Month: April 2015

On a semi-regular basis, I find myself trying to be polite while someone explains their breathtaking \”new\” insight that while economists all worship at the altar of GDP, this wise social critic has noticed that measurements of market output are not identical to social well-being. This supposedly new insight has been obvious to economists since they started trying to measure the size of an economy back in the 1930s  and it\’s been a staple of political rhetoric at least since Robert Kennedy\’s elegant comments on the subject since 1968.

But while no economist believes that GDP is identical to social well-being, many economists do hold a related belief that growth of GDP over time has a positive correlation with human well-being broadly understood. Late last year, the OECD published a report called \”How Was Life? Global Well-Being Since 1820,\” edited by Jan Luiten van Zanden, Joerg Baten, Marco Mira d’Ercole, Auke Rijpma, Conal Smith and Marcel Timmer. In the course of 13 chapters written by different sets of authors, the report looks at evidence on demography, health, personal security, political structures, the environment, and other broad measures of well-being. The volume can be read online or ordered here. Here, let\’s do a quick review of the evidence on long-term correlations between economic growth and other measures of well-being, and then return to a discussion of correlation and causation between these factors.

As a starting point, here\’s a quick review of the evidence on growth of GDP over time.

\”The good news is that since the 1820s the average GDP per capita of the world’s population has increased by a factor of 10, a growth that contributed immensely to increased economic well-being. … The bad news is that GDP growth was very unevenly distributed across the various regions: during the 19th century, rich countries became richer and poor countries fell behind, resulting in a substantial increase in global inequality in GDP per capita. Global inequality kept rising during the first half of the 20th century, when the United States economy grew more rapidly than the rest of the world. After the 1950s, however, this process slowly started to reverse. For the first time, the economic growth rates experienced by poor economies were of a similar magnitude as those of rich economies. And, since the 1970s, low-income countries, in particular in Asia, grew much faster than high-income countries.\”

So how have other dimensions of human well-being been correlated with this rise in per capita GDP, both over time and across countries? The short answer is that there is a strong positive correlation between per capita GDP and and indicators of education and health status. There is a weaker but still positive correlation between higher per capita GDP and participatory political institutions. There is no clear-cut correlation between per capita GDP and personal security. The relationship between per capita GDP and the environment (viewed as a whole) seems to be an inverted U-shape: that is, growth of per capita GDP is first associated with higher environmental damage, but at some point it seems to be associated with lower damage. The relationship between per capita and income inequality seems to follow a regular U-shape: that is, growth of per capita GDP is first associated with greater within-country income equality up to about the 1970s, but since then is associated with greater inequality. Here are some details.

1) Education

Gains in education have a strong positive correlation with per capita GDP over time and across countries, probably a part of a virtuous circle: that is, a more educated workforce helps economic growth, and an economy with higher per capita income can afford to spend more on education. Here\’s an illustrative figure showing growth in global literacy rates over time.

2) Health status over the long-term can be proxied by measures like life expectancy and height. It seems clear that higher per capita GDP is associated with gains in both, although there is some evidence that at the highest levels of GDP, higher incomes are not associated with larger health gains. The report says:

\”Life expectancy at birth was about 33 years in Western Europe around 1830, 40 years in 1880, and almost doubled in the period after, with the largest improvements occurring in first half of the 20th century. In the rest of the world, life expectancies started to increase from much lower levels, rising in particular after 1945. Worldwide life expectancy increased from less than 30 years in 1880 to almost 70 in 2000. There is strong evidence of a shift in the relationship between health status and GDP per capita over the past two centuries. Life expectancy improved around the world even when GDP per capita stagnated, due to advances in knowledge and the diffusion of health care technologies.\”

Here\’s a figure showing population height compared with GDP per capita.

3) Personal security over the long-run can be approximated by using data on homicide rates and on war. The report summarizes the evidence on per capita GDP and homicide rates like this: \”Western Europe was already quite peaceful from the 19th century onwards, but homicide rates in the United
States have been high by comparison. Large parts of Latin America and Africa are also violent crime “hotspots”, and so is the former Soviet Union (especially since the fall of communism), while large parts of Asia show low homicide rates. Homicide rates are in general negatively correlated with GDP per capita – the richer a country, the lower the level, but there are important exceptions.\” Here\’s a figure showing homicide rates in some selected countries since 1950, with the US rate far above the others.

4) The overall pattern of political institutions over time is toward greater participation, but the path has often been a bumpy one. Here\’s a figure showing an Index of Democracy, where the measure of competition is based on what share of the vote is received by the winning party (when a winning party receives nearly all the votes, competition is low) and a measure of participation based on the share of the adult population that votes. On a worldwide basis, both are rising since 1820. But the rise is bumpy and spiky at times.

5) Environmental quality is proxied by three measures in this report: biodiversity, and emissions of sulfur dioxide and carbon dioxide. The summary reads: \”A negative correlation with GDP per capita is clearly in place when looking at quality of the environment. Biodiversity declined in all regions and worldwide as land use changed dramatically. Per capita emissions of CO2 increased after the industrial revolution in Western Europe and its Offshoots, accelerating in the mid-20th century as other regions increased their GDP, and is still increasing globally. Per capita emission of SO2 (a local pollutant) also increased alongside higher industrial production, but were curbed since the 1970s thanks to the advent of cleaner technologies.\” Here\’s a figure showing sulfur dioxide emissions over time:

A key question is whether countries will tend to find ways to reduce environmental damage as their per capita GDP rises–as appears to be happening with SO2. Another way of making the point is that the ways in which economic growth affects the environment are strongly affected by public policy choices. As the report notes:

To some extent SO2 emissions follow an environmental Kuznets curve, with declining emissions beyond a certain level of GDP per capita, and in recent periods biodiversity is also less directly (negatively) related to real income levels. Overall, there is still a rather strong negative link between environmental quality (as measured by these indicators) and GDP per capita, but this link has been weakening in recent years (since the 1970s), probably as a result of successful policies to lower emissions (SO2 probably being the best example).

6) Inequality of incomes is hard to summarize, in part because we live in a time when there is growing inequality of incomes within countries at the same time that global inequality of incomes is falling (with the rise of incomes in countries like China and India). Here\’a figure showing the evolution of the global distribution of income over time.

For the global distribution of income, the curves in the figure are gradually moving out to the right as economic growth raises the average world income. The area under the curves is also getting larger, which captures the fact that world population has dramatically expanded. It\’s interesting to notice that in 1970 and 1980, the global distribution of income had two humps, one at a lower income level and one at a higher income level. By 2000, the world is back to a one-hump income distribution.

From a national and regional level, the patterns show look different: \”Long-term trends in income inequality, as measured by the distribution of pre-tax household income across individuals, followed a U-shape in most Western European countries and Western Offshoots. It declined between the end of the 19th century until about 1970, followed by a rise. In Eastern Europe, communism resulted in strong declines in income inequality, followed by a sharp increase after its disintegration in the 1980s. In other parts of the world (China in particular) income inequality has been on the rise
recently. The global income distribution, across all citizens of the world, was uni-modal in
the 19th century, but became increasingly bi-modal between 1910 and 1970 and suddenly
reverted to a uni-modal distribution between 1980 and 2000.\”

Overall, what should one take away from this exercise in thinking about the relationship economic growth as measured by GDP and other dimensions of human well-being? Here are a few of my own observations.

• GDP is clearly not the same as real social welfare. However, it tends to be true that societies with a higher level of per capita GDP are better off on some other dimensions of well-being, not just consumption but also other factors including health, education, and personal freedom.
• Many dimensions of social well-being are not includes here: for example, average hours worked per week, protection against economic risks, degree of personal freedom, traffic congestion, and others.  
• Patterns of international migration around the world suggest that of those people who want to move, the vast majority prefer to destination with an equal or higher per capita income.
• Every social science student is inoculated with the knowledge that \”correlation is not causation.\” The correlations presented here do not prove causation. Economic growth can happen in many ways, and be accompanied by a wide range of public policies. It\’s easy to come up with examples where growth has been accompanied by greater or lesser degrees of educational improvement, greater or lesser degrees of political participation, greater or lesser degrees of environmental damage. Moreover, there will often been two-way causalities: for example, economic growth may help to foster democracy, but democracy may also foster economic growth. The correlations are what they are, but the causal factors will depend heavily on institutions and laws within countries and localities. 
• When I hear people offer the the stale and hoary complaint about how wrong it would be to equate GDP and social welfare, it seems to me that  they they typically don\’t mean to argue that society would necessarily be better off if GDP were reduced. Instead, they are arguing that they would prefer to have the output of the economy and society–with output very broadly understood–reshaped so that a greater share of output went to areas like helping the poor, protecting the environment, providing health and education services. 
• An economy that is not growing is a zero-sum game. Groups can only gain if other groups lose. One set of social priorities can only expand if other priorities are diminished. A growing economy is a positive-sum game, and in such games, conflict can be much diminished. Those who are concerned about an overemphasis on GDP growth might meditate on the possibility that a larger social pie in and of itself is not your enemy–and in fact a certain kind of economic growth might be your best friend. 

The World Bank is facing what I think of as a March of Dimes moment. The well-known March of Dimes charity was founded in 1938 with a focus on fighting polio. But after the Salk vaccine was licensed for use in 1955 and polio declined rapidly, the charity did not close up shop. Instead, it shifted its focus first to birth defects, and then to issues of healthy pregnancies and premature births.

A combination of growth in lower-income and middle-income countries around the world and change in their economic development challenges is leading to a similar crisis in the mission of the World Bank. Scott Morris and Madeleine Gleave lay out many of the issues in \”The World Bank at 75,\” published in March 2015 as  Policy Paper 058 by the Center for Global Development. They write: \”As a lender to “LICs” and “MICs,” the World Bank will be reaching the limits of its usefulness in much of the developing world in the years ahead. It will continue to play an essential role in a relatively small number of fragile states, but the rest of its core lending model could very quickly become irrelevant to most of its other current borrowers. … On its current path, the World Bank will soon enough be viewed as no longer essential.\”

Although the rhetoric used by the World Bank to describe its mission has changed over time, most of what the World Bank actually does has been broadly the same for decades. It makes loans to national governments, with a heavy focus on infrastructure investment, with one set of loans and conditions for low-income countries and another for middle-income countries. This model is under challenge from several directions.

First, with sustained growth in many low-income and middle-income countries around the world, the number of countries eligible for World Bank loans is likely to fall the next few years. Morris and Gleave offer a map of the countries eligible for World Bank lending in 2015, with the countries meeting the low-income (per capita) guidelines in orange and the middle-income countries in blue. They then project what countries will fall into those categories just four years from now in 2019. Either the World Bank is going to adjust its income guidelines substantially, or it is going to become very focused on Africa and south Asia in the next few years.

A second issue is that developments in the world financial system mean that governments and economies of low-income and middle-income countries now have access to many more alternative sources of finance.  Here are some of the rising sources of finance as listed by Morris and Gleave (footnotes omitted):

Low-income countries have had growing success in obtaining sources of financing other than official development assistance (ODA). Perhaps most prominent is the recent cohort of countries engaged in first time sovereign bond issuances, as well as the coupons on those issuances (see Figure 3). Both the incidence and interest rates reflect what is an extraordinary period in global financial markets, where investors are increasingly “chasing yields” after a sustained period of low interest rates associated with quantitative easing by major economy central banks. …

More generally, financing outside of traditional ODA sources (including the World Bank) are becoming increasingly important for developing countries. Foreign direct investment (FDI) from OECD countries has more than doubled over the last ten years, and is now 1.7 times as large as total ODA. Remittance flows to developing countries, too, are growing rapidly, totaling $430 billion in 2014. And due to their nature as direct income transfers, remittances have a first-order effect on poverty unmatched by many other flows. … And domestic resource mobilization has become an increasingly important source of public financing, as least-developed and lower-middle income countries have doubled domestic tax revenues in the last decade to total almost $14 billion.

Along with the financial flows from remittances, foreign direct investment, and a newfound ability for low-income countries to issue sovereign debt, there is even new competition in the world of development banks. There are existing regional development banks with growing financial clout like the Inter-American Development Bank (IDB), the African Development Bank (AfDB), and the Asian Development Bank (AsDB). As the authors note: \”In 2014, the World Bank’s third largest shareholder, China, announced the creation of a new multilateral development bank for Asia, the Asian Infrastructure Investment Bank (AIIB). At the same time, the Chinese also joined with the other “BRICS” countries, representing over one-fifth of the World Bank’s shareholders and some of the bank’s biggest borrowers, to plan for a new global MDB, the New Development Bank.\”

If the World Bank is going to stay relevant, it needs to evolve. But how? Morris and Gleave discuss the alternatives, which include:

• Maybe instead of a focus on infrastructure, the World Banks should shift some of its emphasis to public goods like research and development for agriculture or disease prevention or reducing air pollution. Or course,these kinds of projects typically involve a large component of grants, rather than loans. 
• Maybe the World Bank should put more of its focus on crisis response, like its recent response to the Ebola outbreak, or on dealing with economic risks like the danger that the price of a key agricultural export commodity will fall. 
•  Maybe instead of focusing on loans to national governments, the World Bank should consider loans to subnational areas, like water or transportation infrastructure for a certain city, or loans to regional areas, like transportation and electricity networks across national borders.
• Maybe instead of making loans based national per capita income, the World Bank should focus on countries where high levels of deep poverty remain, or on countries that combine low income with issues like a high level of debt accumulated in past decades that is hindering future growth, or a lack of capacity to manage public finances and collect taxes. 
• Many researchers naturally look at the World Bank as an institution that could be a knowledge leader and a clearinghouse for what is known about how to make economic development work. This mission would emphasize that World Bank loans and projects should be designed to produce the kinds of measureable inputs and outputs that can be the grist for academic research. 

The World Bank has tinkered with some of these kinds of evolution. In particular, the branch of the World Bank that works with private sector investors (the International Finance Corporation) has been growing in size. The idea is that these investments will focus not just on profitability, which they are achieving, but also on projects that bring additional development benefits and that would not otherwise get funding from private investors, which are harder to demonstrate.

But as the World Bank takes a good look at itself in the mirror, here\’s the hard question it needs to face. It\’s easy to list global problems that need solving. But is the World Bank only trying to justify its continued existence by looking for new tasks? Or can the World Bank identify areas where its own specific skills and capabilities will have a high payoff for economic development?

When I read media discussions about deflation,\” three separate meanings are often used more-or-less interchangeably.

One meaning is the way that economists use the term, in which \”deflation\” means \”inflation happening at a negative rate.\” Inflation means that the buying power of a certain amount of currency is reduced over time. Deflation means that the buying power of currency rises over time.

A second usage is a drop in asset prices: thus, you sometimes hear someone talk about the \”deflation\” in housing prices or the stock market. But a drop in housing prices or in the stock market has no direct effect on GDP, which only measures what is actually produced.  (Housing prices do affect GDP in an indirect way, because GDP treats homeowners as people who are producing housing services and selling those services to themselves, using an \”imputed\” value that will be linked to the cost of renting a house, which in turn is linked to the price of the house.)

A third use of \”deflation\” refers to a drop in economic output. I think that when a lot of people hear the term \”deflation,\” they interpret it as meaning the same thing as \”recession\” or \”depression.\” It\’s of course true that a price deflation may be accompanied by a recession, but this has not always been true.

What are the relationships between price deflation, sharp falls in asset prices, and recession or depression? Claudio Borio, Magdalena Erdem, Andrew Filardo, and Boris Hofmann tackle this question in \”The costs of deflations: a historical perspective,\” published in the Bank of International Settlements Quarterly Review for March 2015.

To get an intuitive feeling for what history teaches about the connection from price deflation to recession or depression, here\’s a useful figure showing when deflations actually occurred. Annual episodes of deflation are shown by circles, while persistent deflation is shown by a horizontal line. (The reader should also note not all countries have price data over this entire period, and in those cases, the triangles show the start of when data is available.)

Clearly, there are many episodes of deflation in the late 19th and early 20th century, and then again during the \”interwar period\” that includes the Great Depression, followed by fewer episodes of deflation since then. The authors note that deflation and Depression clearly go hand in hand, but they also point out that in the 19th century, the 1920s, and the period since World War II, price deflation does not seem to have any strong correlation with economic growth. Indeed, as they point out, economic historians have sometimes referred to 19th century deflation as \”good deflation.\” In the post-World War II years, although the deflations are mostly transitory and this difference is not statistically significant, \”the growth rate has actually been higher during deflation years, at 3.2%
versus 2.7%.\” The Annual Report of the BIS released last summer also made the case that deflation does not have an overall strong historical connection with recession or depression, as I noted here.

To what extent are changes in asset prices correlated with recession or depression? Borio, Erdem, Filardo, and Hofmann use the available data on stock market prices, as well as a newly expanded set of data on historical housing market prices. Thus, they can explore the question of what is the biggest danger for economic growth: price deflation, or a fall in asset prices? Of course, the Great Depression experienced both changes. Here\’s there conclusion:

Output growth is consistently lower during both property and equity price deflations, and the slowdown is statistically significant except in the classical gold standard period for house prices. The importance of property prices is again greater in the postwar period. … Once we control for persistent asset price deflations and country-specific average changes in growth rates over the sample periods, persistent goods and services (CPI) deflations do not appear to be linked in a statistically significant way with slower growth even in the interwar period. They are uniformly statistically insignificant except for the first post-peak year during the postwar era – where, however, deflation appears to usher in stronger output growth. By contrast, the link of both property and equity price deflations with output growth is always the expected one, and is consistently statistically significant. … [I]t is misleading to draw inferences about the costs of deflation from the Great Depression, as if it was the archetypal example. The episode was an outlier in terms of output losses; in addition, the scale of those losses may have had less to do with the fall in the price level per se than with other factors, including the sharp fall in asset prices and associated banking distress.

As the authors readily admit, this analysis is far from conclusive. But it does tend to support the possibility that concerns over price deflation may be overdone, while worries about bubbles in asset prices like stock markets or housing prices may have been underdone. Remember that the last two US recessions in 2001 and 2007-2009 were not preceded by deflation, but where preceded by an asset bubble popping–the dot-com bubble in the earlier episode and the housing price bubble more recently.

The comment is derived from the dialogue in one of Oscar Wilde\’s plays, called Lady Windermere\’s Fan, which was first produced on stage in 1892. Here\’s the relevant snippet of dialog:

Lord Darlington: What cynics you fellows are!
Cecil Graham: What is a cynic?
Lord Darlington: A man who knows the price of everything and the value of nothing.
Cecil Graham: And a sentimentalist, my dear Darlington, is a man who sees an absurd value in everything, and doesn’t know the market price of any single thing.

Lord Darlington\’s comment about cynicism is fairly well-known, at least among economists. At least in my experience, the comeback from Cecil Graham is not known at all.

So which of Oscar Wilde\’s choices do we take? Cynic or sentimentalist? Economic analysis does suggest an intermediate path, which was nicely enunciated in the title of a 1987 book by Alan Blinder, Hard Heads, Soft Hearts.  Blinder writes:

There is an appealing philosophy of economic policy that combines hard-hearted respect for economic efficiency with soft-hearted concern for society\’s underdogs. … We must start thinking with our minds and feeling with our hearts, rather than the other way around. … The hard-headed but soft-hearted approach is based on two principles. The first, the hard head, is that more is better than less. The second, the soft heart, is that the poor are needier than the rich. Neither of these strikes me as particularly controversial nor ideological. And so there is hope. … Of course, simply paying allegiance to the principles of equity and efficiency will not provide answers to all our economic policy questions. Many policies enhance efficiency but damage equity, or vice versa. … In such cases, the principles of equity and efficiency are not enough. We must supplement them with more controversial ethical judgments about whether gains in efficiency compensate for losses in equity, or vice versa. Here the decisions are inherently political and reasonable people may disagree. But keeping the two principles firmly in mind does help.

Perhaps the old joke could be amended in this way: \”An economist is someone who insists on both analyzing prices while also appreciating ultimate values–and struggling with the tradeoffs.\” Or briefer: \”An economist is a cynical sentimentalist, teetering on the sharp edges of both views.\”