Economic growth is a one-dimension concept concerned with the value of the final goods and services produced by 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. In this section, I will go over the major GDP accounting equations, aiming to illustrate that they provide a rather narrow assessment of how well (or not so well) the economy does.
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 the production and by implication, by the consumption of that production. 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.
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.
Nevertheless, the GDP is one of the greatest developments in economic thought — there is no doubt about it. I am not at all in the (seemingly growing) camp of “GDP-bashers” who claim that GDP should be dropped as it doesn’t measure other important factors that determine economic progress. My view is that a) one should look at multiple GDP measures to gauge what is happening in the economy (I prefer to look at the monetarist version, as well as to the demographics and exergy ones), 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 always prioritise to increase.
It is however true that GDP (i.e. a measure of economic growth) does not tell us about other, broader aspects of the socio-economic structure, such as education levels, living standards, productivity growth, quality of work, etc.
“…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
– Income per capita (i.e. 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. Below is a summarised re-iteration of what I wrote:
These two processes, in my mind, are different in what they are but overlap in how they manifest […], suffice to say that economic development requires innovation […] Meanwhile, innovation requires a certain mix of cultural values, legal / regulatory system flexibility and access to resources which enables creative people to a) imagine new products / services, b) put their imagination to work (i.e. execute their ideas), c) bring their final work to market (should they be successful in executing their ideas) and d) be remunerated for the risks taken in creating something new. Where economic growth and development overlap is in the final two parts (c ) and (d) […] Growth means to consume something that was produced — the more consumption there is, the more demand there is and therefore, the more production there is. However, growth, in the absence of innovation which is a key driver of improving productivity, reaches a point where it becomes an unproductive endeavour. In other words, consumption, which is the remuneration of producers, no longer is enough to justify itself and the processes of production need to be improved or new ones developed — this is done through innovation, i.e. economic development.
Why make the difference between economic growth and development?
The answer goes far beyond semantics – it 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.
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, of the debt level and of the economy’s cash flows, when making decisions on how much to spend, on what to spend and the cost of that spending. 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.
I do however, thanks to Ray Dalio’s work on this subject, understand that the job of a policymaker is almost unimaginable difficult to someone that is not in their shoes. Nevertheless, at the end of the day, they are our leaders and we expect them to lead us towards prosperity in the long-term, even if that means lower GDP growth in the short-term. Also, we all are responsible for accepting periods of lower GDP growth, knowing that the future is brighter. 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. As a side 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). If investors simply chase economic growth, they won’t be able to spot the underlying forces that generated that growth.
Capital allocation is about balance. That is, balanced exposure to different risks. As Ray Dalio wrote in a paper that explains the risk parity strategy, returns on assets are the result of “the accrual of and changes in the risk premium, and unanticipated shifts in the economic environment”. Although asset prices discount a wide range of economic factors, inflation and growth are the two most important. When inflation and growth move, asset prices move and, in turn, the risk premium moves too.
Inflation is a monetary phenomenon. As I. Fisher explained clearly in The Money Illusion: “If the flow of goods per capita remains the same, any change in the price level is due to a change in the flow of money. If the flow of money remains the same any change in the price level is due to a change in the flow of goods. If both flows per capita change, both are responsible for the change in the price level and in proportion to their respective changes…Since the demand and supply of money cannot change the price of money itself, they will work out their effects in the prices of other things…the greater the flow of money, the higher the price level, and the reverse.” Central banks affect the quantity and price of money and credit through monetary policy. On the private side, the FX exchange market sets the price of a monetary unit (a currency) in terms of another and the commercial banks create purchasing power (credit) when they lend (as each loan creates a deposit). The biggest determinants of inflation are changes in the quantity of money and credit because it is the amount of spending that changes prices. For more details on this see Ray Dalio’s How The Economic Machine Works.
What is left is to monitor economic growth – in particular, knowing what drives economic growth and, more importantly, what is needed to drive it into the future will provide investors with critical insight into what assets will do well. Looking at the world today, productivity is desperately needed.
Importantly, there has to be a change in the mind-set of many financial capital allocators. We are arguably too focused on the short-term (although this is a by-product of regulation as well, e.g. the frequency of client reporting). Innovation may not pay back investors immediately. Indeed, in the short-term not much economic activity may result from the innovation brought to life – it is over the long-term that we see its true positive impact on our economy and society.
Additionally, there may be several iterations of the new product, process or service before it is in a state that can be scaled up and brought to market. A great example of this is the history of the personal computer which took decades to be developed and went through multiple different versions before it arrived to the PC that we now today.
Therefore, patience (that terrible word that all of us fear) is a pre-requisite for innovation to deliver stellar returns; because even if it is commercially successful, it still needs to be brought to an end consumer markets, a process which takes time.
Progress can therefore be viewed as a function of both economic development and economic growth. We can view economic development as a warden that holds economic growth to account by asking policymakers and business leaders: do you want to encourage the production of or to continue to produce more goods and services in an environment of stagnating / declining productivity by borrowing this output from the future? In other words, are we willing to impose the costs of an illusion of present prosperity on future generations?
There is a question of morality here which we can debate outside this paper. Do we or do we not owe anything to the unborn children of tomorrow?