to looking at the various ways in which economists, and those they advise, have considered government – as a value-creating entity or just a strain on the economy – in this chapter we focus on the relevance of this discussion to how GDP is calculated. The most striking thing to emerge from these analyses is that, contrary to the views of most economists, government certainly does add value to the economy,
Figure 8 below tracks US government value added and expenditure since 1930. During the Second World War the government bought an astonishing half of national output. In this figure we can see that government value added has hovered between 11 and 15 per cent of GDP for the post-war period. As a comparison, the finance industry adds some 4 per cent of GDP in the US and 8 per cent in the UK. But the chart reveals what looks like a strange discrepancy. It shows that government expenditure has been consistently higher than government value added, at between 20 and 25 per cent of GDP.
It is important to stress, however, that the difference between value added and final expenditure is not the government’s budget deficit. Rather, the deficit is government revenue (mainly taxes) minus expenses, including transfers of funds from the government to households, such as pensions and unemployment benefit – which, since households spend the money from pensions and benefits, are defined in national accounting as household, rather than government, spending (it’s the final expenditure that matters, remember). It is that household spending that counts towards final demand for the whole economy. So, what is going on?
Figure 8. US government expenditure and value added as a share of GDP, 1930–201419
Spending and Value
Before answering this question, we have to recognize that government value added cannot be computed in the same way as that of other industries and, as a result, is a complicated issue for national statistical institutes. A lot of government activities are not sold at market prices: that is, prices that pay for all production costs (including wages, rent, interest, royalties as well as inputs into production) and yield a profit for a private-sector business. Instead, government activities are provided at lower, ‘non-market’ prices – or even for free. Consider schools, state-funded universities, public healthcare, public transport, parks, recreation and the arts, police and fire services, the law courts, environmental protection such as flood prevention and so on. These goods are largely financed by taxes or debt.
Given these lower prices, the usual way of calculating value added for a business doesn’t work with government activities. Let’s recall that value added is normally the value of output minus costs of intermediate inputs used in production. The value added by a business is basically workers’ wages plus the business’s operating surplus, the latter broadly similar to gross operating profit in business accounting terms. So adding up the non-market prices of government activities is likely to show less value added, because they are set with a different, non-commercial objective: to provide a service to the public. If the non-market prices of the output are lower than the total costs of intermediate inputs, value added would even show up as negative – indeed, government activities would ‘subtract’ value. However, it makes no sense to say that teachers, nurses, policewomen, firefighters and so on destroy value in the economy. Clearly, a different measurement is needed. As the British economist Charles Bean, a former Deputy Governor for Economic Policy at the Bank of England, argues in his Independent Review of UK Economic Statistics (2016),20 the contribution to the economy by public-sector services has to be measured in terms of ‘delivering value’.21 But if this value is not profit, what is it?
National accountants have therefore long adopted the so-called ‘inputs = outputs’ approach. Once the output is defined, value added can be computed because the costs of intermediate inputs, such as the computers that employees use, are known. But since government’s output is basically intermediate inputs plus labour costs, its value added is simply equal to its employees’ salaries. One significant consequence of this is that the estimate of government value added – unlike that of businesses – assumes no ‘profit’ or operating surplus on top of wages. (In Figure 8 above, the dark-grey line shows the value added of government; it is equal – with slight adjustments – to the share of government employment income in GDP.) In a capitalist system in which earning a profit is deemed the outcome of being productive, this is important because it makes government, whose activities tend to be non-profit, seem unproductive.
But then what about the light-grey line, which represents government final consumption expenditure? We have already seen that pensions and unemployment benefits paid by government are part of household final consumption, not government spending. More broadly, it is not obvious why government should have any final consumption expenditure in the way that households do. After all, companies are not classed as being final consumers; their consumption is seen as intermediate, on the way to producing final goods for households. So why isn’t government spending likewise classed as intermediate expenditure? After all, there are, for example, billions of school studen
ts or medical patients who are consumers of government services.
Indeed, following this logic, government is also a producer of intermediate inputs for businesses. Surely education, roads, or the police, or courts of law can be seen as necessary inputs into the production of a variety of goods? But herein lies is a twist. If government spending were to increase, this would mean that government was producing more intermediate goods. Businesses would buy at least some of those goods (e.g. some public services cost money) with a fee; but because they were spending more on them (than if government was not producing anything, and therefore not buying supplies from businesses), their operating surplus and value added would inevitably fall. Government’s share of GDP would rise, but the absolute size of GDP would stay the same. This does, of course, run counter to Keynesian attempts to show how increases in government demand could lift GDP.
Many economists made exactly this argument in the 1930s and 1940s – in particular Simon Kuznets, who suggested that only government non-market and free goods provided to households should be allowed to increase GDP. Nevertheless, the convention that all government spending counts as final consumption arose during the Great Depression and the Second World War, when the US needed to justify its enormous government spending (the spike in the light-grey line in Figure 8 in the early 1940s). The spending was presented as adding to GDP, and the national accounts were modified accordingly.22
The Value of Everything (UK) Page 11
