Sunday, July 29, 2012

Essay: The Meaning of Economic Growth and GDP

This post contains an essay submitted as part of student course work for the Planning 100 "Introduction to Planning" course taught by me this year at Planning School, University of Auckland. The topic for the essay is: Use appropriate references to explain what is meant by economic growth and how and why economic growth has changed in the past two centuries. Explain the use of “GDP” as a measure of economic activity and discuss its usefulness. The essay explores the topic and also considers economic development in China. It is by Yin (Nikki) Hui, who has kindly given permission for it to be published here.

Economic growth is defined as an increase in the number of goods and services produced in an economy in a given time period, usually a year (Sabillion, 2007). For the majority of human history, economic growth has been so slow as to be non-existent. However, from approximately 1750, there was a “Great Divergence” which resulted in an exponential amount of growth in Great Britain, allowing the citizens of Western Europe to obtain previously unprecedented levels of wealth. Economists have largely debated over the causes of this growth and why Great Britain was the first to industrialize. (“The road to riches”, 1999). The first part of this essay will argue why the key reasons behind this growth was due to changes in political and economic institutions (Acemoglu & Robinson, 2012). The second part of this essay will discuss the usefulness of using GDP (Gross Domestic Product), as a measure of economic growth and the limitations of this measure, as well as ways in which it can be strengthened.

During the 19th and 20th century, economic growth resulted in a tenfold increase in average world income (Maddison, 2003). Some economists argue that an advance in science and technology was the reason behind this growth. Technology and knowledge tend to concur, as technology is driven by scientific knowledge. The discovery of atmospheric pressure gave rise to James Watt’s steam engine in 1744, which was the driving force behind the British industrial revolution (“The Road to Riches”,1999). However, technology does not necessarily lead to economic growth when we look to China as an example. At the start of the 15th century, China’s supremacy in science and technology was astounding, and it was on the verge of industrializing. The Chinese had already invented the compass, gunpowder and the wheelbarrow well before these ideas had had even reached the West. However, in 1400 technological process halted and by 1600, China had fallen behind Europe. If technology were the driving force behind economic growth, China would have been the first country to industrialize; yet this was not the case (Ringmar, 2007).

What fundamentally lead to Britain’s modernization was not technology, but the particular institutions that were present within British society. Institutions are defined as “formal rules, informal norms and their enforcement characteristics” (Ringmar, 2007). No two societies will have the same institutions as societies are subject to economic and political conflict that is resolved in different ways. These differences are often unnoticeable at first, but they accumulate, creating a process of institutional drift. European growth has accelerated phenomenally in the past two centuries because of two critical junctures in history. At the turn of the 14th century, Europe had a feudal order. The king owned all land and granted control of the land to the lords. Peasants or “serfs” had to perform unpaid labor on the land and were subject to taxes and fines. Then in 1348, the Black Death shook up the foundations of the feudal order. The plague resulted in a shortage of labor, and workers demanded more freedoms and higher wages. The Peasants’ Revolt broke out in 1381, and as a result, feudal services diminished and an inclusive labor markets began to rise. The second critical juncture occurred in 1600, with the expansion of world trade in the Atlantic Ocean. In Britain, Elizabeth 1 and her successors were unable to monopolize trade with the Americas. This created a group of wealthy traders who opposed absolutism and demanded changes to the institutional structures of Britain (Acemoglu & Robinson, 2012).

While economic institutions are important in determining the prosperity of a nation, it is political institutions that determine what economic institutions a nation has. The previous critical junctures gave power to the citizens who formed a coalition which was able restrict the power of the monarchy and executive, forcing them to listen to the demands of the coalition. The shift in power from the elites to the general masses sparked the Glorious Revolution of 1688. The Glorious Revolution diminished the power of the monarchy and enabled Parliament to determine the economic institutions which would foster investment, trade and innovation. These included patents, which granted property rights for ideas, the application of English law to all citizens, the ceasing of arbitrary taxation and the abolition of monopolies. Furthermore, the state promoted merchant activities and rationalized property rights to facilitate the construction of the infrastructure that would be key to economic growth. Property rights in particular are important, as they create an incentive for entrepreneurs to invest in order to increase productivity. These institutional changes underpinned the Industrial Revolution of 1750-1850 (Acemoglu & Robinson, 2012).

As a result of inclusive economic institutions, inventors such as James Watt, who perfected the steam engine in 1774, were able to become innovative because they were confident their property rights would be respected and they had access to markets where their innovations could be profitably sold. When institutionalized, technology can lead to increased productivity and growth (Sabillion, 2007). This growth greatly benefited the working class, whose living standards rose sharply from 1820 and onwards. Industrialization then spread to the United States, which became first nation to adopt the new technologies coming from Britain. The War of Independence and enactment of the U.S Constitution Act displays similar characteristics to the long struggle in England of parliament against the monarchy. The French Revolution was another critical juncture that meant the institutions of Western Europe started to converge with those of Britain, and conversely, these nations were able to industrialize (Ringmar, 2007).

Looking to the other side of the world, China had experienced great things in the past but had grown conservative over the years. China was a feudal society that was ruled by a despotic emperor and bureaucratic elite. In the 15th century, these rulers stopped long-sea voyagers, blocking trade and commerce, which meant growth stagnated (Sabillion, 2007). However, China is also one of the examples of how changes to the institutional structures of a country can send it on a different path of economic growth. During 19th and 20th century the economy was in a process of decline under the rule of the Communist Party and Mao Zedong. Consequently, the political and economic institutions created were highly extractive in nature. In the 1950s, Mao promoted the Great Leap Forward and in the 1960s he propagated the Cultural Revolution. These initiatives led to the mass persecution of intellectuals and educated people and the death of millions. However, when Mao died in 1976, Deng Xiaoping came into power and implemented several economic reforms. Economic incentives were given to farmers, foreign investment was encouraged, and state owned enterprises underwent privatization. Despite the economy stagnating changes to economic institutions meant there were reductions in poverty and income inequality from the 1970s onwards and China experienced a phenomenal growth rate of 9.5% a year (Acemoglu & Robinson, 2012).

Since historical times, growth has been commonly measured using GDP, which is the annual market value of final goods and services produced in a nation after accounting for changes in inflation. GDP is a measure of market activity, yet it is commonly used as an indicator of quality of life. However, GDP has many limitations which make is less useful as a measure of economic performance. The global economic crisis took many by surprise because of the high performance of the world economy between 2004 and 2007. During this period, temporary profits in the financial industry, increasing debt levels, and the real estate bubble painted a false picture of true economic conditions. This highlighted the fact our current system of measurement is failing us, and steps should be taken to improve GDP as a measure of economic performance and social progress (Stiglitz et al, 2010). One of the limitations of GDP is that it does not give any indication of income distribution. Although GDP may be increasing, this wealth may be only going to a select few in the economy, which decreases equity. Moreover, GDP includes expenditures that do not increase standards of living. For example, traffic congestion may increase GDP as a result of the increased fuel consumption, but this depletes air quality and time is wasted while travelling. Costs related to natural disasters and the cleaning up of pollution are also accounted for as positives in GDP (Anew NZ, 2006).

Furthermore, non-market activity is not accounted for in GDP. Many services people have received from family members in the past for free are now purchased on the market. This may translate to a rise in income and standards of living, although this is not the case. Non-monetary services contribute an important role to economic activity, yet they are not reflected when calculating GDP (Anew NZ, 2006).

More importantly, one of the most fundamental limitations of GDP is that it fails to take into account the effect economic expansion has on the environment, which has issues concerning sustainability. We live within a finite biosphere, and when growth encroaches too much on surrounding ecosystems, we will begin to sacrifice natural capital such as fish, minerals, and fossil fuels, which have more economic value than man-made goods. If we continue to deplete these resources they will no longer be available for future generations to benefit from. We are facing a looming environment crisis, especially over concerns of global warming, yet carbon emissions are not reflected in GDP. Clearly, if the environmental costs of production and consumption were reflected, measures of economic performance would look vastly different (“Economics in a Full World”, 2005).

Despite it’s limitations, GDP is hard to replace because it provides one summarized figure, which is comparable between nations. In a single number you get an idea of whether the economy is expanding or contracting, and this can be comparable over time. However, since GDP is used as a measure of people’s well being there needs to be more incorporation of quality of life factors that go beyond measuring output. These factors include health, education, political voice, social interaction and the environment (Stiglitz et al, 2010). The General Progress Indicator (GPI) is an example of an alternative measurement to GDP. It measures well being by taking into account of economic, social and environmental factors. In the GPI, the costs of pollution, the loss of natural resources, and ozone depletion are all submitted as negative (Anew NZ, 2006).

Furthermore, in order to make GDP a more useful measure of economic health and well being, focus should be taken away from production into income and consumption, as material living standards are more closely associated with these measures. In addition to this, the indicator should also reflect distribution of income. Particularly, measuring government provided services, such as education, should be improved as these contribute a vital role to economic activity and benefit society greatly. Lastly, GDP could be improved through broadening income measures to non-market activities, by showing how people spend their time over years and across countries to give a better reflection of change (Stiglitz et al, 2010).

In conclusion, economic growth is usually characterized by a rise in the living standards of people. The economic growth that occurred during the 18th and 19th century that started in Britain, and then spread to other parts of the world was a result of changes to political and economic institutions. These changes influenced the way society was governed, and thus how individuals behaved. These actions either allowed for economic growth, or stunted it. GDP is the most commonly used method to measure growth. However, GDP has many limitations, which restricts its usefulness. If GDP is used as a measure of wellbeing,

it needs to be improved or alternative measures need to be sought, as human well being incorporates various factors that are separate from material wealth. The human population is now better paid, educated and fed than his forefathers could have ever imagined. Yet this growth has been largely unsustainable, which raises the question of whether we can continue to see improvements in human standards of living in the future.

Bibliography

Acemoglu, D & Robinson, J. (2012). Why Nations Fail. London: Profile Books Limited.

Acemoglu, D., Johnson, S., & Robinson, J. (2005). The American Economic Review. Vol. 95 (3), pp. 546-579.

Anew NZ Progress Indicator Action Group. (2006). Measuring Real Wealth in New Zealand. Auckland.

Daly, H.E. (2005). Economics in a Full World. Scientific American, September, 100- 107.

Maddison, A. (2003). The World Economy: Historical Statistics. Paris: Development Centre, OECD. pp 256-62, Table 8a and 8c.

Ringmar, E. (2007). Why Europe was First. UK and USA: Anthem Press.

Sabillion, C. (2007). On the causes of economic growth: the lessons of history. New York: Algora Publishing.

Stiligitz, E.J., Sen, A., & Fitoussi, J.P. (2010). Mismeasuring our lives. United States of America: The New Press.

The Road to Riches. (1999). The Economist: Millennium Special Edition, December 31, 10-12.

1 comment:

Evans K. Ngeno said...

Thanks for the info on GDP.

Sunday, July 29, 2012

Essay: The Meaning of Economic Growth and GDP

This post contains an essay submitted as part of student course work for the Planning 100 "Introduction to Planning" course taught by me this year at Planning School, University of Auckland. The topic for the essay is: Use appropriate references to explain what is meant by economic growth and how and why economic growth has changed in the past two centuries. Explain the use of “GDP” as a measure of economic activity and discuss its usefulness. The essay explores the topic and also considers economic development in China. It is by Yin (Nikki) Hui, who has kindly given permission for it to be published here.

Economic growth is defined as an increase in the number of goods and services produced in an economy in a given time period, usually a year (Sabillion, 2007). For the majority of human history, economic growth has been so slow as to be non-existent. However, from approximately 1750, there was a “Great Divergence” which resulted in an exponential amount of growth in Great Britain, allowing the citizens of Western Europe to obtain previously unprecedented levels of wealth. Economists have largely debated over the causes of this growth and why Great Britain was the first to industrialize. (“The road to riches”, 1999). The first part of this essay will argue why the key reasons behind this growth was due to changes in political and economic institutions (Acemoglu & Robinson, 2012). The second part of this essay will discuss the usefulness of using GDP (Gross Domestic Product), as a measure of economic growth and the limitations of this measure, as well as ways in which it can be strengthened.

During the 19th and 20th century, economic growth resulted in a tenfold increase in average world income (Maddison, 2003). Some economists argue that an advance in science and technology was the reason behind this growth. Technology and knowledge tend to concur, as technology is driven by scientific knowledge. The discovery of atmospheric pressure gave rise to James Watt’s steam engine in 1744, which was the driving force behind the British industrial revolution (“The Road to Riches”,1999). However, technology does not necessarily lead to economic growth when we look to China as an example. At the start of the 15th century, China’s supremacy in science and technology was astounding, and it was on the verge of industrializing. The Chinese had already invented the compass, gunpowder and the wheelbarrow well before these ideas had had even reached the West. However, in 1400 technological process halted and by 1600, China had fallen behind Europe. If technology were the driving force behind economic growth, China would have been the first country to industrialize; yet this was not the case (Ringmar, 2007).

What fundamentally lead to Britain’s modernization was not technology, but the particular institutions that were present within British society. Institutions are defined as “formal rules, informal norms and their enforcement characteristics” (Ringmar, 2007). No two societies will have the same institutions as societies are subject to economic and political conflict that is resolved in different ways. These differences are often unnoticeable at first, but they accumulate, creating a process of institutional drift. European growth has accelerated phenomenally in the past two centuries because of two critical junctures in history. At the turn of the 14th century, Europe had a feudal order. The king owned all land and granted control of the land to the lords. Peasants or “serfs” had to perform unpaid labor on the land and were subject to taxes and fines. Then in 1348, the Black Death shook up the foundations of the feudal order. The plague resulted in a shortage of labor, and workers demanded more freedoms and higher wages. The Peasants’ Revolt broke out in 1381, and as a result, feudal services diminished and an inclusive labor markets began to rise. The second critical juncture occurred in 1600, with the expansion of world trade in the Atlantic Ocean. In Britain, Elizabeth 1 and her successors were unable to monopolize trade with the Americas. This created a group of wealthy traders who opposed absolutism and demanded changes to the institutional structures of Britain (Acemoglu & Robinson, 2012).

While economic institutions are important in determining the prosperity of a nation, it is political institutions that determine what economic institutions a nation has. The previous critical junctures gave power to the citizens who formed a coalition which was able restrict the power of the monarchy and executive, forcing them to listen to the demands of the coalition. The shift in power from the elites to the general masses sparked the Glorious Revolution of 1688. The Glorious Revolution diminished the power of the monarchy and enabled Parliament to determine the economic institutions which would foster investment, trade and innovation. These included patents, which granted property rights for ideas, the application of English law to all citizens, the ceasing of arbitrary taxation and the abolition of monopolies. Furthermore, the state promoted merchant activities and rationalized property rights to facilitate the construction of the infrastructure that would be key to economic growth. Property rights in particular are important, as they create an incentive for entrepreneurs to invest in order to increase productivity. These institutional changes underpinned the Industrial Revolution of 1750-1850 (Acemoglu & Robinson, 2012).

As a result of inclusive economic institutions, inventors such as James Watt, who perfected the steam engine in 1774, were able to become innovative because they were confident their property rights would be respected and they had access to markets where their innovations could be profitably sold. When institutionalized, technology can lead to increased productivity and growth (Sabillion, 2007). This growth greatly benefited the working class, whose living standards rose sharply from 1820 and onwards. Industrialization then spread to the United States, which became first nation to adopt the new technologies coming from Britain. The War of Independence and enactment of the U.S Constitution Act displays similar characteristics to the long struggle in England of parliament against the monarchy. The French Revolution was another critical juncture that meant the institutions of Western Europe started to converge with those of Britain, and conversely, these nations were able to industrialize (Ringmar, 2007).

Looking to the other side of the world, China had experienced great things in the past but had grown conservative over the years. China was a feudal society that was ruled by a despotic emperor and bureaucratic elite. In the 15th century, these rulers stopped long-sea voyagers, blocking trade and commerce, which meant growth stagnated (Sabillion, 2007). However, China is also one of the examples of how changes to the institutional structures of a country can send it on a different path of economic growth. During 19th and 20th century the economy was in a process of decline under the rule of the Communist Party and Mao Zedong. Consequently, the political and economic institutions created were highly extractive in nature. In the 1950s, Mao promoted the Great Leap Forward and in the 1960s he propagated the Cultural Revolution. These initiatives led to the mass persecution of intellectuals and educated people and the death of millions. However, when Mao died in 1976, Deng Xiaoping came into power and implemented several economic reforms. Economic incentives were given to farmers, foreign investment was encouraged, and state owned enterprises underwent privatization. Despite the economy stagnating changes to economic institutions meant there were reductions in poverty and income inequality from the 1970s onwards and China experienced a phenomenal growth rate of 9.5% a year (Acemoglu & Robinson, 2012).

Since historical times, growth has been commonly measured using GDP, which is the annual market value of final goods and services produced in a nation after accounting for changes in inflation. GDP is a measure of market activity, yet it is commonly used as an indicator of quality of life. However, GDP has many limitations which make is less useful as a measure of economic performance. The global economic crisis took many by surprise because of the high performance of the world economy between 2004 and 2007. During this period, temporary profits in the financial industry, increasing debt levels, and the real estate bubble painted a false picture of true economic conditions. This highlighted the fact our current system of measurement is failing us, and steps should be taken to improve GDP as a measure of economic performance and social progress (Stiglitz et al, 2010). One of the limitations of GDP is that it does not give any indication of income distribution. Although GDP may be increasing, this wealth may be only going to a select few in the economy, which decreases equity. Moreover, GDP includes expenditures that do not increase standards of living. For example, traffic congestion may increase GDP as a result of the increased fuel consumption, but this depletes air quality and time is wasted while travelling. Costs related to natural disasters and the cleaning up of pollution are also accounted for as positives in GDP (Anew NZ, 2006).

Furthermore, non-market activity is not accounted for in GDP. Many services people have received from family members in the past for free are now purchased on the market. This may translate to a rise in income and standards of living, although this is not the case. Non-monetary services contribute an important role to economic activity, yet they are not reflected when calculating GDP (Anew NZ, 2006).

More importantly, one of the most fundamental limitations of GDP is that it fails to take into account the effect economic expansion has on the environment, which has issues concerning sustainability. We live within a finite biosphere, and when growth encroaches too much on surrounding ecosystems, we will begin to sacrifice natural capital such as fish, minerals, and fossil fuels, which have more economic value than man-made goods. If we continue to deplete these resources they will no longer be available for future generations to benefit from. We are facing a looming environment crisis, especially over concerns of global warming, yet carbon emissions are not reflected in GDP. Clearly, if the environmental costs of production and consumption were reflected, measures of economic performance would look vastly different (“Economics in a Full World”, 2005).

Despite it’s limitations, GDP is hard to replace because it provides one summarized figure, which is comparable between nations. In a single number you get an idea of whether the economy is expanding or contracting, and this can be comparable over time. However, since GDP is used as a measure of people’s well being there needs to be more incorporation of quality of life factors that go beyond measuring output. These factors include health, education, political voice, social interaction and the environment (Stiglitz et al, 2010). The General Progress Indicator (GPI) is an example of an alternative measurement to GDP. It measures well being by taking into account of economic, social and environmental factors. In the GPI, the costs of pollution, the loss of natural resources, and ozone depletion are all submitted as negative (Anew NZ, 2006).

Furthermore, in order to make GDP a more useful measure of economic health and well being, focus should be taken away from production into income and consumption, as material living standards are more closely associated with these measures. In addition to this, the indicator should also reflect distribution of income. Particularly, measuring government provided services, such as education, should be improved as these contribute a vital role to economic activity and benefit society greatly. Lastly, GDP could be improved through broadening income measures to non-market activities, by showing how people spend their time over years and across countries to give a better reflection of change (Stiglitz et al, 2010).

In conclusion, economic growth is usually characterized by a rise in the living standards of people. The economic growth that occurred during the 18th and 19th century that started in Britain, and then spread to other parts of the world was a result of changes to political and economic institutions. These changes influenced the way society was governed, and thus how individuals behaved. These actions either allowed for economic growth, or stunted it. GDP is the most commonly used method to measure growth. However, GDP has many limitations, which restricts its usefulness. If GDP is used as a measure of wellbeing,

it needs to be improved or alternative measures need to be sought, as human well being incorporates various factors that are separate from material wealth. The human population is now better paid, educated and fed than his forefathers could have ever imagined. Yet this growth has been largely unsustainable, which raises the question of whether we can continue to see improvements in human standards of living in the future.

Bibliography

Acemoglu, D & Robinson, J. (2012). Why Nations Fail. London: Profile Books Limited.

Acemoglu, D., Johnson, S., & Robinson, J. (2005). The American Economic Review. Vol. 95 (3), pp. 546-579.

Anew NZ Progress Indicator Action Group. (2006). Measuring Real Wealth in New Zealand. Auckland.

Daly, H.E. (2005). Economics in a Full World. Scientific American, September, 100- 107.

Maddison, A. (2003). The World Economy: Historical Statistics. Paris: Development Centre, OECD. pp 256-62, Table 8a and 8c.

Ringmar, E. (2007). Why Europe was First. UK and USA: Anthem Press.

Sabillion, C. (2007). On the causes of economic growth: the lessons of history. New York: Algora Publishing.

Stiligitz, E.J., Sen, A., & Fitoussi, J.P. (2010). Mismeasuring our lives. United States of America: The New Press.

The Road to Riches. (1999). The Economist: Millennium Special Edition, December 31, 10-12.

1 comment:

Evans K. Ngeno said...

Thanks for the info on GDP.