Ferraris and Resource Stocks

Probably the most famous economic indicator is Gross Domestic Product (GDP). GDP per capita gives us a measure of how much was produced in an economy per person. Most, if not all, governments use GDP per capita growth as a measure of their economic performance and a large branch in economic research focuses on understanding why some countries have such high GDP per capita while others do not.

GDP is calculated as the sum of household consumption, investment (saving), government expenditures and net exports (net exports are total exports minus imports). GDP therefore is supposed to provide a summary measure of all the goods produced, services provided and investments made in a country.

Investment is measured as net savings, that is how wealth changes from the start of the year to the end of the year. If a country consumes more than it produced, then net savings are negative. If it consumes less than it produces, they are positive.

But when it comes to the natural wealth of a country, GDP has failed to take into account the fact that the consumption of natural wealth represents the running down of an asset.

Take the simplest example of an oil well. Calculating GDP as we currently do, if a country extracts 1 million barrels from an oil well, we would not take into account the fact that the extraction of this oil represents the running down of a country’s savings, its oil reserves. If you took money out of your bank account and spent it on a television today, you would subtract that money from your savings.

The same logic applies to resource wealth. Each barrel of oil under the ground was already worth its price on the market. Some value was generated by extracting that barrel and moving it from under the ground to above the ground where it can be easily transported, refined and then burned, but it also means that the owner of the well will not have the ability to extract and sell that oil in the future. When we calculate total savings, we should subtract the value of the oil that was extracted.

If a government wants to make decisions on spending, investment, and taxation that take into account how these policies will affect welfare over time, Martin Weitzman showed thirty years ago that the statistic they should be focusing on is the sum of consumption and investment. These measures should take into account all of a country’s assets, including natural resource wealth.

A large body of research in environmental and resource economics has focused on the what and the how of measuring GDP “accurately” (often referred to as Green GDP). While there is some debate about technical details in the inclusion and exclusion of certain goods or services some consensus exists.

For example, there is broad agreement that we need to build national natural wealth accounts. These accounts would be used to keep track of how a country’s natural wealth (mineral reserves, forests, fisheries, water resources, etc.) changes from year to year. These accounts would be used to calculate the genuine savings for each country to correct national aggregate statistics so that governments do not ignore the opportunity cost of resource extraction.

Naturally, some of these resources are hard to measure or monetize (how do we measure the value of biodiversity to future generations?), but the value of oil and coal deposits are easy to calculate. The World Bank tried to do some of this accounting and found that countries like Venezuela or Nigeria would be 4 to 5 times as rich as they currently are if they had invested revenue from resource extraction in other types of capital. Other work has shown that while under conventional measures of saving resource-rich countries grow more slowly than other countries with similar savings rates (often referred to as the “resource curse”), if we account for the fact that resource extraction is a negative saving, this difference in growth rates disappears.

When statistics fail to treat the consumption of natural resources as a reduction in saving, governments will be more likely to ignore how their current policies affect future generations. An easy way of juicing up consumption is to extract and sell a lot of oil, copper, or timber, but while the impact on GDP is numerically the same as an increase in productive capacity the impact on long-run growth is very different. The extractive economy has not fundamentally changed to become more productive. Instead citizens are consuming wealth that they (or their descendants) will not be able to consume in the future and there is a false belief that the economy is more productive than it actually is.

By incorrectly measuring indicators, we make it more difficult for people to hold their government accountable. News coverage and macroeconomic analysis focus solely on GDP per capita so governments focus their efforts on these indicators as well. Policies that encourage resource extraction are promoted as “pro-growth” when in reality they are unrelated, unless we invest revenues from oil into machines, infrastructure, or education, we are simply consuming something we could consume in the future.

Failure to recognize this measurement mistake allows governments to spend resource revenues on current consumption and make their GDP look great, leaders can brag about great economic indicators while passing on the consequences to future generations. An honest accounting of a country’s economy should reflect these tradeoffs. No one would believe that someone who spent their inheritance on a Ferrari was richer than the person who invested their inheritance. Yet we do the equivalent when we lionize extractive countries with high GDPs. We shouldn’t.

 

Image courtesy of Flickr. Originally published by S&S on March 1, 2017.

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