By Matthew Bishop and Michael Green
The current economic mess has many alleged causes, from greedy bankers and over-generous Chinese lenders, to financially illiterate home buyers and regulators asleep at the wheel. Yet the crisis also revealed, and was in part due to, the limitations of the economic data we have relied on since the Great Depression. Celebrating ever-rising Gross Domestic Product (and for that matter rising corporate profits and share prices) blinded us to the increasingly serious risks we were taking.
We have been here before. One of the least heralded, but most important, lessons from the Great Depression was the need for better data about the economy. Catastrophically bad decisions were taken by policymakers because the economy had essentially been “driving blind.” This led economists on both sides of the Atlantic to do Nobel Prize-winning work creating the first comprehensive measures of national income. These measures of Gross Domestic Product (GDP) ushered in dramatic improvements in economic policy. Today, in the aftermath of a crisis that demonstrated the unreliability of GDP and many other economic performance indicators, a similar effort is now needed to create statistics capable of guiding us through a 21st century in which the relationship between economic growth and social progress and well-being seems certain to become increasingly complex. There are promising signs that this data revolution is beginning, led by an unlikely quartet: French President Nicolas Sarkozy, British Prime Minister David Cameron, Nobel Prize-winning economist Joseph Stiglitz, and the Organisation for Economic Co-operation and Development (OECD). But there is a long way to go and a fierce debate lies ahead.
"LIES, DAMNED LIES"
It is easy to deride statistics as too boring to matter, or as “lies, damned lies.” Yet what we measure is an important reflection of how we understand the world and how we make choices. Indeed, the foundations of modern economics were laid in the 17th and 18th centuries during the great economic debate between mercantilists and free traders about how to measure the well-being of a nation. The former advocated tariffs and other restrictions on trade to limit imports, boost exports, and maximize the flow of bullion into an economy. The free traders rejected the idea that prosperity should be measured in reserves of precious metals and argued that such obstacles to commerce harmed the welfare of everyone. Ultimately, the free traders prevailed, with an argument most famously articulated by Adam Smith in his 1776 treatise, An Inquiry into the Nature and Causes of the Wealth of Nations.
Yet Smith’s insight—that a country’s wealth lay not in hoards of gold and silver but in its productive potential—drew substantially (and without attribution) on evidence from the work of statistician William Petty, who a century earlier had estimated not only England’s national income but its total net worth, including the value of labor. By reframing what was meant by economic success, he dealt an important blow to the mercantilists long before Smith delivered the coup de grace. Like the struggle between mercantilism and free trade three centuries ago, the fierce debates over the fallout from the global financial crisis are also rooted in conflicting ideas about measurement.
TOXIC MARKET HYPOTHESIS
Toxic assets may be the symptom of the current economic crisis but the root cause was toxic ideas. One such idea—the Efficient Market Hypothesis (EMH)—was the product of academic economics in the 1960s and 1970s.
It was soon popularized in a simplified form by business schools, taking hold on Wall Street and then among policymakers, who embraced it in an almost dogmatic fashion. The emh helped to underpin the widely-held view in the corridors of political power and on the trading floors that, as long as quarterly profits, stock prices, and GDP were rising, all was well within our economic system. How wrong that proved to be.
Those profits—along with share values and national income—disappeared in a puff of smoke in the fall of 2008.
Even Alan Greenspan, the economic guru who had presided over the boom and championed the emh as the revered head of the Federal Reserve, was forced to admit, grudgingly, that his faith in these ideas and their associated measures of success as the best guide to the health of the economy had been too strong.
Another toxic idea was that we had somehow cracked economic management. Britain’s Chancellor of the Exchequer, Gordon Brown, boasted that his policies had “put an end to boom and bust,” in which case every increase in GDP was unambiguously a step in the right direction. Greenspan’s successor at the Fed, Ben Bernanke, coined the term “the great moderation” to describe what was increasingly seen as a new era of economic rationality featuring permanently low inflation, full employment, no more crashes and never-ending growth.
The global economic meltdown may have busted these toxic ideas, but the institutional framework of today’s capitalism—including our economic statistics—still rest upon them. To tell us where the economy is going, business television channels keep on reporting quarterly profits and minute-by-minute stock price movements. Politicians are cheered or tormented by quarterly GDP statistics that are taken to be a measure of whether voters’ lives are getting better or worse.
Yet, as the crisis revealed, these rising numbers might, in some circumstances, instead be leading indicators of an unsustainable economic bubble based on taking excessive risk—a bubble that could burst and leave us all significantly worse off.
The idea that we need new tools to measure society’s well-being is not a new one. More than 40 years ago, Robert Kennedy critiqued national income accounting on the grounds that it “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.” The crisis revealed how important and urgent it is that we start to measure properly those more profound indicators of progress if we are to emerge effectively from the present morass and avoid future ones.
THE PURSUIT OF HAPPINESS
Skeptics will find plenty to criticize in some of the alternatives being pushed around in high places in the aftermath of the crisis. Not without reason do they scoff at the idea that the small, primitive Asian kingdom of Bhutan, with its Gross National Happiness index, is now a model for the world. The idea that governments should make serious policy choices on the back of subjective measures, such as surveys that ask citizens to rank how happy they feel, can seem faintly ridiculous. Worse, there is a real danger that these shaky intellectual foundations will be used by advocates of “zero growth economics” to justify policies that are downright damaging to the pursuit of well-being—the psychic or the material kind. But none of these concerns justifies sticking with the statistical status quo.
Even so, there are useful lessons to be learned from Bhutan’s pioneering efforts to get a statistical grip on what really gives a nation a sense of well-being. That is why we should take seriously a heavyweight effort to rethink how we measure economic success, which was kicked off even before the crisis by Nicolas Sarkozy. Anglo-Saxon capitalists will naturally catch a fright at a French president talking about the need for a “great revolution” in the way the global economy works, but they should bear with it—and better still, get involved in the pursuit of better measurement. Sarkozy’s Commission on the Measurement of Economic Performance and Social Progress, chaired by Joseph Stiglitz and backed by a host of leading economic thinkers, issued its first report in 2009. Its work amounts to a clinical dissection of why GDP has failed to do its job adequately. GDP leaves out much of what a country produces, such as improvements in the quality of goods and services. It fails to take account of living standards. It offers no insight into the quality of life. And it fails to address the sustainability of the economic health it claims to measure.
Statisticians at the OECD, the official think-tank of the world’s leading economies, are now figuring out how to turn the commission’s insights into practical tools. British Prime Minister David Cameron has also jumped on this measurement bandwagon, under the Bhutanic banner of Gross Domestic Happiness. With Anglo-French rivalry driving it, these efforts may actually get somewhere.
Still, it would be a fundamental mistake to think that these efforts should produce a single number, equivalent to GDP, to measure a nation’s well-being. One lesson of the crisis is that the world is a complex place that demands a different sort of risk-based thinking by us all—a commitment to weighing different scenarios and considering the probabilities of their occurrence. For example, before the crash, we knew that personal, corporate and governmental leverage levels were soaring as everybody borrowed more money. But as long as GDP was going up, nobody regarded this as a reason to worry.
If national accounts looked more like balance sheets, soaring leverage might have made us worry earlier about where we were headed, and hopefully would have led us to take a different path. National balance sheets can be designed and should include debt along with environmental assets, to give a sense of sustainability. Yet they will always require careful interpretation, unlike a simple GDP growth number, which is either up or down. Indeed, this is a crucial point. We need statistics that contribute to a richer debate about the state of our societies and the choices we face—not numbers that reduce reality to the point of distortion.
Rethinking how we measure success will also mean revising how decision-makers assess available choices. Since 1979, the World Economic Forum has produced the Global Competitiveness Report to help countries make policy choices that maximize economic growth. This remains a valuable tool. But broader definitions of well-being need to incorporate how societies create social and environmental value in addition to economic prosperity. To that end, the authors are now working with avina (a foundation based in Panama), the California-based Skoll Foundation, and others to develop a new Social Competitiveness Index. This will measure and compare the capacity of countries—government, the private sector and civil society, working together—to innovate and to test and scale up solutions to the social and environmental problems that they face in the 21st century.
MEASURING SUCCESS
The effort to rethink success is not just an issue for countries and governments. The crisis also taught us that how we measure corporate success is equally flawed and desperately needs an overhaul. Mark-to-market accounting principles, for example, allowed firms to book huge paper profits and, come the crash, suffer enormous paper losses that bore little relation to the underlying long-term value of the assets they held. Short-termism is hard-wired into corporate behavior by the way we currently measure value. Those rules need to change if we want a better capitalism, one focused on long-term value creation rather than turning a fast buck, the sort of devil-may-care deal-making justified on Wall Street by the phrase ibgybg—“I’ll be gone, you’ll be gone.”
There is also a growing recognition that companies do not create financial value alone. They also generate (or destroy) social and environmental value. Thus we should measure financial, environmental and social impact when evaluating the performance of a business. This so-called “blended-value” concept, pioneered by social entrepreneur Jed Emerson, was once a left-field idea. Now it is endorsed by leading management thinkers like Harvard’s Michael Porter and Michael Kremer. For now, such measures seem a bit fuzzy when compared to traditional financial metrics such as profit. Yet the idea that businesses need to take these different kinds of value seriously in making decisions is starting to take hold in mainstream finance. In the fall of 2010, J.P. Morgan launched a new accounting framework for “impact investments,” which seek social value in terms of their impact on the poor as well as financial returns, and hailed this as a new asset class.
Rewriting the rules about what we value and how we value it is not going to be easy. We will all have to engage with a world of blurred statistical lines and uncertain judgments. Market-loving capitalists may find this uncomfortable and, with a French president leading the charge, even unpalatable. This is an intellectual exercise that will surely produce its share of wet and woolly thinking. Yet, for this very reason, it is a debate that the wealth-creating classes must embrace.
The metrics we use to measure economic success were not handed down on tablets of stone. Simon Kuznets, the economist who led the work of creating America’s national income statistics in the 1930s and 1940s, certainly understood the limitations of his GDP measure and strongly disagreed with its use by policymakers and politicians as the sole measure of economic success.
Indeed, he resigned from his post overseeing the U.S. national accounts when he lost an argument over his desire to include unpaid domestic work in the calculation of GDP. We can only speculate about how different the world would have been if he had won that argument, but it would surely have led policymakers to have made some significantly different decisions that might have led society in quite another direction. Since we are, to a large degree, what we measure, we will only build stronger economies and healthier societies if we start to measure what we want to be.
*****
*****
Matthew Bishop and Michael Green are the authors of The Road From Ruin (Crown Business). Bishop is the New York bureau chief of The Economist. Green is an independent writer and consultant.
[Illustration by Carolyn Tubekis]