Why bother with GDP?

Modern GDP statistics (“the value of goods and services produced in a given period”) have their origin in the USA around the 1930s with the work of Kuznets, who produced the first national income data in order to see the impact of the Great Depression on the US economy. They became more important during the Second World War when the UK government, prompted by Keynes, and the US government needed to be able to manage the war effort to maximum effect while still providing enough resources for consumption.

A major criticism of GDP is that it takes no account of what is produced, merely its value. As a result,  disasters can be good for GDP if they involve countries reconstructing roads or buildings damaged in the disaster. War is also a good way of boosting GDP since it will involve producing more tanks, weapons and aircraft! Similarly, two forks are, in GDP terms, as useful as a knife and fork, but less useful in reality when trying to spread butter. GDP and GDP per capita also take no account of how the income is shared among the population. A rich oil producing country might have a high GDP per head but, if the income is concentrated in the hands of a few, the standard of living of the majority might be below that of a country with a lower average of GDP.

Measurement of GDP is difficult since it is impossible to measure every transaction and therefore relies on surveys e.g. the Living Costs and Food Survey for about 5,000 households and monthly surveys of approximately 45,000 businesses. The development of technology has made the measurement of GDP more difficult. The UK Government set up an inquiry under Charlie Bean – OB and former Deputy Governor of the Bank of England – who identified activities which are now much harder to measure and value such as using Google Maps rather than buying a paper OS map or streaming films rather than buying or renting DVDs. Another problem is that many things have become cheaper and better – my new DVD recorder is easier to use and records more than a previous model but, in GDP terms, it is less valuable because it is cheaper.

There have been many debates over what should be included in GDP and although these might seem largely irrelevant, they matter when trying to compare countries’ GDP. In the past certain things, such as the sale of cannabis in cafes in Holland were legal and therefore recorded while a similar purchase in Romford would not be counted. However Eurostat wanted consistency among its members and decided that all transactions for goods or services involving money were to be recorded, whether they are legal, illegal, good or bad. Therefore, in a purely numerical way, those who argue in favour of increasing GDP as being a key government objective, could argue that encouraging the sale of drugs or prostitution is as valid as increased spending on education or health – something even an economist would find hard to justify! More relevantly sales of guns in the UK are part of the shadow economy but in the US they are legal, widespread and contribute to GDP.

GDP data is particularly suspect in developing countries where a significant percentage of production takes place in the hidden economy; for example, in Zimbabwe only 6% of the labour force is formally employed. Similarly, my purchase of bottled water from Sainsbury’s is counted in the UK’s GDP, but the effort of an African villager who spends hours walking to and from a stream to collect “free” water has no value according to GDP statistics. There are also basic measurement difficulties in LDCs, such as obtaining accurate population figures, accurately measuring inflation and valuing the hidden economy, e.g. only half the maize produced in Nigeria is sold in a shop or market.

There is now a consensus that we are trying to measure too many things in our single GDP number and, although we can improve it by using GDP per head or median GDP or NNP, it is still deficient.

Economists have therefore started both to consider other possible methods of estimating economic activity and to develop alternative measures which go beyond simply the output of goods and services. One way of tackling the former is to look at light intensity to indicate economic activity in different areas with increases in intensity over time indicating growth. Such methods indicate that the proportion of economic activity occurring in villages, and not always measured, is more significant than thought and therefore the GDP of many developing countries is, similarly, larger than previously calculated. It also provides a fascinating snapshot of the difference between the North and South Korean economies.

However a major concern is how we measure the damage which our focus on output is doing to the environment. China’s focus on growth has resulted in 40% of its river water being undrinkable and one cannot always see the stars at night because of pollution. GDP does not take into account depreciation of natural resources lost to build houses and factories and damage to the environment but this is not easy to do. How does one put a monetary value on a rainforest, beautiful view or footpath by a river? One way is to make an estimate based on how much people pay to see them and, for things which benefit the environment, how much it would cost to replicate them. The UK government in 2012 formed the “Natural Capital Committee” to advise the government on things such as ‘forests, rivers, minerals and oceans’ and by 2020 the ONS must include a measure of natural capital in the UK’s national accounts. The aim is to move towards sustainable growth. Along the same lines, a US think tank has invented Earth Overshoot Day – the date when the earth used up its regenerative capacity for the year. In 2018 this occurred on 1st August.

Other measures include the Genuine Progress Index – a measure of economic welfare which is currently in use in Maryland. GDP is the base but invisible “goods” e.g. leisure time, volunteering, & housework are added while “regrettables” e.g. crime prevention spending such as burglar alarms, pollution and commuting time are subtracted. The Happy Planet Index tries to measure what matters – namely sustainable wellbeing for all and tells us how well nations are doing at achieving long, happy, sustainable lives.  Some countries have followed Bhutan which developed a Gross National Happiness index which sets out priorities such as psychological well-being, health, education, living standards, good governance and ecological resilience. Before adoption, all new projects must undergo a GNH impact review. We carry out an annual happiness survey as does the OECD and many of its members. These focus on six key variables which determine happiness – GDP/head, healthy years of life expectancy, having people to turn to, trust in others, freedom to make decisions and donations to charity.

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Shopping not going too well for Sainsbury’s and Asda.

A typical UK family spends approximately 10% on food, with the figure being 4% higher for low income families. Therefore, what happens in the grocery industry is of significance to all consumers in the UK.

The proposed merger of Sainsbury’s and Asda would, if no changes are made in their operation, create a business which has 29% of the grocery market (Sainsbury’s 15% and Asda 14%), employ 343,000 workers (Sainsbury’s 187,000 and Asda 156,000), have 2,104 stores (Sainsbury’s 1,428, Asda 676) and revenue of £50.7bn (Sainsbury’s £28.5bn, Asda £22.2bn). The new business, which joins Britain’s second and third largest supermarkets together, would push Tesco out of first place

The arguments in favour of the merger focus on the economies of scale which the new firm would gain, such as bulk buying and marketing economies. It would allow it to build a stronger on-line presence and counter the competition from the discounters Aldi and Lidl and also from the entry of Amazon into the grocery market. According to the Chief Executive of Sainbury’s, consumers would benefit from price cuts of 10% on “everyday products”.

Elsewhere, there were concerns that the merger would reduce competition. The CMA has identified 694 areas of the country where it would fall because both Sainsbury’s and Asda have stores (either supermarkets or convenience stores) which currently compete. However, Sainsbury’s and Asda argue that the physical presence of stores is increasingly unimportant as more shopping is done on-line. Consumer groups and trade unions fear that the merger would effectively create a duopoly among the supermarkets (Tesco and Sainsbury’s/Asda) which would allow pressure to be placed on suppliers to lower prices, would involve redundancies as the new firm closed stores and sacked staff and lead to lower quality and higher prices.

Although their final report is not due until April, the Competition and Market Authority announced last month that the proposed merger  was likely to be against the public interest, leading to higher prices and a reduction in the range and quality of products. They have the power to block the deal or, if they allow it, to ensure that the two companies sell off a number of stores and allow another company to buy either the Sainsbury’s or Asda brand.

Do we have a housing crisis?

Last week it was announced that an American businessman had bought a house in St James’s Park, near Buckingham Palace, for £95 million. As you might expect, the house has a pool, gym, staff quarters and private gardens. At the other end of the scale, the Institute for Fiscal Studies recently reported that 40% of 25 – 34 year olds are not able to afford a 10% deposit to buy the cheapest house in their neighbourhood. In London, approximately twenty years ago, 90% would be able to afford the deposit whereas today only 33% can afford the deposit. Because of the difficulty faced by people getting on to the housing crisis, newspapers have been talking about a housing crisis for some time.

A sign of the housing crisis is the high price of housing, signifying either excess demand or restricted supply. Focusing first on the demand for housing, for many years buying a house was an ideal way of building up wealth for potential homeowners, thus increasing the demand for housing. Not only did borrowers previously receive tax remission for mortgage payments, the price of houses increased more or less continuously and so one could borrow, knowing that when the mortgage was repaid, the increase in the value of the house would more than have covered the cost of the mortgage. More recently the Government introduced the ‘Help to Buy Scheme’ in 2013, (now extended to 2023) which lends, interest fee, up to 20% of the cost of a new build home (40% in London) to borrowers who have been able to raise a 5% deposit, meaning they only need a mortgage for 75% of the value. It has helped to finance the construction of 170,000 homes of which 140,000 have been purchased by first-time buyers. But it has been expensive, costing taxpayers nearly £8 billion since 2013, and providing considerable profits for house builders as demand increased more than supply, thereby pushing up prices. Another criticism has been that the scheme has not helped the low-paid since they have not taken as much advantage of the scheme as those with higher incomes. In addition, we are seeing that buyers of homes using the scheme who now wish to sell, have found that their property has fallen in value since future buyers are not eligible for the help to buy assistance. There have also been a number of suggestions to boost supply. These include allowing more building on green belt land and introducing measures (not yet introduced) to help older buyers down-size and therefore free up larger homes.

Why are we so concerned about declines in house building and house purchases? Apart from the social and political issues which result from people not being able to afford to buy their own house, having to pay excessive rents or sleeping on the streets, there are significant economic implications of a failing housing market. Firstly, if  building slows, bricklayers, electricians, plumbers, etc, lose their jobs and firms making bricks, providing carpets, furniture, ovens, fridges, etc, also experience a decline for their products and services and subsequently cut back on labour. As a result, incomes fall and, given the multiplier effect, the impact on the economy will be significant. It is worth noting that the multiplier effect will be large since so much of the expenditure involved in housing is domestic – i.e. there is relatively little leaked out of the economy in the form of imports.

Another way in which the housing market affects the economy is that a poorly-functioning housing market, causing high prices in booming areas, makes it difficult for firms to expand their labour force because workers cannot afford to move into the area. A final issue occurs via the wealth effect – the idea that households’ consumption is determined not only by their income but also by their wealth. For most people, their house is the main source of their wealth. Therefore, a booming housing market makes existing homeowners feel richer and they therefore spend more, believing that they have less need to save since their increasingly valuable house is adding to the value of their assets. Since the financial crisis, the housing market declined. When house prices dropped, people felt poorer and therefore felt the need to save more. This reduced consumption at a time when aggregate demand was already falling, thereby exacerbating the problems faced by the economy.

However, recently, after ten years of decline, the number of mortgages issued has increased and there was the highest number of first time buyers last year for 12 years, according to the government’s annual English Housing Survey, published in January. The increase was linked to the Help to Buy scheme, loans from parents and grandparents and a relaxation in the mortgage market. However we have also seen the slowest growth in house prices for six years, possibly down to Brexit uncertainty and last year receipts from stamp duty (a tax on house purchases) fell, largely because of the slowdown hitting the top end of the market.

Falling Share Prices – Causes and Effects

This week has seen major falls in share prices across the world with $6 trillion being wiped off world share values.  America’s Dow Jones index dropped 5.2%, Japan’s Nikkei index fell 8.1% and the UK’s FTSE index fell 4.7%, the lowest it has been for 15 months, while in Japan and America the falls broke records for the size of their drop since October 2008.

The initial reason for the fall was, paradoxically, good US economic data as their service sector boomed and wage levels grew at the fastest rate since the start of the decade. This good news meant that it is now more likely that US interest rates will rise sooner and by more than had previously been anticipated. Mark Carney reinforced this view when he expressed similar sentiments about the future of UK interest rates.

Although a rise in interest rates has been expected for some time as the world economy’s growth accelerated, the reminder that it might occur soon has come as an unpleasant shock. The scaling back of QE by central banks is expected to reduce the ability to borrow cheaply, some of which has financed recent purchases in shares. Financial investors expect that the forthcoming rise in interest rates will reduce company profits, therefore reducing the demand for shares. Simultaneously existing shareholders might be encouraged to sell quickly before prices fall further, thereby increasing the excess demand. In addition, the economic uncertainty was increased by the fall in the value of bitcoin by approximately 50% since the state of the year.

Economists are trying to decide whether we are currently experiencing a “correction” or  are entering a bear market, where prices fall by more than 20%. The “correction” proponents believe that shares are over-priced in terms of their price compared to their earnings – the price:earnings ratio – and therefore the fall was due. However there is concern that the behaviour of investors, whether in shares, currencies or commodities, sometimes leads to markets over-shooting since falls (increases) in price encourage selling (buying) which further reduces (increases) the price.

According to economic theory, the fall in share prices might lead to a negative wealth effect (the idea that consumption is determined by one’s wealth as well as one’s income). However, given that many shareholders are in the upper income brackets, their marginal propensity to consume will be low and therefore the effect will small. More significant might be the general impact on consumer and business confidence from the media reports about the falling share prices. As Keynes wrote in his General Theory,  “animal spirits” outweigh the  “weighted average of quantitative benefits multiplied by quantitative probabilities.”.

A Little Nudge

The Government’s Nudge Unit (or, to give it its correct title, the Behaviour Insights Team) has been in the news again recently. Their latest investigation involves an attempt to reduce the number of inappropriate calls to the 101 number (the number where one can report crimes, traffic accidents and minor offences). The problem which they are addressing is that 20% of calls to this number are classed as inappropriate and involve matters which are not of police concern, such as failure of the local council to empty the bins, or the high price of a restaurant meal. They found that delaying answering for 6 seconds reduced inappropriate calls by 75%.

Nudging people to behave takes many forms but one of the most successful is to make things easy for people. Thus healthy options are at the front in the cafeteria, many streamed TV programmes automatically go on to the next episode and, more importantly, British workers are automatically enrolled in work-place pensions unless they opt out.

The Nudge Unit was established in 2010 to help government departments improve their success rates in diverse areas by taking account of the way people behave. For example an experiment in vending machines in Australia resulted in a 20% switch from the most sugary drinks to alternatives simply by labelling the most sugary ones in red. Writing letters to the GP surgeries prescribing the most antibiotics, telling them that neighbourhood surgeries prescribed less, resulted in a 3% fall in prescriptions.

Port Talbot & A’level economics

A’level economics students frequently moan  that what they have been taught is not relevant to what is going on around them while economics teachers complain that students do not relate what they have been taught to the real world!

The recent events at Port Talbot provide an ideal example to use economics concepts.

The multiplier can be used in assessing the costs to the area should Port Talbot close since not only will steel jobs be lost if the plant closes, additional jobs will also be at risk as steel workers suffer lower disposable income and cut back on expenditure,  particularly in non-essential areas.

In considering the type of unemployment created, one can use the idea of structural unemployment since many of the steel workers affected will not have the skills needed in newer, growing industries.

The possible closure of the plant is relevant to the arguments about the benefits of free trade and the theory of comparative advantage whereby UK steel purchasers benefit from cheaper steel imports from China which need to be set against the  job losses among UK steel producers. This aspect can be expanded to consider whether the Chinese are dumping steel on the world market and, if so, what action should be taken, especially in the light of the tariffs on Chinese steel imposed by the USA and those imposed by China on imports of steel from the EU and elsewhere.

A final example is in the  field of market failure where Tata have complained that the UK Government’s environmental policies have raised energy prices and helped make UK produced steel (and heavy industry generally) uncompetitive. UK electricity prices are almost double those in the rest of the EU and more than double those in China and while these high prices help to subsidise renewable forms of energy, they make life difficult for UK firms.

The market for legal advice in the UK – competitive market or cozy cartel?

A report in today’s Independent newspaper suggests that the cost of legal advice from one of small number of well known firms in the UK, collectively known as the “Magic Circle”, has risen by around 100% in real terms since 2003.  The market structure for this industry seems to display all the hallmarks of an oligopoly, and one which might tend towards some form of collusion; demand is inelastic, there are a small number of interdependent firms and customers have difficulty collecting good information about substitutes.

In addition, beyond these largest firms a form of price leadership structure may be in operation.  As these large firms ratchet up their charges smaller firms outside the Magic Circle take the opportunity to increase their fees in a clear example of what is commonly referred to as Stackelberg equilibrium.  The economic rents enjoyed by these firms in the form of supernormal profits may be quite considerable.

The question is, as economists should we care, and if so, what can be done?  The availability of good legal advice at a reasonable price may well have positive externalities as it protects the functioning of a market economy and also allows smaller firms to compete in all markets with larger ones as they do not face the barrier to entry in any market of very high legal costs associated with operating in the market.  In short, high legal costs may make a host of markets much less contestable.

This suggests some government action is necessary.  Everyone with a knowledge of economics should be able to recommend lots of policies to make any given market more competitive, and the market for legal advice is no exception.  A reduction of barriers to entry, a requirement for transparency in pricing, an investigation into possible anti-competitive practices and the use of large fines for those found guilty might all be relevant.  However, as we have seen in the energy market action by consumers may also be needed.  A willingness by customers to shift their business to cheaper firms and an attempt to make firms move to a fixed price model by supporting those firms which do will certainly give the Magic Circle something to think about.

Ultimately, a combination of government action and consumer action will be needed but nobody should be under any illusion; the legal profession generally and the “Magic Circle” will fight against it tooth and nail.  Economic history suggests that those enjoying economic rent seldon give it up easily.