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English isn't my native language, so bear with me here. Finnish is spoken by only about 5 million people and since my topics are rather universal, I felt like I should make an effort and write my posts in English. Comments and questions are welcome.

2011-04-28

GDP, ISEW and Other Nonsense [Part 2]

So what's so bad about ISEW and GPI? The first thing to notice is that there is a large amount of subjectivity involved. In fact a quick overview seems to indicate that the methods used change very often depending on when and by who the indexes are done. But this is in fact a minor problem.

To understand some basic concepts of utility and welfare, I suggest starting with Murray N. Rothbard.[1] For a neoclassical critique of ISEW, I suggest the works of Eric Neumayer.[2]

This is a basic example of how ISEW is calculated. It reminds me of John Maynard Keynes' The General Theory of Employment, Interest and Money and Adam Smith's An Inquiry into the Nature and Causes of the Wealth of Nations because what these all have in common is that everything true in them isn't original and what is original isn't true.[3] [4]

A perfect example of what is wrong in ISEW is the concept of "defensive" expenditures. Let's quote from the FoE website:
...some health expenditures may be purely defensive against activities counted elsewhere in the economy as consumption, and it would seem inappropriate to include both sets of expenditures as additive contributions to welfare.

For example, it has been estimated that treatment of smoking-related illness in UK costs the National Health Service in excess of £600 million per year (HEA, 1993).

Since consumer expenditure on smoking is counted under personal consumption as a contribution to welfare, it is clearly inappropriate to add the costs of treating the diseases caused as a direct result of that expenditure into the welfare measure.

I think Reductio ad absurdums are absolutely fantastic, so how about this?
Since consumer expenditure on running shoes is counted under personal consumption as a contribution to welfare, it is clearly inappropriate to add the expenditures on sports drinks caused as a direct result of the additional running into the welfare measure.
Stupid, right? Let's see what Neumayer has to say about all this.
The concept of defensive expenditures is very dubious and elusive since it is rather arbitrary what should count as defensive. This argument applies both to the question of what should count as environmentally defensive expenditures and to what should count as defensive expenditures in general. If health expenditures are defensive expenditures against illness, why should food and drinking expenditures not count as defensive expenditures against hunger and thirst? Are holiday and entertainment expenditures defensive expenditures against boredom? Should they all be subtracted from consumption expenditures? Daly and Cobb (1989, p. 78) defend their concept of subtracting defensive costs in saying that “ ‘defensive’ means a defense against the unwanted side effects of other production, not a defense against normal baseline environmental conditions of cold, rain and so on.” But even accepting this definition, one could argue that at least part of food, drink, entertainment and holiday expenditures are caused by the stressful, exhausting and boring modes of modern production that make these expenditures necessary as a defense against their unwanted side effects. As the United Nations’ revised system of national
accounts rightly retorts: “Pushed to its logical conclusion, scarcely any consumption improves welfare in this line of argument” (United Nations 1993, p. 14).
Several columns are devoted to negative externalities, which means you can get this index to say whatever you want. Negative externalities, as normally defined, are endless. So are positive externalities. As long as a you pick enough of either and give them enough weight, you can get the index to say whatever you want. Of course whether an externality is positive or negative depends on who is judging it(everyone would probably agree that pollution is always negative, but I've heard a well-reasoned case for why higher education isn't always positive, as is normally assumed).

Even if we assumed these problems away, I still wouldn't trust an estimate on the "long-term environmental damage incurred through energy consumption." To give specific values to these kinds of costs is nothing but a perfect example of God-like hubris. I could seriously write quite a long piece on this, but I'll try to keep this short and concentrate on just a few things.

A brilliant display of weirdness can be found in column R(Loss of Farmlands):
Like Daly and Cobb (1989) we assume that the underlying value of land exceeds the market value today, because the market value reflects the fact that productivity can be increased in the short term by the application of energy and nitrogen fertilisers. "Since our aim is to calculate sustainable economic welfare, we have chosen a figure that represents the value of land as if cheap energy sources had already been depleted."
Let's assume that the loss of farmlands is in fact a problem(that we're running out of something that can be produced almost ad infinitum). Let's assume that prices generated through the market process don't actually mean anything(that we know better and that people do not care about the future when they value farmland). Let's also assume a situation that does not exist and might not exist in the future(see where I'm going with this?). I'm sure this will in fact give us a very meaningful number...

The worst part is that ISEW can't measure what it claims, even if all its assumptions were correct and everything could be precisely measured. The index tries to mix sustainability and current welfare, so the resulting number can't possible measure "sustainable economic welfare." A country that has an extremely high standard of living but isn't sustainable in the long-term could easily have a higher score than a sustainable country with a lower standard of living. Another point Neumayer makes about strong and weak sustainability in relation to the ISEW:
What is really surprising, however, is that the ISEW does not explicitly distinguish sub-indices for different forms of total capital (e.g. man-made and natural capital) and different forms of natural capital (e.g. renewable and non-renewable resources), but eventually computes one overall index only. This meshing together of values from natural and other forms of capital amounts to a conceptual break since the heart of the concept of strong sustainability demands that natural capital itself and even sub-categories of natural capital are held constant. Ironically, the ISEW does not measure strong sustainability, but weak sustainability at best since it assumes perfect substitutability among different forms of capital!
A comment on my last post:
Dogo said...
What would you consider a good indicator of welfare, then?
There isn't one. GDP, unemployment, life expectancy(though here there are some methodological inconsistency problems between countries) , literacy rates and such are decent proxies sometimes. All of these tell me something, but no index comes close to telling me everything.

Usually I just look at GDP per capita to get an estimate of what the standard of living in a country is, but I do this rather loosely. For example a 10% difference in this figure between countries wouldn't make me automatically conclude that the other one has a higher or lower standard of living or "greater aggregate welfare" than the other.

Unemployment correlates pretty well with the business cycle in the short run(though here there are exemptions like massive public works or/and war, e.g. WWII and the US). Structural long-term unemployment on the other hand can be an indication of the extent of unemployment benefits in a given country.

GDP is tricky and could be replaced by GNR(Gross National Revenue), GDO(Gross Domestic Output) or PPR(Private Product Remaining) or a combination of two of these. I'm going to be lazy and not check, but I think GDO and GNR are essentially the same thing or very similar at the very least. Here's George Reisman on GNR:
An accounting aggregate that would be far more appropriate to a genuine macroeconomics is what I have called gross national revenue (GNR). This is the sum of all business sales revenues plus wage payments. It also equals the sum of the consumption and productive expenditures that actually pay it.[5]
And Mark Skousen on GDO:
Gross Domestic Product systematically underestimates the expansionary phase as well as the contraction phase of the business cycle. For example, in the most recent recession, real GDP declined 1–2 percent in the United States, even though the recession was quite severe according to other measures (earnings, industrial production, employment) ... A better indicator of total economic activity is Gross Domestic Output (GDO), a statistic I have developed to measure spending in all stages of production, including intermediate stages. According to my estimates, GDO declined at least 10–15 percent during most of the 1990–92 recession.[6]
These would be more more helpful in the analysis on the business cycle, but as welfare aggregates they'd be about as useful as GDP currently is.

PPR is basically GDP after you substract government expenditures from it twice.[7] This removes many of the absurdities we can find in historical GDP figures; WW II as a prime example. During this period unemployment wasn't a helpful indicator, as millions of men were sent to fight a war. GDP wasn't helpful either, because prices were rendered meaningless through a combination of government expenditures(as I mentioned earlier, the price of military equipment has nothing to do with consumer preference), the creation of vast amounts of new money and price & wage controls. PPR would've shown that the welfare of the general public indeed fell during that time(I find it ironic that Keynesians claim that WW II created an economic boom, but I've never heard of an economic boom with rationing of basic necessities).

Dogo said...
On a tangential note, I happened upon Heritage foundation's Economic Freedom Index recently. Would you think that a high/low score on this indicator would correlate with a high/low score on some 'proper' welfare indicator?
The index mixes many things together to come up with one number and obviously there's no objective way to weigh the different freedoms listed, so it's not exact science. Also the ranking doesn't reflect the past, so if a country's been in the top 20 for 50 years and then drops by 10 points, it would take some time for it to affect measures like GDP. Obviously the reverse is also true.

On the other hand the ranking seems to validate economic theory quite well(one could also look at the last 300 years of history and it should become quite apparent what the benefits of economic freedom are). How many of the countries in the top 40 have "immigration problems" and how many in the bottom 100 have a net outflow of people? Where people actually want to live says a lot.

[1] Murray N. Rothbard Toward a Reconstruction of Utility and Welfare Economics
[2] Eric Neumayer The ISEW - Not an Index of Sustainable Economic Welfare,
Eric Neumayer Sustainability and Well-being Indicators
Eric Neumayer On the Methodology of ISEW, GPI and Related Measures
[3] Henry Hazlitt The Failure of the "New Economics"
[4] Murray N. Rothbard The Adam Smith Myth
[5] George Reisman Standing Keynesian GDP on Its Head: Saving Not Consumption as the Main Source of Spending
[6] Jesus Huerta de Soto Money, Bank Credit and Economic Cycles (footnote pp. 418-19, Originally presented by Mark Skousen in “I Like Hayek: How I Use His Model as a Forecasting Tool,” presented at The Mont Pèlerin Society General Meeting, which took place in Cannes, France, September 25–30, 1994)
[7] Murray N. Rothbard America's Great Depression (Appendix, pp. 339-41)

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