Authors: David Smith
The other missing bit of government spending comes in our next GDP category, investment. When a business buys a computer, that is investment. When a household does so, it is consumer spending. Most investment in Britain is done by the private sector, on plant, machinery, vehicles and so on. But government, often now in partnership with the private sector, also carries out investment. New hospitals, roads, government computers, for instance, count as part of investment, or ‘gross fixed capital formation’, as statisticians usually describe it. Investment in productive capacity, as every businessman knows, is vital for long-run economic growth. For many years it was thought that Japan’s economic success was due to high levels of investment, averaging 30 percent of GDP. More recently, Japan’s economic problems, together with those in other Asian economies, have raised the question about whether, as far as investment is concerned, it is possible to have too much of a good thing. In Britain in the year 2000 investment totalled £165 billion, or just over 17 percent of GDP.
Adding up spending by consumers, spending by government and investment gives us, for the year 2000, 63 plus 19 plus 17 percent, or 99 percent in total. Give or take the 1 percent for rounding, it appears we have got to GDP. Well, we would have, but only if we lived in a ‘closed’ economy with no overseas trade. What we are measuring, albeit via different categories of spending, is gross domestic
product
, in other words the value of spending on goods and services produced in Britain. That Japanese DVD player or German car included in consumer spending – quite a lot of them actually – should not be part of Britain’s GDP (although the proportion of the selling price that reflects distribution costs within Britain and the retailer’s profit should be). At the same time, there are plenty of products and services produced in Britain but consumed in other countries. GDP therefore also has to reflect exports and imports. Exports are goods and services made here but consumed elsewhere. Imports are made elsewhere but consumed here.
In 2000 exports totalled £265 billion, equivalent to 28 percent of GDP. We add this £265 billion to the totals for consumer spending, government outlays and investment. Imports, on the other hand, were £281 billion, 30 percent of GDP. We take this away from our GDP total. The fact that both exports and imports were roughly 30 percent of GDP shows that Britain is an open economy, as it has been for centuries. Both America and Japan, the world’s two biggest economies at the time of writing (Britain has sneaked back up to fourth place), have much smaller export–import shares. The fact that imports exceeded exports shows that Britain was running a trade deficit.
This book is intended to be an equation-free zone, but GDP = C + G + I + X - M is a way of setting down simply what has been spelt out above. Strictly speaking it is not an equation at all but an ‘identity’. C is consumer spending, G government spending, I investment, X exports and M imports. Sometimes you will see instead of GDP the letter Y (for reasons that have never been entirely clear to me), for national income, but the meaning is the same.
Why is this so useful? First, it provides a simple way to understand explanation of the various types of spending that drive the economy. Second, anybody trying to forecast what will happen to the economy will first need to predict what is likely to happen to these expenditure components of GDP. All the main models of the economy are based around this simple identity. It also provides, with the accompanying statistical information, a rough idea of the orders of magnitude involved. A 1 percent rise in consumer spending, for example, increases GDP by about 0.6 percent, but it would take an increase in investment of more than 3 percent, or a rise in exports of over 2 percent, to produce the same effect.
Does it really add up?
Sharp-eyed readers who have been working out GDP for themselves will have noticed that they come up with an answer £20 billion or so short of the £943 billion we are looking for. There are two reasons for this. One is that the statisticians in Britain separate out from other consumer spending the small amount of spending by non-profit institutions – charities and not-for-profit companies – on behalf of households. The other is that some of what is produced in any given year is not sold but goes into stocks, or inventories. Inventories can be important in determining quarter-on-quarter or year-on-year movements in GDP. At the onset of recession, for example, there is often an unplanned buildup in stocks of unsold goods. But the big picture for GDP is provided by our five other components: C, G, I, X and M.
There is one other little complication. Much of what we spend our money on is subject to tax. Taxes such as VAT and excise duties are known as ‘indirect’ taxation whereas taxes on income, such as most obviously income tax and also National Insurance, are known as ‘direct’ taxation. Included in the total for consumer spending, for example, will therefore be a significant indirect tax element. Many goods, roughly half, are subject to VAT at 17.5 percent. In theory the government could temporarily boost GDP simply by increasing VAT, although the subsequent effect of that should be to make us spend less. Because of this tax complication, economists usually distinguish between GDP at ‘market prices’ – the prices that are actually paid – and GDP at ‘factor cost’, which is those same prices excluding the tax element. The difference between the two measures is simply the amount of indirect taxation, in other words GDP at market prices less indirect taxes equals GDP at factor cost. Again, there is no need to worry about this distinction. The two measures will not show much variation when it comes to measuring economic growth except when there are big changes in indirect taxation such as in 1979, when Margaret Thatcher’s Conservative government increased VAT to 15 percent, from the old rates of 8 and 12.5 percent, or in 1991, when the Conservatives raised VAT again, from 15 to 17.5 percent. The market price/factor cost difference is worth keeping by you, however, if only for one-upmanship purposes, invaluable in economics.
Does housework have any value?
All the above, I hope, will have seemed entirely logical. There is, however, a long-running debate in economics about whether GDP and closely related measures are comprehensive enough. The problem arises because plenty of activity goes unmeasured in the economy. This is not just the kind of activity that people deliberately keep away from the taxman, the so-called black economy – thought to be worth between 5 and 15 percent of GDP in most countries – but also much more mundane things. If two of us go to the local park and exhaust ourselves playing tennis for a couple of hours, then, apart from the small amount we have paid to hire the court and perhaps buy a couple of new balls, the effect on GDP is negligible. If, on the other hand, two professionals slog it out for a considerable amount of prize money on the Centre Court at Wimbledon, there is quite a sizeable GDP effect. Many would say this is as it should be. Plenty of people are prepared to pay good money to watch the professionals but you could not give away tickets to witness my efforts.
Much more difficult questions arise in respect of housework. Mr Jones, a gentleman of some means, employs a housekeeper, Miss Williams. She is courteous and efficient and he pays her a good wage. She is also very pretty. Soon the inevitable happens and love blossoms over the feather duster. They marry and, while she carries on much as before with the housework, he stops paying her a wage. After all, in marriage what is his is hers. The effect, however, is to reduce GDP. Before the marriage part of his spending was on her housekeeping services. And, while she was paid out of his income, her earnings counted separately for GDP purposes. These effects, which are identical, reduce the expenditure and income measures of GDP respectively, while the value of her output is also apparently lost to the national economy.
Can this be right? Plenty of people think not. For almost as long as there have been national accounts, there have been people arguing for the inclusion of non-paid housework, as well as the many other unpaid but useful activities without which the economy would grind to a halt. Work on a so-called ‘genuine progress index’ in the province of Nova Scotia, Canada, found that people put in 941 million hours a year on domestic chores and primary childcare, 1,230 hours per adult. This was 25 percent more than the 707 million hours a year of paid work in Nova Scotia. When the researchers valued this unpaid work at the prevailing pay rates for domestic work and childcare they found it added up to just over half of measured GDP. Including this unpaid work, in other words, would push up the level of GDP by half as much again.
As they put it:
Work performed in households is more essential to basic survival and quality of life than much of the work done in offices, factories and stores, and is a fundamental precondition for a healthy market sector. If children are not reared with attention and care, and if household members are not provided with nutritious sustenance, workplace productivity will decline and social costs will rise. Physical maintenance of the housing stock, including cleaning and repairs, is also essential economic activity. Yet this huge unpaid contribution registers nowhere in our standard economic accounts. When we pay for childcare and house cleaning, and when we eat out, this adds to GDP and counts as economic growth and ‘progress’. When we cook our own meals, clean our own house and look after our own children it has no value in our measures of progress.
It is a persuasive argument, and it has its echoes in the currently fashionable debate about the ‘work–life balance’, that the way we have come to work and live overstates the economic and social value of time spent at the office (it usually is the office) or factory. Unfortunately, there would be very real problems in trying to include unpaid activity in the national accounts. GDP, as we have seen, is made up of a huge number of recorded transactions. What happens when there is no recorded transaction? Do we assume that a husband will pay his wife the going market rate for doing the housework (or, if he is a house-husband, vice versa)? If so, why should the couple not just employ somebody to do the job? If the value the husband or wife puts on the housework is less than the market rate, how much less is it? We really do not know and it would be very difficult to find out. Official statisticians have enough trouble trying to monitor recorded transactions. GDP may be an incomplete measure of the amount of activity in the economy but for the moment it is the best we have. Despite these problems, the UK’s Office for National Statistics had a go in 2002 at estimating the value of unpaid work in the home, including food preparation, washing, ironing, transporting children around, and so on. Its estimate was £700 billion. While stressing that its estimate should be treated with caution, it noted that the value of this so-called household production was equivalent to 77 percent of adjusted GDP, more than in Canada.
Shoppers and savers
As far as individuals are concerned, they have so far been seen in action, at both microeconomic and macroeconomic levels, as workers helping in the production process, as earners and, of course, as spenders, quite big spenders at that. What has not yet been touched on is the role of individuals as savers. We know that this is important. Look at the personal finance pages of any newspaper, or the size of a financial services industry supported largely by personal saving. Over the long term households in Britain save an average of 10 percent of disposable income (take-home pay), although this proportion, known as the ‘saving ratio’, has been lower in recent years. Saving, encouraged by successive British governments via tax relief on, for example, personal equity plans (Peps), tax-exempt special savings accounts (Tessas) and individual savings accounts (Isas), is generally regarded as a good thing. Most governments provide some form of incentive to save. If there has been a shift in recent years it has been away from the self-interested encouragement by governments of saving in products such as Premium Bonds and National Savings certificates, which are a way of packaging and thus funding government debt. Most obviously in wartime but also at other times, people have been persuaded to help the government to fund its debt by buying bonds, war loans or other products. These days, governments are keen to encourage saving not only for its own sake but also to provide the resources for productive investment. In a closed economy with no government, the only source of funds for investment, in fact, would be from the amount people put aside for saving. Things are rather more complicated in an open economy with no capital controls (which means that funds can and do flow in and out of the country), but the general point still stands.
Countries with very low saving ratios are generally either not investing enough or they are excessively dependent on funds flowing in from overseas. At the tail end of the long US economic boom of the 1990s, when the saving ratio dropped to zero alongside still strong investment, many economists expressed concern that this was not a sustainable situation. In the event investment fell sharply when the economy slowed. Japan, again, long provided the example to the rest of the industrialized world, with saving as well as investment equivalent to about 30 percent of GDP. Latterly though, the Japanese economy could have done with consumers spending more and saving rather less. Japan, in fact, may be a living example of what is known as ‘the paradox of thrift’. The paradox is that, while a high level of saving is beneficial in the long term, providing the funds for investment and therefore for strengthening the economy’s ability to grow, in the short term more saving (and therefore less spending) means a lower rate of economic growth, which may itself discourage firms from investing.