Copyright Hugh Small

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2 Copyright Hugh Small Author s note 4 March 2013: This pamphlet s conclusion that the official GDP figures for underestimated GDP growth has been confirmed by Peter Goodridge, Jonathan Haskel, and Gavin Wallis in their paper Can Intangible Investment Explain the UK Productivity Puzzle?* In this pamphlet I relied on a subjective assessment that intangible assets omitted from the official calculation had increased in the last four years, even though reported GDP was flat, because e-commerce and big data were obviously developing fast. But growth is never continuous, and it needed their detailed mathematical treatment to show that in each of the years in question the omission had caused an underestimate of GDP growth. I am grateful that Prof. Haskel and his colleagues produced such timely evidence to support my informed guess. *

3 2008 Q1 Q2 Q3 Q Q1 Q2 Q3 Q Q1 Q2 Q3 Q Q1 Q2 Q3 Q Q1 Q2 Solving the Productivity Puzzle... and how to game the GDP calculation In the UK, employment is rising while GDP is flat or falling. As a result labour productivity, expressed as units of GDP per hour worked, appears to be falling. This new phenomenon is causing concern; the Governor of the Bank of England has said that it is hard to reconcile flat GDP with increasing employment, and the Office of National Statistics is investigating Employment GDP Employment is rising while GDP is falling. Source: ONS Official concern stems from the fact that weak GDP growth may affect the UK s cost of borrowing. Controversial new infrastructure projects are proposed in an attempt to stimulate economic growth. Some commentators have gone so far as to say that poor labour productivity is holding back economic recovery. 2 This paper summarises a corrective view which is widely shared in academic circles: Current estimates of UK GDP are too low because the methodology undervalues private sector investments in a mature economy. 1

4 Agenda This paper is not concerned with the question of whether GDP measures WELFARE or ENVIRONMENTAL costs; it only addresses the failure of current GDP estimates to measure FINANCIAL value in the UK. Current estimates of UK GDP are too low because the methodology undervalues private sector investments in a mature economy: 1. Current GDP estimation methods were designed to value underdeveloped economies in which investment in tangible fixed assets is a good indicator of financial value; 2. The private sector in mature economies like that of the UK is instead increasingly investing in other assets which are not valued by current GDP estimates; 3. It will not be possible to improve GDP calculations to accurately reflect the value of the investments of a mature economy. 2

5 1. Current GDP estimation methods were designed to value underdeveloped economies in which investment in tangible fixed assets is a good indicator of financial value: The definition of GDP requires that all fixed asset investments be added to GDP in the year in which the investment is made. Investment is defined as expense which creates assets (tangible or intangible) which will bring benefits in future years. In the UK, software has been added as an intangible fixed asset since 2006, and R&D will be added from 2014). 3 Other investment assets (databases, staff training, business process improvement, industry restructuring etc) are excluded because it has not been found practical to measure them. The definition of GDP implicitly assumes that fixed asset investment will generate an appropriate return, and therefore has financial value. This may be an appropriate assumption in an underdeveloped growth stage economy that has been starved of capital. GDP is a measure of value added, and both increases in gross production and reductions in expenses or intermediate consumption may increase it. Unfortunately the inclusion of production-oriented tangible fixed assets values gross output (profitable or not) higher than efficiency measures which increase profitability. This may be appropriate in the public sector of growth stage economies, as it is in businesses which are in the growth stage of the industry life cycle. 4 Fixed asset investment in an underdeveloped economy is also an extra signal of value because it normally demonstrates an improved economic climate: investor confidence in the rule of law ; expansion of infrastructural basic entitlements : sanitation, transport, communications, which increase workforce productivity. 3

6 2. The private sector in mature economies like that of the UK is increasingly investing in other assets which are not valued by current GDP estimates: 30% 25% 20% 15% 10% 5% Middle income Low income OECD members United States United Kingdom 0% Investment component as a proportion of GDP Source: World Bank data (NE.GDI.FTOT.ZS) The above graph shows that tangible fixed asset investment of the type measured by current GDP estimation methods counts for less and less in developed countries. It would be wrong to conclude that the OECD countries have been under-investing since Studies show that they have been investing in other assets which are not included in the GDP estimates. 5 The ability of new tangible fixed assets to pick off the low-hanging fruit of an underdeveloped economy has faded, and there is no longer any justification for including them while excluding less tangible investments. Unfortunately the public sector in developed economies may be gaming the incomplete GDP estimates by funding infrastructure investments which have marginal or negative return (high speed rail, hub airports, etc). This will increase GDP estimates in the short term but will destroy financial value in the medium to long term. 4

7 2. (Continued) The private sector in mature economies like that of the UK is increasingly investing in other assets which are not valued by current GDP estimates: This gaming will not occur in the private sector, which weighs much more carefully the investment opportunities in tangible fixed assets. Businesses have other opportunities for investment, and are driven by profit. But if they are allowed to profit from loss-making public infrastructure projects, they will participate. This will deprive the UK of the national wealth these private sector companies would otherwise generate. Especially in times of slack demand, businesses exploit labourintensive and profitable investment opportunities on the input (intermediate consumption) side of the business, aiming to reduce material usage and long-term costs. GDP is a measure of value added and will increase later when these opportunities increase profitability, even with flat sales. Unfortunately GDP estimates will not get the short-term boost from them that tangible fixed asset investment (normally aimed at increasing gross output) provides. 6 The assets created by these input-optimising investments are nearly all omitted from the GDP estimates. Business leaders are not only driven by a desire to increase sales ( gross output ). They know that investing in cost reduction (e.g. reducing the use of raw materials) can be much more profitable. The same is true with economic growth; GDP if estimated accurately would be a measure of value added, i.e. profit. But as a result of the estimation bias towards gross output, which is an artefact of its heritage as a measure of a developing economy, there is a widespread belief that economic growth means increased gross output. This may explain why it sometimes appears as if the sales force is in charge of national economic strategy. 5

8 2. (Continued) The private sector in mature economies like that of the UK is increasingly investing in other assets which are not valued by current GDP estimates: Intangible assets are investment products which should be capitalised and added to GDP like tangible fixed assets, but most aren t because of the difficulty of calculating their cost. * Other investment Net product = Value added = Contribution to GDP as currently underestimated = a + b - c a) Some investment Enterprise b) Sales c) Intermediate consumption *ONS estimate. Other estimates range up to 123 bn 7 6

9 3. It will not be possible to upgrade GDP calculations to accurately reflect the value of the more innovative intangible fixed assets. Example: big data Intangible assets like software (2006) and R&D (2014) can be capitalised because they are produced by specialist departments whose costs can be calculated. The surge in big data investment, in contrast, invests manpower throughout the organisation, making it hard to measure. Computer Dept. Software Laboratory R&D Everywhere Supplier data Big data Customer data Operations data 7

10 3. (Continued) neither would it be desirable to value a developed economy using a proper GDP which includes all investment: The rationale for including any investment in GDP is that the investment will bring a financial return in future years. This may be approximately true in a developing economy which has been starved of capital, but much less true in a developed economy where investment is more speculative. Non-financial management indicators are therefore to be preferred to GDP, such as employment levels or efficiency of use of raw materials or land. Lessons can be learned from private sector management accounting strategy: In the 1980s in the private sector there was a move away from trying to use financial accounts to manage a business; unaudited non-financial indicators became more popular: o Order pipeline; o Customer turnover; o Revenue per customer, etc. ONS should create other management indicators simultaneously with GDP, with an in-depth analysis of inconsistencies drawing on experience in industry; The UK public sector should also learn from the private sector how to prioritise investment in intangible assets. 8

11 References 1 Sir Mervyn King, 14 November 2012 reported at Office of National Statistic: The Productivity Conundrum, Explanations and Preliminary Analysis, 16 October Sluggish Productivity Growth Holding Back World s Economies: 3 ONS: Results from the Second Survey of Investment in Intangible Assets, 16 November See the author s When Businessmen Fear Growth, available at 5 Carol Corrado, Jonathan Haskel, Cecilia Jona-Lasinio, Massimiliano Iommi: Intangible capital and growth in advanced economies: measurement methods and comparative results Discussion paper 2012/06 July Imperial College Business School, London. 6 The status of tangible assets as capital is indisputable. Such assets are created when today s resources are set aside and used to expand tomorrow s production capacity. (Corrado et al., op. cit.) 7 ONS: Results from the Second Survey of Investment in Intangible Assets, 16 November 2012, and Intangible investment and Britain s productivity: Treasury Economic Working Paper No. 1 October 2007