Mankiw Reminds Us: GDP is Not a Perfect Measure of Economic Well-Being

December 30, 2008

Last week on his blog, Greg Mankiw made the most important point of this entire question of fiscal stimulus policy: GDP is not a perfect proxy for economic well-being.

Usually, GDP is a reasonable proxy for economic well-being, so more is better, but that is not true in this example. Part of the problem here is that GDP includes government purchases at cost. If the government hires people to produce stuff that is worthless, that stuff is included in GDP just as much as if the government buys something valuable. When calculating GDP, the national income accountants do not pass judgment on the social utility of government spending. Anyone concerned with economic well-being has to go beyond thinking about GDP.

The moral of the story: If the government spends a fiscal stimulus package on goods and services without much public value (as in Case C), it could well stimulate the economy as measured by macroeconomic aggregates but leave the participants in the economy worse off (compared with a feasible alternative, Case A). Avoiding this trap requires that the government spend taxpayers dollars only those items that pass a strict cost-benefit test. That is hard to do quickly. Willy-nilly spending is a good way to stimulate the economy only if the outcome is judged by the wrong metric.

Paying people to dig ditches and paying others to fill them up may increase GDP, but that production in itself doesn't produce any tangible benefit for society. You might as well drop dollar bills out of helicopters.

Some free market types in the tax policy arena have made similar mistakes when citing how much tax hikes hurt the macroeconomy. They will cite how much GDP is lost due to supply-side effects, but if higher taxes on labor for example do indeed make people substitute domestic labor for market labor (e.g. stay-at-home wives as opposed to the wife working and hiring a nanny), the lost economic well-being from the tax is only the difference between the pre-tax value of market labor and the domestic labor, after also accounting for any change in leisure. But if you only looked at the lost GDP and assumed it was a perfect proxy for economic well-being, you would take from the policy that the tax has caused a huge decline in economic well-being. That's because the folks at BEA don't count the value of domestic production in the national accounts.

Similarly on the issue of the harms of environmental taxes, many will put forth how much GDP will be lost from say a carbon tax. But they ignore the fact that any improvement in environmental quality would not be measured by GDP. But environmental quality is not valued at zero. It's just that the harm to the environment from marketplace production is not counted in GDP. If a company is producing 1 ton of steel per day, but then discovers some technology that allows them to produce 1 ton of steel yet with half the emissions, there is no change to GDP. But society is definitely better off.

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