Origins of National Income
From the ultra pro-business World Economic Forum to the progressive “thinktank” New Economics Foundation, we find a growing consensus that the standard measure of economic performance, Gross Domestic Product (GDP), needs replacement. Its failure to adequately measure welfare or well being appears as a common threat in the critique of GDP (treated in detail in the 2009 study from Boston University), a theme repeated in the media. More broadly, some have argued that GDP, with its focus on marketed goods and services, is fundamentally wrong in what it measures. These broader objections overlap with the recent environmentalist critique of GDP and economic growth itself.
When assessing the GDP measure and possible alternatives to it, I found it useful to go back to the origins of the concept. Soon after the inauguration of Franklin D. Roosevelt as president of the United States in March 1933, the US Senate commissioned a study (text here) on how to measure the output of the American economy (the Senate then included the first woman elected to the body, New Deal Democrat Wyatt Caraway from Arkansas). Published in 1934, “National Income, 1929-1932” , was carried out by a Russian émigré Simon Kuznets (1901-1983), then on the staff of the National Bureau of Economic Research (NBER).
Subsequently Kuznets would receive the Bank of Sweden Prize for economic science (aka Nobel Prize in Economics) for his work in the 1940s and 1950s on economic growth (see his National Product since 1869, NBER 1946, and “Economic Growth and Income Inequality”, American Economic Review 1955). In method Kuznets was an “institutional/structural” economist of the NBER tradition, strongly influenced by Wesley C. Mitchell, a breed of economists much derided in the 1970s and subsequently by the neoclassical economists as non-theoretical.
As the Great Depression ran its disastrous course in the United States, policy makers had no reliable measure of economic activity. As a result, assessing by how much the economy had contracted represented informed (well or ill) guesses. Congress assigned Kuznets the task of developing reliable measures. The explicit purpose of the measures was macroeconomic policy management, a previously non-existent field in the United States. To the extent that any government body sought to affect the general level of output, it was the Federal Reserve System via its monetary policy. In 1929 when the Great Depression began, federal expenditure was about 12% of GDP, and maintaining a balanced budget was the function of fiscal policy.
Limits and Misuse of National Income
I strongly recommend that all those arguing for alternatives to the GDP metric should read at least the introduction to Kuznets’ 1934 report. After a summary of his proposal for the measure of “national income” (pp. 1-2), Kuznets warns,
The above detailed classifications provide a fair description of the various groups of services which are included, at their market value, in the national income. But they are far from an exhaustive account of the possible contents and scope of the national income measurement. [Emphasis added, p. 3]
The first of the omissions he lists are the non-paid activities of family members, explaining that “the organization of these services render them an integral part of family life at large, rather than of the specifically business life of the nation” (p. 4). Illegal activities (“such as bootlegging”, Prohibition was repealed on 5 December 1933, a few weeks after Kuznets completed his report) make up the second the second broad category of activities excluded from national income.
Kuznets warned against treating his aggregate measure as possessing a precision it did not have,
The valuable capacity of the human mind to simplify a complex situation in a compact characterization becomes dangerous when not controlled in terms of definitely stated criteria. With quantitative measurements especially, the definiteness of the result suggests, often misleadingly, a precision and simplicity in the outlines of the object measured. [p. 5]
Extremely relevant to current discussions of growth and the environment, Kuznets stressed that the measure of national income was not value free, but laden with social implications,
Measurements of national income are subject to this type of illusion and resulting abuse, especially since they deal with matters that are the center of conflict of opposing social groups where the effectiveness of an argument is often contingent upon oversimplification. [pp. 5-6]
Further, Kuznets was explicit that his calculations did not measure the welfare or well being of people,
The abuses of national income estimates arise largely from a failure to take into account the precise definition of income and the methods of its evaluation which the estimator assumes in arriving at his final figures. Notions of productivity or welfare as understood by the user of the estimates are often read by him into the income measurement, regardless of the assumptions made by the income estimator in arriving at the figures. [p. 7]
Lest he be misunderstood, Kuznets gives explicit examples of invalid inferences from national income measurement,
…[W]e find all too commonly such inferences that a decline of 30 percent in the national income (in terms of “constant” dollars) means a 30 percent decline in the total productivity of the nation, and a corresponding decline in its welfare. Or that a nation whose total income is twice the size of the national income of another country is twice “as well off”, can sustain payments abroad twice as large or can carry a debt burden double in size. Such statements can obviously be true only when qualified by a host of “ifs”. [p. 7]
Kuznets and Keynes
The Senate commissioned the Kuznets study with a clear instrumental purpose, to provide the statistics necessary to manage the aggregate economy and avoid another depression. To be effective economic management required timely information on the performance of the economy plus an analytical framework to convert that information into policy action. Simon Kuznets provided the first. John Maynard Keynes would provide the second, explained in his The General Theory of Employment, Interest and Money, published in 1936. The ideas were widely discussed by 1933-1934 in the United States as well as Britain.
In retrospect, we can understand that Kuznets’ narrow focus on “the business life of the nation” reflected the nature of capitalist economies, that their instability arises from the private business sector. Congress commissioned a study motivated by economic collapse. “Business” caused the collapse. Thus, business activity was the focus of the study.
In practice, Keynes’ concept of the “multiplier” (designated as M below) along with his distinction between induced (consumption, saving and taxes) and exogenous (private investment, exports and government spending) national income categories provided the analytical framework to marshal the new statistics in policy making. The UK equivalent of Kuznets would come over ten years later, D. G. Champernowne’s “The National Income and Expenditure of the United Kingdom, 1938-1945” which would lay the basis for the annual Bluebooks.
The direct contribution of Kuznets’ national accounts to the development of Keynes’ macroeconomic theory is well-documented, not least by Keynes himself. Simply stated, Keynes theory of national income determination has three components:
- the distinction between endogenous and exogenous variables,
- the ratio of consumption to household income (marginal propensity to consume), and
- the multiplier. In the simplest case, private investment is the exogenous variable that determines the level of national income (GDP), which itself determines consumption.
Central to moving from speculative theory to empirical verification were accurate statistics to calculate the multiplier, which Keynes did using the national accounts estimates developed by Kuznets (explained by Tily). The volatility of private investment plays the key role in the conceptual framework. In a 1936 article in the Economic Journal Keynes refers to Kuznets as providing evidence for his hypothesis of the instability of investment,
In my General Theory of Employment, Interest and Money, Chap. 8, pp. 98-104, I made a brief attempt to illustrate the wide range of fluctuations in net investment, basing myself on certain calculations by Mr. Colin Clark for Great Britain and by Mr. Kuznets for the United States. [Keynes, p. 40]
Kuznets’s pioneering work on national accounts provided a major boost to Keynesian economics in the United States. While in my opinion Britain was the home for the major early theorists, US based economists led in early development of empirical and policy application, most prominently Alvin Hansen (1887-1975) who created the president’s Council of Economics Advisers.
Two measures of GDP
The importance of GDP as an instrument of policy management should be clearly distinguished from is misuse as a measure of wellbeing, even more from its iconic role as the measure of economic success (“growth”). Indeed, the environmental critics of growth as a policy goal might gain from looking back at the 1967 book by British economist E. J. Misham, The Costs of Economics Growth, in which he argued that expansion of aggregate output was consistent with declining welfare of the population. Progressives may find his politics off-putting (he studied at the University of Chicago, centre of right-wing economics).
Because capitalist economies suffer from inherent instability, purposeful and effective policy management is essential to prevent and recover from recession and catastrophic events such as the Great Depression (1929) and the Global Financial Crisis (2008). National income accounts, GDP, played a central role in developing the theory and practice of policy interventions.
In this context we should clearly distinguish between the income approach and expenditure approach to estimating GDP. The first adds up the marketed production of an economy using “factor” incomes as proxies – wages, profit, self employed income, rent and interest. This method plays a limited role in short term policy management. Much more important for counter-cyclical interventions is the expenditure approach,
GDP = [consumption] + [private investment] + [exports – imports] + [public expenditure] + [inventory change]
If all good and services are sold, the inventory change is zero (no additions or reductions). Keynes argued that GDP determines consumption and imports. Substitution of GDP for consumption and investment produces the famous Keynesian national income equation in which:
GDP = [multiplier] x [private investment + exports + public expenditure]
Using Kuznets’ statistics, Keynes estimated, “the [US economy’s] multiplier seems to have been less than 3 and probably fairly stable in the neighborhood of 2.5” (quoted in Tily p. 128). For a thorough discussion of the multiplier, see PEF roundtable. To take a simple example, if GDP contracted by £100 billion, Keynes’ equation implies that public expenditure of amount [£100b/M] would recover the lost output. If M=2.5, then the required fiscal boost would be £40b.
There exist alternative policy indicators to GDP that serve as well or better for anticipating economic instability, so-called leading indicators whose origins at the NBER pre-date both the empirical work of Kuznets and the theoretical framework of Keynes. However, those measures would not aid policy without a calculation of the multiplier, which requires national accounts (GDP) expenditure statistics. Knowing that a fiscal stimulus is necessary is the first step. How large it should be is the next and GDP measures tell us that.
United States. Bureau of Foreign and Domestic Commerce, Seventy-Third Congress, 1933-1935 and Kuznets, Simon, 1901-1985. National Income, 1929-1932 , Washington: U.S. Government Printing Office, 1934.