Rethinking Economic Progress

The Boston Economist — The measurement of national and global economic activity serves as a critical lens through which we comprehend the dynamic nature of economies — observing their growth, contraction, and structural changes. Traditional indicators such as Gross Domestic Product (GDP) have long been the bedrock of economic analysis. Recently, economists have acknowledged the multidimensional nature of economic growth and prosperity, leading to the development of other indices like the Human Development Index (HDI) and Gross National Income (GNI).

While each of these indices provides valuable insights, they also come with their own set of advantages and limitations. This essay explores the strengths and weaknesses of key economic indices and considers how their combination or enhancement could offer a more comprehensive understanding of economic progress.

Gross Domestic Product (GDP)

GDP was first introduced in 1934 by economist Simon Kunetz. 1934 was among the worst years of the Great Depression and global economists needed a measure of economic productivity to gauge recovery efforts (Fioramonti, 2014). GDP is calculated by computing the annual value of private investment spending, consumer spending, government spending, and net exports. The key benefit of GDP as an economic measure is its connection to other economic indicators, as defined by Okun’s law — When real GDP is growing strongly, employment will increase as companies hire more workers and people have more money in their pockets to buy goods (Prachowny, 1993). When GDP is shrinking, employment declines. In essence, GDP facilitates people’s determination of whether or not an economy is succeeding because GDP is a simple economic index connected with other well known figures such as unemployment, output, and price level.

Figure 1: Employment of non-agricultural workers compared with Real GDP from 2000 to 2021 (Jansen, Rettenmaier, 2022)

GDP’s shortcoming as an economic index is its limited range of the actual conditions of a nation, which include the distribution of wealth, corruption levels, global contribution, and sustainability. As Senator Robert Kennedy observed in a 1968 speech, “The Gross National Product includes air pollution and advertising for cigarettes, and ambulances to clear our highways of carnage. It counts special locks for our doors, and jails for the people who break them. GNP includes the destruction of the redwoods and the death of Lake Superior. It grows with the production of napalm and missiles and nuclear warheads…And if GNP includes all this, there is much that it does not comprehend. It does not allow for the health of our families, the quality of their education, or the joy of their play.” Kennedy accurates observed that GDP fails to measure improvements in quality of life as a result of spending and production. GDP solely measures production as an economic indicator, but fails to account for numerous economic and non-economic variables that contribute to quality of life (what economic indicators should strive to measure) An example of this is in China.

The case of China illustrates the limitations in relying solely on GDP as an indicator for assessing a nation’s overall well-being. Between 1991 and 2015, China’s Real GDP in 2010 USD rose from $910 Billion to $8.9 Trillion. Real GDP per capita over this time rose from $800 to $6,500 (Chen, et al., 2013). This is largely due to the increase in factories which supply goods, especially machinery such as circuits, industrial parts, and computer hardware to other nations. China’s exports amounted to $3.34 trillion in 2021 (Observatory of Economic Complexity, 2021). However, because GDP is solely measures production, the dramatic rise in wealth in China does not necessarily reflect an increase in the quality of life. The nation is still riddled by the issues of an authoritarian government, rural poverty (due to the concentration of industrial wealth in large urban centers), and tremendous pollution as a direct result of the increase in production of goods. 19% of China’s land is polluted, and contamination of food and water in the nation as a result of industrial chemicals has become increasingly common. Nearly 40% of land in China has degraded, reducing the land available for use by China’s millions of farmers, and advancing their poverty (Marchetti, 2019) . Finally, another reduction in the quality of life as a result of China’s astronomical rise in production is discrimination and mistreatment of migrant workers. As tens of millions of workers from poorer, rural provinces such as Heilongjiang and Henan seek the economic opportunities provided by urban factories, discrimination has become commonplace in China. Urban residents in China make 30% more than their rural migrant counterparts. 71% of migrant workers faced lower pay than urban workers, and 81% faced discrimination in opportunities for promotion (Demurger, et al., 2008). While China’s dramatic rise in production, as reflected by the tremendous increase in Real GDP per capita, has brought about an increase in wealth, it has led to an equally significant number of issues of quality of life for hundreds of millions of people, highlighting the shortcoming of GDP in measuring overall quality of life.

While GDP may serve as an excellent rudimentary economic indicator, simple to analyze for economists, the government, and the public as a measure of output, it lacks in capturing the intricacies of a nation’s well-being and progress. Its exclusive focus on production fails to account for essential elements that contribute to the overall welfare of a society.

Gross National Income (GNI)

GNI is an economic indicator counting the GDP plus incomes earned by foreign residents minus income earned by non-residents (OECD, 2023). GNI has become particularly helpful in the context of a globalized economy. A demonstration of this disparity between domestic production and production resulting from foreign investment can be found in Northern Europe — Ireland.

As a result of low corporate taxes, developed infrastructure, advanced technology connectivity, and membership in the European Union, Ireland has become a hub for foreign companies to develop their European operations — the top ten largest technology firms in the world have set up offices in Ireland (IDA Ireland, 2023). Consequently, 23% of Ireland’s workforce is employed by foreign firms and wages for these workers alone constitute roughly 10% of Ireland’s GDP. About 37% of Ireland’s GDP is a result of foreign value added (OECD, 2017). However, it is crucial to note that the profit being made by many of these firms is being exported back to their home nations, which is taken into account by GNI, but not by the GDP. This has led to a significant gap between Ireland’s GDP and GNIs per capita — the former at $103,983 and the latter at $58,117 (World Bank, 2022).

While GNI appropriately addresses the issue of foreign value added to an economy (an issue that will be increasingly common as economic globalization advances), its shortcomings are similar to that of the GDP — it still takes into account production of things that do not necessarily benefit a nation’s well being, and is solely a measure of production. GNI does not reflect how or where money is invested in a nation, nor the quality of life of a people in a nation as a result of increased production and wealth.

GNI has many of the same drawbacks as GDP in measuring economic productivity — however, it appropriately addresses the significant factor of foreign investment, a factor that will become increasingly important as economic globalization continues.

Human Development Index (HDI)

HDI was developed in 1990 as a summary measure of economic achievement in key dimensions of development: health, education, and standard of life. A nation’s HDI is the geometric mean of these three dimensions. Health dimension is measured by the life expectancy index derived from life expectancy at birth. Education is determined by the index from mean and expected years of schooling. Finally, standard of living index is determined from GNI per capita at current price level. The HDI uses the logarithm of income, to reflect the diminishing importance of income with increasing GNI (Human Development Report, 2013; United Nations Development Program, 2023).

The dimension indices are calculated with the following formula:

Actual Value — Minimum ValueObserved Maximum Value — Minimum Value

For example:

Figure 2: Sample Calculation of a nation’s Human Development Index (Human Development Report, 2013)

HDI is the most helpful economic indicator amongst those widely in use today. This practicality as an indicator can be attributed to several key factors:

• Accounting for the diminishing significance of increasing Gross National Income by using logarithmic calculation
• Multidimensional analysis, i.e. observes beyond how much a country produces, how it uses the money created by that production
• Accounting for potential to sustain economic growth with consideration of human capital, and to a lesser extent, physical capital

First, the calculation of HDI pertaining to GNI takes into account the diminishing significance of a greater income, as demonstrated by the Easterlin Paradox, which states that at a point in time, happiness varies directly with income both among and within nations, but over time happiness does not trend upward as income continues to grow: while people on higher incomes are typically happier than their lower-income counterparts at a given point in time, higher incomes don’t produce greater happiness as they continue to increase (Easterlin, 2020). The difference in quality of life between someone in a nation such as Burundi with a GNI per capita of $240 and someone in a nation such as Cambodia with a GNI per capita of $1,700 is far more significant than that of someone from Norway (GNI per capita of $95,510) and Liechtenstein (GNI per capita of $116,600) (World Bank, 2022), despite the raw difference being significantly larger between the latter nations.

Figure 3: Graphical representation of the Easterlin Paradox showing the correlation between a nation’s GDP per capita and Life Satisfaction score (Easterlin, 2009)

In addition to accounting for the logarithmic nature of increasing production (and consequently, income) in nations, the HDI represents the appropriate allocation of income, which is not necessarily a given in many places due to government corruption, poor government coordination, and lack of resources. For example, Equatorial Guinea boasts a per capita GDP of $18,127, the fifth highest in Africa and on a similar level to nations such as South Africa and Algeria (World Bank, 2022). They also boast a high GNI per capita of $11,990 (World Bank, 2022). However, Equatorial Guinea also faces a rate of education and health expenditure lower than many of its neighbors with fewer resources. For example, 60% of six to twelve year olds in the nation are not enrolled in school, only 25% of newborns are vaccinated for polio, and life expectancy at birth is 63.8 years — these rates are among the lowest in Africa and in the world, on par with nations like Burkina Faso and Cameroon (With GDPs per capita of $2,461 and $4,064 respectively). This is largely in part due to the fact that much of Equatorial Guinea’s tremendous GDP is a result of its massive oil reserves, which have made the small nation quite wealthy in terms of natural resources. However, due to rampant government corruption and wealth inequality, the average Equatorial Guinean reaps few of the benefits. International investigations have revealed that Government officials often assign construction and renovation projects of infrastructure to contractors that are partially or completely owned by themselves or other high-ranking Government officials (Human Rights Watch, 2017). As a result, Equatorial Guinea’s annual expenditure on roads, airports, buildings, and other infrastructure between 2009 and 2013 was $4.2 billion, while expenditure on education and healthcare were a mere $140 million and $92 million respectively. Overall, the Government of Equatorial Guinea spent $80 out of every $100 earned in revenue on infrastructure while only spending $3 on education and $2 on healthcare (Human Rights Watch, 2017). Utilizing GDP per capita as the sole measure of economic progress, Equatorial Guinea would appear to be a thriving nation, among the most economically successful in Africa. However, thanks to the multidimensional analysis provided by HDI, especially the consideration of healthcare and education, economists can observe that Equatorial Guinea is not necessarily one of the most thriving nations in Africa, despite producing a great output (35th in Africa and 145th globally in HDI).

Finally, the Human Development Index accounts for factors that develop potential for an economy to grow in the future, namely, human capital. The Endogenous Growth Theory maintains that economic growth is primarily spurred by a nation’s self investment in human capital, technological progress, and physical capital stock (Aghion, Howitt, 1998). Human capital refers to the skill of a nation’s workers, crucially influenced by educational expenditure, which is accounted for in a nation’s HDI score, but not in numerous other indicators. In addition, appropriate government expenditure and lack of corruption (both of which are addressed in the HDI calculation) improve technological progress and physical capital investment, meaning that unlike the GDP, HDI accounts for a nation’s potential to continue to grow.

As opposed to traditional, rudimentary economic indicators like GDP or GNI, HDI accounts for a multitude of factors, but most crucially, how well people in a nation fare, regardless of how much the nation produces.

An Indicator of the Future

In the quest for a more comprehensive approach to measuring a nation’s progress in a way that demonstrates quality of life, sustainability, national output, and a variety of other factors in a global economy, the conventional economic indicators of the past are giving way to more sophisticated measures. At the crossroads of economic analysis and societal well-being, it becomes increasingly apparent that relying solely on metrics like Gross Domestic Product (GDP) is insufficient for capturing the intricacies of a nation’s advancement. The limitations of GDP, as demonstrated through various real-world examples, have prompted a shift towards more holistic indicators such as the GNI and HDI. An economic indicator which appropriately combines GNI, HDI, GDP, and a variety of other measures of a nation’s well being and quality of life is the United Nations Sustainable Development Goals Index.

The SDG Index was introduced by the United Nations in 2015 to provide a more accurate image of a nation’s well being than existing economic indicators. It includes factors like a nation’s poverty rate, life expectancy, gini coefficient (a measure of wealth inequality), crime rates, and combat deaths (United Nations, 2023). While the sustainable development index provides a strong image of a nation’s well being, it does not necessarily reflect economic progress, and specifically does not account for the Easterlin paradox or individual economic liberty.

To develop an ideal economic indicator, it must properly account for several factors:

1. The Easterlin Paradox — The diminishing significance of increased wealth.
2. A nation’s investment in its own growth through technology, physical capital, and human capital.
3. Differentiation of domestic wealth and foreign exported wealth
4. Wealth distribution through the gini coefficient

It is imperative that an economic indicator accounts for the Easterlin paradox — if an economic indicator is to measure well being and production simultaneously, it must acknowledge the diminishing significance of increasing production, as illustrated by the earlier example of Norway and Liechtenstein. In addition, an economic indicator should account for a nation’s investment in future growth — the three primary factors of economic growth are physical capital, human capital, and technology. While GDP measures production, and consequently, wealth in a nation, this wealth does not necessarily mean future income will continue to increase unless a nation is appropriately investing in its own factors for growth. This can be measured by expected years of schooling and mean years of schooling, private and government investment spending, and the Solow Residual (A measurement of technological progress which maintains that changes in output that can’t be explained by changes in the capital stock or changes in the number of workers must be due to technological progress.) (McCombie, 2001). In addition, as the economy becomes increasingly globalized, it is crucial to differentiate domestic income from foreign income as investment in foreign nations becomes increasingly common. The disparity between income from domestic profits and production resulting in exported profits is highlighted by the case of Ireland. Finally, the gini coefficient, a measure of wealth inequality, should be included in any economic indicator. The gini coefficient measures the Lorenze curve, the gap between the wealthiest and poorest equal portions of the population (World Bank, 2024).

Figure 4: A simple Lorenz Curve, demonstrating the gap between perfect equality and the actual distribution of wealth in a nation

As observed in various nations such as Equatorial Guinea and China, wealth concentrated in the hands of few individuals does not necessarily indicate economic prosperity (China scored 38 gini index, and Equatorial Guinea scored 50, indicating high levels of income inequality).

Looking to the future, the positives and negatives of existing economic indicators, as evidenced by real-world examples like China, Ireland, and Equatorial Guinea, demonstrate the need for a new indicator. An ideal economic indicator should address the Easterlin Paradox, a nation’s investment in growth potential, differentiation of domestic and foreign wealth, and wealth distribution (through the Gini coefficient). These considerations are imperative for a nuanced understanding of a nation’s prosperity, emphasizing the need for an indicator that reflects not only productivity but also the quality of life, sustainability, and global interconnectedness.

References

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