The Law of Unintended Consequences was propounded by a sociologist, Robert Merton, and is officially not part of Economics. Just why is Economics, which once claimed to be a science, so highly flawed? I think the first mistake is in its very objective, to be seen as a science, hence calling upon itself to be compared with the physical sciences.
Declaimer: This article was originally in February 2017, and some of the data points may be outdated
This, the desire to be called a science, has led to a very peculiar emphasis on hocus pocus mathematics, which, though optically elegant, is completely useless as a working model of how the world works. Reality is jagged, and evolving, both of which do not lend themselves to the strait-jacket of mathematical economics, although Probability Theory does have limited applications.
Who in his right mind would deny that GDP growth rates (and inflation, for that matter) are opinions masquerading as numbers, yet we go talking about GDP growth rates as if they gave information about the economy, and by way of corollary, the performance report card of a government. That is somewhat like judging the financials of a company through just its topline.
Take China’s GDP growth rate, which has hovered above 10% for many years, yet nobody asked whether such growth rates were on steroids, with ballooning debt levels, deteriorating bank Balance Sheets, and scary public debt ratios. Compare it to India’s slower GDP growth rate, which came with a stable public debt ratio and a relatively healthy banking system.
To process a number, you have to measure it first, for which it first has to be measurable. Some of the things that Economics talks about, like economic activity, are not measurable. This gives rise to some rather funny situations: sex with your wife does not count as an ‘economic’ activity, and hence does not raise GDP, but sex with a prostitute raises more than the GDP. This has often been used to argue for legalization, because it raises, inter alia, taxes, ancillary revenue, and the GDP.
To take this to its logical conclusion, it would be possible, therefore, to argue for ‘industry status’ and hence, bank funding of the operating infrastructure. This is not dissimilar to the successful campaigns run by the real estate and film industries for similar support. The Govt, in turn, covers these industries in the Service Tax regimes. This is not limited to sex, but to all personal services, e.g., if you pay your maid for housework, it goes into GDP calculations, but if you then marry her, it doesn’t. Yet nurses are counted as part of the healthcare industry, normally considered a valid economic activity.
This, by the way, is what we do to defense spending, which is non-productive and, in fact, destructive. Theoretically, a Govt could spend on defense and keep pushing up its GDP till it reaches hyperinflation (the old Guns vs Butter argument).
The most puritanical definition of GDP included only the sale of goods, many services (like butler/valet services) were seen as replacing a person’s effort. This logic could be extended to hotels and restaurants, which could be left out of GDP calculations on a similar logic. The original definition was to consider those things that raised ‘economic productivity’, which is a somewhat nebulous concept, best explained by a return to the Crusoe island and its 2-man economy. That activity that creates a product/asset, that improves the quality of life of a customer (evidenced by his ability to pay an economic price for it), is valid economic activity for the puritanical GDP definition, but must now be reflected in the narrower ‘economic productivity’. Judged by this definition, most government expenditure, especially that part which is stolen, would not qualify to be called GDP. Most bank recapitalizations (a.k.a. QE) would also fall into the same category.
We know that the Observer Effect affects the behavior of individuals just because someone is watching it. While this has been proved in many micro-economic situations, puritans argue that the popular focus on GDP numbers, to the exclusion of almost everything else, has created a Govt machinery that is always trying to ‘push GDP’ at the cost of retaining the value of money (i.e., deficit financing). The entire series of QE initiatives across the world would not have happened if the objective was not to fix this immeasurable metric called GDP. Govt finances in many countries have gone to pieces, trying to fix the unfixable.
One of the reasons why Keynes is more popular in Govt policy than Hayek is their focus on activity to the exclusion of almost everything else. Keynes, the man who recommended that you dig holes and fill them up, chose “aggregate demand’ (read consumer spending) as the beacon to follow. Going back to our 2-man Robinson Crusoe economy on a marooned island, you find that the basic objective of Economics turns out to be the maximization of (economic) productivity, using the models of resource allocation (which, by the way, assume that economic resources are finite and hence need to be rationed to the highest, most productive application).
Resources seem to be finite at the micro-level, for the individual or the firm. But as Governments have proven, money is not limited and we seem to be having more humans in the economy than we need. Creating (economic) activity to achieve “full employment”, therefore, would need Keynes’ involvement. And since the unemployed have voted, governments have gravitated towards the Keynesian prescription rather than the puritanical one.
Adam Smith defined economic productivity, as including those activities that increase income, like the employment of factory labor to add value to raw materials. But the labor of menial servants serves to make a man poorer, without increasing his income or his capability (to increase income). If you apply this (puritanical) criteria to national income measurement, you will find that many activities fail to meet this stringent criterion. Hayek just recommended that markets would price away sub-optimal processes, and hence, government policy should focus on strengthening market infrastructure.
The Modi government’s focus on improving India’s economic productivity will take it into Hayek’s camp, which is good. The government seems to be focusing on investing in enablers, and market infrastructure and therefore, promoting private sector involvement. This will improve economic productivity, which will improve our macro-fundamentals. But it is a fundamental departure from the Keynesian model, of somehow building up aggregate demand, ignoring the priorities of economic productivity. The tendency of the previous Congress Government to focus on public spending to build up GDP will now be replaced by the slower, but far more productive, focus on engendering private sector activity, which will also improve economic productivity. This will increase real incomes, but like with the frog in the boiling water, will not be understood and appreciated by mainstream media or the larger populace.
The debate between increasing government expenditure (Paul Krugman) and reducing taxes (the Gold Bugs led by Bill Bonner) is a Keynes vs Hayek debate. The Puritans expect the government to rationally take those actions that promote economic productivity. But we know from Behavioural Economics that governments, particularly, are not rational, at least to their observers. And the problem stems from the fact that their objectives are political, not economic.
Yet another idea that comes through is that the kind of transformative innovation (Google, Apple, Facebook, IBM) that makes up a major part of American activity but does not get reflected in the numbers, is qualitatively better than the debt-fuelled, government-expenditure-driven GDP growth that we see in China. India is somewhere in the middle. But it is worth remembering that the GDP value of all the things that, say, an Apple iPhone has replaced, would understate American GDP, making measures of ‘economic productivity’ a far better indicator of where the economy stands, at least qualitatively. Maybe this understanding is reflected in the currency valuations of the respective countries.
Sometimes, the same economy, at different points in time, will show different patterns. India had high-inflation, and high M3 growth numbers in the Congress years, which distorted GDP growth rates. The current growth rates have been achieved with deleveraging and low inflation, which results in real growth in economic productivity. Maybe that is what should be (but isn’t) reflected in the report card of the current government.
