The Growth Delusion

by David Pilling

  His work was far from finished. In 1936 Kuznets helped organize the first Conference on Research in Income and Wealth with high-level participants from both academia and government. It was during this conference that the term gross national product, or GNP, was first used. The proceedings of the first three annual conferences were published, revealing sharp differences among participants about what should be measured and what should be left out.

  Although Kuznets is considered the father of GDP, in several important respects the methodology that evolved by the early 1940s—and which has remained largely in use ever since—went against his most profoundly held beliefs. Kuznets was striving for a measure that would reflect welfare rather than what he considered a crude summation of all activity. He wanted to exclude illegal activities, socially harmful industries, and most government spending. On many of these issues he lost. One student of national accounting goes so far as to suggest, “Kuznets, far from being the progenitor of GDP, was its biggest opponent.”12

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  One of the most important consequences of the Second World War was the invention of the atomic bomb. It was developed by scientists, some of whom had fled Nazi Germany, working on the top-secret Manhattan Project in the New Mexico desert. The bomb was not only an outcome of the war; it also helped win it. Less well known is the case of GDP, the invention of which was hastened and molded by the life-and-death struggle with fascism. As with the atomic bomb, its invention had a material impact on the war. Like some of those who led the Manhattan Project, Kuznets was also a reluctant participant in his own creation.

  Kuznets thought that a sensible definition of the economy should exclude defense spending. During the war he bent to pressure to include expenditure on armaments to defeat fascism, but in peacetime, he argued, a country’s ability to wage war did not contribute to people’s welfare. National income statements, he wrote in 1937, should be constructed from the viewpoint of an “enlightened social philosophy” and should discount activities that were detrimental or, in his word, a “disservice.” The first item he listed for exclusion was “all expenses on armament.” For Kuznets, spending on preparations for war subtracted from a nation’s well-being because it reduced individuals’ capacity to consume and because it was defensive in nature. If such spending was a necessary evil, then it should appear as a minus in the accounts rather than a plus.

  But national income was a child of war. Kuznets lost the battle before it had begun. From 1940 the annual conferences that Kuznets had been holding on developing national accounts were held behind closed doors. Discussions of the state of the US economy had become a top-secret part of war planning. Making the link more explicit still, in 1942 Kuznets was transferred to the Planning Committee of the War Production Board. His main task there was to work out whether the economy had enough spare capacity to switch into the manufacturing of munitions. More generally, he needed to assess the economy’s ability to sustain an all-out war in Europe as well as in Asia, where the Americans had been fighting Japan since the attack on Pearl Harbor the previous year.

  Kuznets threw himself into the task. He sought to discover how America’s economic capacity could best be employed so that it struck a balance between building a fighting machine and maintaining the domestic consumption necessary to keep the economy ticking over. Within the government and military establishment there was sharp disagreement between those who wanted to commandeer, even nationalize, the means of production so that they could be diverted to the war effort and others, including those working with Kuznets, who concluded that the economy had plenty of spare capacity that could be marshaled without curtailing domestic consumption. These economists may even have influenced the timing of America’s entry into the war in Europe, having concluded that the US would better be able to sustain its effort if it delayed involvement until late 1943 or early 1944.13

  Just as Germany had lacked an atomic bomb that could have tilted the war in its favor, so it was missing the statisticians and economists who could also have helped it. Germany ended the war without having made anything like the advances in national accounts secured by the US.14

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  There was another powerful force at play, namely John Maynard Keynes. In 1940, two years before Kuznets was drafted into the War Production Board, the famous British economist had written an instantly influential pamphlet with the less-than-ambiguous title How to Pay for the War. As Britain struggled to stave off the threat from Nazi Germany, Keynes complained that economic statistics were too fuzzy to work out the amount of resources that could be mobilized for the war effort. He sought, in the words of his pamphlet’s opening sentence, “how best to reconcile the demands of war and the claims of private consumption.”

  Keynes wanted to work out the fairest way of sharing diminished resources while preserving the government’s ability to raise debt to pay for the war. “In order to calculate the size of the cake which will be left by civilian consumption,” he wrote, the government would have to estimate various things, including the economy’s “maximum current output,” the sustainability of drawing on foreign reserves to pay for imports, and the amount it would need to spend on guns, aircraft, and soldiers. According to his rough-and-ready calculations, output could probably be increased by 15–20 percent by bringing boys and women into the workforce and by lengthening overtime. But, he complained, “the statistics from which to build up these estimates are very inadequate. Every government since the last war has been unscientific and obscurantist, and has regarded the collection of essential facts as a waste of money.” Only the state, he concluded, was in a position to collect and process such statistics. In their absence, the government was stumbling about in the dark.

  That was not all. Until Keynes, attempts to define the scope of a national economy had excluded the government. But Keynes thought the government played a vital role in the economy, particularly during business downturns, when he advocated government spending to stimulate demand. If government expenditure were excluded from GDP, then its perceived role in the economy would be diminished. Until that point national income had been considered the sum total of market activity, or the spending of private individuals, including businesses, on investment and consumption.15 In this definition there was no room for government.

  Kuznets considered most government spending—including on such things as roads—as a so-called intermediary cost “implicit in our economic civilization.” To Keynes, this was a conceptual error. If government expenditure was excluded, then whatever the state spent on the war effort would count against economic growth in the national accounts. The more the government spent, the less there was available for private consumption and investment. Keynes’s economic views demanded that this definition of the national economy be turned on its head. The government had to be considered part of the economy.

  This was an almost revolutionary assertion. It was nothing less than a redefinition of what the economy was. By baking this idea into our national accounts, Keynes continues to show his influence. Without this definitional shift, what we know today as Keynesian fiscal stimulus would be difficult to justify since it would detract rather than add to national income. Only if the government is considered part of the economy can its spending contribute to final output. In this way, “a British war-time definition of the economy has become a global consensus.”16

  Keynes’s ideas had a huge impact in Britain, where a new system was being put into practice by two young economists, Richard Stone and James Meade, who were appointed by the Treasury to produce Britain’s first modern set of national accounts. These were duly published in 1941, bearing the distinct imprimatur of Keynes’s theoretical input. Keynes’s ideas also quickly took hold on the other side of the Atlantic, where financing the war had become the raison d’être for producing an accurate set of accounts. Kuznets’s objections were swept aside by realpolitik, und
erpinned by the intellectual contribution of the forceful and influential British economist. That Keynes was the true inventor of GDP, writes one commentator, is “one of economic history’s best kept secrets.”17

  There was a third area in which Kuznets lost influence over his invention. Kuznets thought anything detrimental to social welfare should also be excluded. This included not only things like armaments, but also advertising, speculation and all illegal activities, such as gambling, extortion, and prostitution. What should be added and what should be left out is a bit like making a cake. The type of recipe you select will affect the flavor and texture: you can have the plain sponge of growth or the chocolate cake with extra filling. Kuznets’s tastes were restrained, even prim. He thought national accounts should measure only economic activity that was good for you—definitely on the sponge-cake side of things, then. Kuznets lost that debate and we have been left with a recipe for double chocolate fudge cake with whipped cream and sugar sprinkles. Everything, good and bad, goes into it. Economic growth—like butter and cream—is not always good for your health.

  In his slightly dry style, this is what Kuznets had to say on the matter:

  It would be of great value to have national income estimates that would remove from the total the elements which, from the standpoint of a more enlightened social philosophy than that of an acquisitive society, represent disservice rather than service. Such estimates would subtract from the present national income totals all expenses on armament, most of the outlays on advertising, a great many of the expenses involved in financial and speculative activities.”18

  The way we calculate economic growth today ignores Kuznets’s warnings. The bigger our banks, the more persuasive our advertisers, the worse our crime and the more expensive our health care, the better our economies are seen to be performing. That is not what Kuznets wanted. But it is what we got.

  2

  THE WAGES OF SIN

  One day in 2012 two accountants working at Britain’s Office for National Statistics embarked on an unusual project: they started counting prostitutes. Joshua Abramsky and Steve Drew were not bored; they were responding to a diktat from Eurostat, the statistical arm of the European Union, which wanted EU nations to standardize how they calculated national income.

  One of the anomalies in how countries compile their national accounts is their treatment of illegal activities, such as gambling, prostitution, and the handling of stolen goods. Simon Kuznets thought only activities that contribute to human welfare should be counted, but who was to decide what they were? He thought advertising was worthless. Perhaps someone else would judge video games a waste of time, or stop counting alcohol and cigarettes or junk food on the grounds that they are bad for one’s health.

  Years before, Eurostat had settled the dispute by ruling that any monetary transaction in which parties willingly consent to take part should be counted as economic activity.1 After all, in some European countries, including Holland, where prostitutes famously sit in window displays along the canals of Amsterdam, prostitution is legal. So, in some countries, are certain types of drugs. And in those European countries such activities are counted as part of the economy. For consistency, Eurostat wanted other countries to adopt the same approach.2 National income, it reasoned, is supposed to measure the goods and services produced in a country over a certain period. It can’t distinguish between “good” and “bad” activity. If bombs and derivative products (the toxic and occasionally exploding creations of the banking world) are counted, then why not a shot of heroin or an hour of paid-for sex?

  But how were Abramsky and Drew to work out the contribution of prostitution to the British economy? Where were they to go for information? They didn’t, as one might assume, head straight to the nearest red-light district to see how many prostitutes they could spot. Being statisticians, they did what came naturally: they turned to research papers.3 Information was sketchy. There was no easy way to calculate how many prostitutes there were working in Britain. In the standard household survey there was, hardly surprisingly, no question about the use of sexual services. Abramsky and Drew turned instead to a 2004 survey of off-street prostitutes in London, which they supplemented with an estimate from the Metropolitan Police of the number of on-street prostitutes in the capital.4 They then scaled that up to arrive at an estimate of the number of prostitutes in Britain in 2004. Using census data of males over sixteen, they brought the figure up to date under the assumption that the number of prostitutes would rise in proportion with the male population.

  From these back-of-a-condom-packet calculations they estimated—with an alarming if spurious accuracy—that there were 60,879 prostitutes working in Britain in 2009. As if to underline the arbitrariness of the exercise, only female prostitutes were counted.5 How much were their services worth? For that the statisticians would need to know how many customers each prostitute saw and how much they charged for sex. Again they turned to research. This time they relied on Dutch academic work for an estimate of how many clients prostitutes saw each month, and for prices they went to PunterNet, a website where men rated the services of women they had visited. At about 25 clients per prostitute per week charging an average of £67.16 per “personal service,” they worked out a number for the total expenditure on prostitution in Britain in 2009.

  Abramsky and Drew performed a similar exercise with illegal drugs. They restricted their search to crack cocaine, powder cocaine, heroin, cannabis, ecstasy, and amphetamines. (So if your drug of choice is not on this list, you’re really not doing your bit for the economy.) They also made similar assumptions about intermediate consumption—the raw materials needed to make the final product—for example by discounting the electricity used to grow marijuana from the final sale price in order to arrive at a value-added amount.6

  The exercise, which provoked a minor commotion in the British press, feels faintly ludicrous, but what we choose to count and what we don’t has real consequences. This was a letter to the Financial Times in response to the newspaper’s report that sex work and illegal drugs had added £9.7 billion to the British economy and a quite unrelated editorial urging Britain to keep its defense expenditure at 2 percent of GDP.7

  The 2 percent of GDP Nato benchmark to which you refer in your editorial “Fight or flight will be the UK’s choice on defence” is surely a very strange way in which to calculate a country’s defence budget. Applying this criterion to the UK has meant that the targeted expenditure figure has recently risen as a result of prostitutes’ earnings and the consumption of illegal drugs being included in the composition of GDP, which seems mildly ridiculous. If only prostitutes worked a bit harder the army could have a few more guns!

  Applying different methodologies to how we calculate the size of economies distorts international comparisons, one of the very things for which GDP is regularly used. The US, for example, does not count illegal activity. It does, of course, count guns, which are legal in America but illegal in much of Europe.

  The treatment of drugs in America (a heavy user) and Colombia (an important supplier) is entirely different. Colombia has traditionally counted drugs as part of its economic activity, though their contribution has been declining. In 2010 it fell sharply following the demise of Pablo Escobar’s Medellin cartel. At its peak, in the late 1980s, according to Ricardo Rocha, an economist at Bogotá’s Rosario University, cocaine amounted to 6.3 percent of Colombia’s GDP.8 By 2010 the cartels were no longer pulling their weight and their contribution had slipped to a measly 1 percent.

  These things make a difference. In 1987, in what became known triumphantly as Il Sorpasso (after a cult movie), Italians awoke to find that their economy had overtaken that of Britain to become the fifth biggest in the world. The reason? The Italian statistical agency had improved its measurement of the notoriously large, untaxed gray economy. The result was an 18 percent jump in the size of the economy courtesy, at least in part, of the Mafia.
“All of a sudden we’re waking up and discovering that we’re richer and better than we thought,” Massimo Esposito, an editor of Il Sole-24 Ore, Italy’s business daily, said.9

  What we measure can, and frequently does, affect how we see ourselves. It can also affect policy. Now that we recognize the sterling contribution of crack cocaine and prostitution to Britain’s economy, the logical next step might be to legalize (and tax) these goods and services. That might be no bad thing. But we should acknowledge the effects our measurements have on policy. Who doubts, for example, that Western governments encourage arms manufacturers because they contribute to the economy, no matter the toll in death and injury?

  Similarly, governments around the world go easy on tobacco companies, which contribute to economies and pay tax to treasuries. The (not-so) hidden cost to society of cigarettes—ill health, medical expenditure, and early death—is accepted as a necessary by-product of their economic contribution. Besides, the resulting hospital care and cancer treatment also contribute to economic output. It is a good example of how we prioritize growth without stopping to think why. Because we view policy almost exclusively through the lens of economics, we are tempted to see lung cancer as a necessary trade-off for growth. Subtracting tobacco from economic activity rather than adding it would not cure us of nicotine craving, but it would likely change government incentives and thus its policy toward the tobacco industry.