Economic growth is not economic development

Measuring Economic Growth

Economic growth is a one-dimension concept concerned with the value of the final goods and services produced and sold in an economy. It is usually measured as GDP. Just like there are various theories of economic growth, there are also different ways of measuring GDP.

Among the most common, if not the most common, GDP formula is the aggregate demand function, where output (Q) equals the sum of consumer spending (C), government spending (G), investment (I) and net exports (X-M): Q = C + G + I + (X-M). In other words, economic growth is explained by production and by its consumption.

The aggregate demand function has a number of setbacks, including a) it tells us nothing about what drove this spending (i.e. debt or productivity), b) it assumes that a dollar spent by the government is the same as a dollar spent by consumers and the same as a dollar spent by a corporation and c) it may create the wrong incentives to boost current spending when the economy may be in need of more savings (future spending).

Another way of measuring GDP looks at economic growth as a function of changes in the workforce and its productivity (measured as output per hour worked). The formula is: ∆GDP = ∆Workforce + ∆Productivity.

Although this method of calculating economic growth gives us a better insight into some of the fundamental forces that impact it (demographics and how productive workers are), it is no panacea in understanding the broader economic conditions that go beyond growth.

For example, we might see GDP decline due to poor health services that are unable to deal with large-scale virus outbreaks which can cause deaths and a reduction in workforce. Or we might see productivity decline due to a lack of investment in the capital stock. Whatever the reasons behind the changes in either the workforce or its productivity, they remain unknown from the above equation.

The exergy economic model is another way to measure GDP. It tries to explain growth as a function of how efficient energy is used across the economy. Under this model, a decrease in productivity leads to a decline in energy production, which then leads to more depressed productivity levels and so it goes in a downwards spiral.

On its own however, this way of looking at GDP, just like all the others mentioned above, does not explain why things are changing, but only rather that production of goods and services declines or increases based on how exergy efficient the economy is. It does not offer an insight into what is causing exergy to decline or increase.

Meanwhile, the monetarist school of thought looks at GDP from the perspective of money aggregates. MV = PQ is the formula for nominal GDP, where M is the quantity of money (the broader the better), V is the velocity, P is the price and Q is the real value of economic output.

A more appropriate version of this growth accounting equation was introduced to me by MacroStrategy — it accounts for the velocity and prices of financial assets: M * V * Va (Asset velocity) = P * Pa (Asset prices) * Q. The model, although it enables for a very good understanding of how changes in the quantity of money (primarily) impact nominal GDP, it leaves out productivity, demographics and debt.

Meanwhile, one could point out that the growth model developed by Robert Solow accounts for technological change by introducing the TFP residual. However, as James Montier and Philip Pilkington from GMO show in a recent paper, the TFP might not be that useful in gauging technological change (or anything for that manner).

Even if you agree with the Solow model, the TFP residual is not good enough to account for innovation or changes in living standards ; some even consider it “a measure of our ignorance”. That said, the Solow model is, to my mind at least, conceptually correct in the sense that technological change is one of the core drivers of economic activity (over the long-term). However, it treats both labour and capital as homogenous inputs, which is not accurate.

My view is that a) one should look at multiple GDP measures to gauge what is happening in the economy, b) that GDP should be used within the broader context of other measures (like debt levels, wealth concentration, level of investment and capital formation, etc.) and c) it should not be a number that policymakers should be obsessed with.

However, no matter how we look at economic growth, the various formulas for GDP (i.e. the measure of economic growth) do not tell us about other, broader aspects of the socio-economic structure, such as education levels, living standards, productivity growth, quality of work, etc.

Economic Development – Beyond Growth

“…the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile.” – Bobby Kennedy

In all fairness however, the measures of economic growth weren’t designed to measure “what makes life worthwhile” – it is up to us to go beyond them.

Economic historian Charles P. Kindleberger recognised this when he wrote: “Economic Growth means more output and changes in the technical and institutional arrangements […] While Economic Development is a wider concept and it goes beyond the changes in the structure of output and allocation of inputs”.

Indeed, we can have economic growth with little or no economic development – hence why we have a whole category of countries classified as “developing”. The fact that growth can occur in the absence of development was also recognised by Joseph Schumpeter in The Theory of Economic Development. He wrote: “Add successively as many mail coaches as you please, you will never get a railway thereby”.

As such, it is paramount to make the difference between growth and development in order to fully grasp what are the potential ingredients of economic progress and back them accordingly through capital deployment and appropriate policymaking. 

Unlike growth, economic development is a multi-dimensional concept – it seeks to explain changes in living standards. As such, economic development takes into account the following information:

–       Education standards

–       Access to healthcare

–       Changes in life expectancy

–       Quality of infrastructure 

–       Environmental impact

–       Housing availability and quality

–       Changes and concentration of wealth

–       Economic growth

The final item on the above list is economic growth, measured as GDP per capita. It is important to note that growth is part of the wider process of economic development.

As I wrote in “Energy, Productivity and Debt”, economic development and economic growth overlap as processes but they are different in what they actually are.

Why make the difference between economic growth and development?

The answer revolves around the need to craft appropriate policies and to allocating resources efficiently. More specifically, there are broader considerations that, depending on where we are in a) the energy cycle and b) the debt cycle, ought to take precedence over boosting GDP, for the sake of long-term progress that is.

Appropriate policies

The pursuit of growth in the absence of an increase in productivity is a recipe for disaster. The reason is that this “productiveless” growth will be fuelled by debt, which eventually becomes “too much debt” that is misallocated. This boosts GDP in the short-term but it happens at the expense of long-term growth and development as the whole process comes to a halt when the deleveraging phase begins.

As such, policymakers, who already have a very difficult job of trying to balance out which economic levers to pull in order to steer the socio-economic ship towards calmer waters for as long as possible, need also to account for the rate of growth of productivity, for the debt level and for the directio of an economy’s cash flows.

Indeed, it can be dangerous to only focus on GDP growth. As American writer Edward Abbey put it in his 1977 book The Journey Home: “Growth for the sake of growth is the ideology of the cancer cell.” – I agree.

Next time you hear a policymaker talking about how much their policies boosted the GDP, ask yourself: “At what cost does this number come? More debt? Or is it driven by productivity?”.

Efficient capital allocation

The successful (i.e. profitable) deployment of financial capital (i.e. investment) is dependent on backing those endeavours that are efficient (i.e. productive).

Financial resources are enablers of real economic resources: commodities, land, machinery, human talent etc. When an investor provides financial capital (via equity or bonds) they essentially tell economic actors: do more, move forward, try again.

Note: This is one of the reasons why I believe that the proliferation of financial engineering can become an inefficient endeavour: at some point financial products are created to enable financial products – money is generated for the sake of money, instead of unlocking economic activity. However, as money creates money it does so by consuming natural resources, thus depriving other sectors / industries of these resources.

The golden rule is that these economic actors are productive so that they eventually generate a cash flow in which the financer participates in one way or another.

If there is too much financial capital in the economy, then economic actors are no longer accountable to the golden rule, i.e. they don’t need to be productive to be generating these cash flows as they are fuelled by an excess of purchasing power in the economy (e.g. debt).

However, if investors simply chase economic growth, they won’t be able to spot the underlying forces that generated that growth. Neglecting the non-quantitative factors that contribute to economic growth (see the list above) eventually leads to a decrease in growth. It is for this reason that capital allocators ought to make the distinction between growth and development and invest for the sake of development rather than growth.

Categories: Economics

Tagged as: ,

Leave a Reply