Talk given in Peterboroughalongside presentation of the Q Business Confidence Monitor results.

Transcription

1 Talk given in Peterboroughalongside presentation of the Q Business Confidence Monitor results. 1

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4 Economic growth is almost always defined in terms of percentage increases in Gross Domestic Product (GDP). The figures quoted in the media are after adjustment for changes in price levels. GDP is a measure of the scale of economic activity. In simple terms, it measures the quantity of goods and services produced by an economy. The quantity is measured in monetary terms, using market prices where these are available. The national accounting system underlying the calculation of GDP is a relatively recent development. Various attempts were made to estimate nations income and wealth prior to the 1930s, yet the results tended to be insufficiently detailed, comprehensive or timely to be useful for understanding business cycles. This proved problematic during the Great Depression when US politicians wanted to be able to assess the outcomes of their economic policies. The first set of official US national income statistics were requested via a Senate resolution in 1932 and reported in With the outbreak of World War II, US national accounts saw a shift in emphasis towards the products of economic activity. This led to the launch of the Gross National Product (GNP) data series in National economic statistics were critical to management of the US economy during the war as they enabled investigation of the feasibility of planned military production and the implications for consumer spending if productive 4

5 capacity was diverted to achieve these plans. Meanwhile, other countries were developing national accounting measures in parallel. The first official UK national accounting estimates were published in In 1945, the League of Nations (shortly to become the UN) convened a committee of statistical experts which commenced the process of international standardisation of national accounts. The methodologies have continued to evolve, for example by improving inflation adjustments and the measurement of international trade in services, but the main features of the current system were in place by the mid-twentieth century. GNP continued to be the main statistic of focus until the early 1990s when it was supplanted by GDP, reflecting the increasing prevalence, and hence importance, of foreign ownership of domestic production. GDP can be calculated in three different ways, each of which gives the same answer (subject to statistical error). The next 3 slides present the formulae for these 3 calculations. 4

6 The expenditureapproach focuses on the demand side, in other words those who purchase the goods and services produced. GDP is calculated as consumer spending plus government spending plus investment (by firms, households and government) plus exports less imports, as shown by the pink shaded columns in the supplementary slide. It is summarised by the formula GDP = C+G+I+X-M (where I stands for investment) which will be familiar to those who have studied macroeconomics. Note that the first three components on the right-hand side of this equation relate to customers who are based in the country in question, but include their purchases of imported goods and services, so these have to be deducted (the fifth component), and purchases of domestic goods and services by those based overseas have to be added (the fourth component). NPISH stands for Non-Profit Institutions Serving Households. 5

7 The output (or production)approach to calculating GDP focuses on producers output. It is calculated as their Gross Value Added (Gross Output less Intermediate Consumption of non-durable inputs produced by others) plus certain taxes net of subsidies (those which are linked to the amount of production, eg, VAT and excise duty). This is shown by the blue shaded rows in the supplementary slide. The cost of durable goods, ie, those involved in but not used up during the production process, is not deducted from Gross Output when calculating Gross Value Added. So GDP is not the total output of all producers in the economy; you only count the output which is sold to its end-user, not the intermediate outputs which are used as inputs to production by other domestic producers. 6

8 The incomeapproach to calculating GDP focuses on the distribution of the income from production between the different factors of production. Broadly speaking, the income is distributed to employees, producers and government, as shown by the lilac shaded rows in the supplementary slide. Gross operating surplus means producers gross trading profits. Gross mixed income relates to those producers for which operating surplus and employee compensation cannot be separated (eg, the self-employed). 7

9 Producers include businesses, government, non-profit institutions and households. But the bulk of production is by business. So to understand how GDP relates to business metrics, here s a very simple representation. You can think of a company s gross output (or revenue) as being matched by its expenditure on inputs from other firms, wages, taxes and profit. The sum of the last three items (shown in red) is known as Gross Value Added (GVA). If you sum GVA over all producers located within the country s geographic boundaries, and add in taxes on production like VAT and excise duty (net of subsidies on production), you get GDP. This diagramillustrates the link between an individual producer and the income and production approaches to calculating GDP. The link with the expenditure approach is harder to see. You can think of an individual firm s contribution to the expenditure approach in two ways. Either you count 100% of its output which is sold to an end-user (or is exported) and 0% of other output. Or you can think of end users expenditure on products as being made up of the GVA of each producer along the supply chain. 8

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11 Capital expenditure is not deducted as part of the input costs when calculating the gross value added by producers (in the output presentation of GDP). Neither is a deduction made for the depreciation of productive capacity as existing assets wear out or become obsolete. The costs of production are, in effect, understated. Indeed, the G of GDP refers to the fact that the calculation is before deduction of capital expenditure. Figures net of consumption of fixed capital (broadly equivalent to the depreciation charge found in corporate accounting) -Net Domestic Product (NDP) are calculated but these are not widely used since the consumption of fixed capital figures are inevitably subject to considerable uncertainty. The D of GDP refers to the fact that economic activity is allocated to countries on the basis of the geographic location of production. Gross National Income (formerly GNP) is similar to GDP but instead allocates economic activity according to the initial destination of the income generated. So, for example, if a Japanese company repatriates profits from a US factory, those profits will count towards US GDP and Japanese GNI. If a worker lives in Belgium and works in France, his wages will count towards French GDP and Belgian GNI. Although GNI and GDP are very similar for the UK (GNI was 1% higher than GDP in 2011 ), they differ significantly for some countries (eg, for Luxembourg, GDP was 48% higher than GNI in 2011 ). GDP measures the expenditure on domestically produced goods, rather than the 10

12 expenditure of the country s residents, and these can diverge if there is an imbalance in international trade. Hence it is a measure of production not consumption. It excludes transfers of income that are not directly related to economic production such as taxes and welfare payments, transactions with the European Union, overseas aid and private gifts. GDP also excludes the proceeds from secondary trade in capital goods, for example buying and selling houses and company shares, as this does not involve production. 10

13 Property sector rising house prices only indirectly contribute to rising GDP. This is because selling an existing house is a transfer of money; no goods or services are produced. Construction of new houses counts towards GDP, as do services associated with buying and selling houses such as estate agent fees, legal fees and moving costs. Finance sector some financial institutions charge directly for their services (eg brokerage fees on buying and selling shares) and these feed directly into GDP. However, many banking services which are remunerated through differences between interest rates for lending and borrowing rather than by explicit fees. These are included in GDP by modelling the difference between actual interest rates and a reference interest rate. This can lead to some surprising results; for example, the UK financial services sector s GVA peaked in early 2009 (ie, several months afterthe start of the financial crisis) due to the rise in interest rates charged at that time. Public sector goods and services such as healthcare and education are typically not freely traded on markets and so do not have observable market prices. Instead, the public sector s contribution to GDP (when measured in current price terms) is calculated by valuing its output at the cost of provision, equal to: the cost of inputs purchased from other producers; plus employee compensation; plus a notional charge for the consumption of fixed assets such as buildings. This might differ quite significantly from the amount the service users would be willing to pay for the output if it was provided 11

14 through the private sector instead. When GDP growth rates are calculated in volume terms, direct measures of public sector output are used instead where possible. These are based on the activities carried out and services provided, weighted by the associated unit costs. This enables changes in the efficiency of producing public services to be reflected in GDP growth rates, which would not be possible if outputs were assumed to equal inputs. In theory, these direct output measures should be adjusted for changes in quality, but the techniques for doing so are still at an early stage of development. 11

15 When comparing GDP figures from different periods, it is important to know how much of the difference is due to changes in the volume of production and how much is caused by changes in prices. National statistics offices therefore produce two main sets of figures: the monetary value of GDP in current price terms and percentage changes in GDP measured in volume terms The former includes the effects of changing price levels whereas the latter does not. The GDP growth rates quoted in the media tend to be the ones calculated in volume terms. Growth is measured in volume terms for many sectors of the economy by adjusting nominal price output figures for changes in price levels; for other sectors, particularly government services, changes in output are measured directly. When calculating changes in volume measures of GDP, it is important to take account of changes in the quality of goods and services produced. This is particularly important for sectors experiencing rapid technological changes, such as computing, or when making comparisons over extended time periods; otherwise, producing the same number of goods to a higher specification would not be recorded as an improvement (increase) in output. However, it is often difficult to distinguish changes in quality from changes in price, particularly for services. There are various possible approaches to volume measurement and quality adjustment, and this is an active area of research. Even though improvements are being made, it is an inevitable area of subjectivity and uncertainty in quoted GDP growth rates. Some authors have suggested that there may 12

16 be a tendency to underestimate quality improvements, in which case GDP growth rates will be understated. When comparing countries GDP figures, particularly when GDP is being used as a proxy for living standards, it is important to adjust for differences in the population size. Hence per capita figures are commonly used. Interestingly, GDP growth rates are rarely calculated in per capita terms; adjusting for increases in population presents a less rosy picture of a country s economic performance (see supplementary slide). A further complication for GDP comparisons between countries is differences in the cost of living, as well as the use of different currencies in many cases. It is standard practice to use purchasing power parity exchange rates to adjust for this. These rates are necessarily derived using statistical techniques rather than being observable in financial markets, so this adds an extra layer of uncertainty to GDP figures. 12

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18 GDP figures form part of an extensive set of national accounts, which provide a wealth of supporting information such as GDP s split between sectors of the economy and between the main categories of economic actors (households, firms, government). There are an international set of national accounting rules, intended to standardise calculations between countries and facilitate international comparison of GDP statistics. The first international system of national accounts was launched in The UK currently uses the 1993 rules, the UN System of National Accounts 1993 (SNA93). The rules allow considerable flexibility in the methods adopted, not least to accommodate the vast differences between countries economies (especially those at different levels of development). A more detailed, prescriptive set of rules has been developed by Eurostat in order to increase the consistency between EU countries national accounts, in particular the GNI figures used to calculate their contributions to the EU budget. The UK currently uses the 1995 rules, the European System of Accounts 1995 (ESA95), which are based on SNA93. In its national accounts for the calendar year 2013, due to be published in September 2014, the UK will be adopting the new rules of ESA10, based on SNA08. This is already attracting media attention. The UK s GDP (measured in current prices) is expected to increase by 2% to 3% as a result, although there may not be much impact on GDP 14

19 growth figures. As countries adopt new national accounting rules at different times, this hinders inter-country comparisons. 14

20 The conceptual framework underlying national accounts has important similarities with company (entity) accounting. It consists of a linked set of accounts: current accounts (production, income and expenditure items), accumulation accounts (changes in asset/liability values), and balance sheet accounts (assets and liabilities). Economic activity is, in principle, measured on an accruals basis, with revenue matched against expenditure when transactions occur rather than when the corresponding payments are made. For example, surveys ask businesses about their income receivable and expenditure payable (rather than income received and expenditure paid). In this case, achieving an accruals basis relies on accurate completion of the questionnaires. As all except the smallest businesses prepare accounts on an accruals basis, it seems reasonable to assume that most respondents will report accruals-based figures. In other cases, special adjustments are made to achieve an accruals basis. For example, the ticket revenue from the London 2012 Olympics was allocated to the period when the Games took place, rather than when the tickets were sold, contributing to a spike in UK GDP in the third quarter of Nonetheless, in practice, some economic activity is measured using a cash basis. The conceptual framework for national accounting uses the principles of double-entry book-keeping that underpin corporate accounting. It is not possible for national accounting to use double-entry book-keeping directly as relatively few details of 15

21 individual transactions are available. Transaction data is therefore supplemented by various sets of statistical data, for example from surveys of businesses and households, plus modelled data where suitable information on market transactions is not available. Information relating to one party to a set of transactions (the payee or the recipient) is collated and data from different sources is compared to ensure that, across the economy as a whole, total payments match total receipts. The national accounting system is sometimes referred to as a quadruple-entry system because it incorporates two entries for both parties to each transaction. For example, the sale of goods to a household might be recorded as final consumption expenditure and a decrease in cash assets for the household, and sale of goods and an increase in cash assets for the producer. In theory, quadruple entry means that every transaction gives rise to four entries in these accounts so that they always balance and their movements can be reconciled. But in practice, account entries are estimated using statistical methods rather than individual transaction data so this reconciliation is not possible. Instead, an extensive balancing exercise is used to harmonise the GDP estimates obtained by applying the three different calculation approaches. Revisions to GDP occur as more complete data becomes available. A preliminary estimate is published c.25 days after quarter end, based on the Output approach only. The second estimate c.1 month later includes more detailed Output data, plus some Income and Expenditure data. The third estimate appears in the quarterly accounts c.1 month after that; it contains the first breakdown of Income and Expenditure components. The annual national accounts contain much more detailed information and include the effects of balancing the three calculation approaches. The next year s annual accounts may reflect further data changes. Revisions in subsequent years are generally due to refinements of accounting methods. 15

22 GDP figures depend on methodological choices about what exactly is included and how. Not all economic activity can be measured via observation of market transactions, so this activity is either excluded (reducing GDP s coverage) or estimated (increasing GDP s uncertainty). For the UK, activities for which estimation is used include: Hidden transactions, such as tradesmen s undeclared income. Goods made for producers own use, such as farmers consuming some of the food they produce. Public sector production is valued asthe cost of inputs; estimation is required for the capital consumption component of this. Banking services which are remunerated through differences between interest rates for lending and borrowing rather than by explicit fees. A notional rental value is included in GDP for owner-occupied properties; it appears as both production by households and consumption expenditure by households. 16

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24 Source: ONS quarterly national accounts, Q1 of 2013, 27 June 2013 Figure 1: Annual GDP, table A2, CVM SA For any GDP calculation, a range of figures are possibledue to statistical estimation, methodological choices and (where applicable) inflation and currency adjustments. The reported GDP figures should therefore be interpreted as, at most, a general indication of the scale of economic activity, without attaching great significance to small percentage changes from quarter to quarter. Although national statisticians acknowledge this, the media and politicians nonetheless place considerable emphasis on short-term fluctuations in GDP. 18

25 Theamount of production is only one of the characteristics of an economy we re interested in; many other things are important too. There are signs that the UK media is now considering a broader range of metrics, in part because the recent recession has highlighted the way that important indicators can tell different stories. One example is employment which didn t suffer as badly as headline GDP during the recession. Another example is household income and concerns that recent increases in GDP aren t yet translating into higher take-home pay. 19

26 GDP aggregates a lot of information into a single statistic, so inevitably it only gives a limited picture of the economy. Individual people and businesses can find that their experience of the economic climate is very different to the headline impression given by GDP. GDP is most often calculated for countries, although it may also be calculated for smaller geographic areas or aggregated across countries. Studying economic data at a national level can give a misleading impression if there is significant variation in economic activity between regions. For example, whilst it is well-known that average incomes are higher in London than in the rest of the UK, the extent of the difference may come as a surprise. The diagram shows that average gross value added (ie, GDP less taxes on products) per person ranged from 53% of the London value in the North East to 64% of the London value in the South East in By 2009, the gap between London and the other regions had widened, and there was also greater variation between the non- London regions: average gross value added per person ranged from 43% of the London value in Wales to 61% of the London value in the South East. ONS produces various splits of GDP and related statistics which provide information on how the income generated by production of goods and services is shared between the main groups of economic actors. However, because they are based on economy-wide data, different information sources are needed to understand how income is shared 20

27 within those groups. This is important for understanding the economic well-being of individual members of society because many countries have a very unequal distribution of income. Average GDP per person can only give a very crude indication of living standards: from an individual s perspective, their own net income and its adequacy for purchasing the goods and services needed for a high quality of life is obviously much more relevant. 20

28 GDP can be thought of as providing information on economic flows : it is a summary measure of the money, goods and services that flow between producers and consumers during a given period of time. GDP is therefore, in effect, a single figure from an income statement. In order to assess the sustainability of economic activity, it is also necessary (although not sufficient) to have information on the underlying stocks or assets used to generate that economic activity. The national accounts include a balance sheet which, in the case of the UK, records the value of some manufactured and natural capital ( non-financial assets ) and most financial capital ( financial assets less financial liabilities ). The underlying conceptual framework document explains how the current accounts (from which GDP is derived) and accumulation accounts relate to changes in the national balance sheet. However, in practice, the UK does not publish a reconciliation of the opening and closing positions and there are conceptual inconsistencies between the national balance sheet and GDP. 21

29 There is a tendency among politicians and journalists to interpret GDP as a measure of society s collective well-being, even though most economists and national statisticians acknowledge that this is inappropriate. The expenditure approach to calculating GDP is the one most obviously linked to living standards through the idea that well-being is generated by the consumption of goods and services. However, GDP is primarily a measure of production, not expenditure, and includes production for investment as well as production for consumption. Moreover, consumption is not the only determinant of well-being; well-being is critically dependent on non-economic factors like personal relationships and a sense of community. Some production harms well-being yet is included in GDP, for example the production of cigarettes. In turn, smoking gives rise to other economic activity such as nicotine patches and addiction support services, not to mention the increased health costs of treating smoking-related illness. Smoking therefore boosts GDP. A country which was identical except for having fewer smokers would have lower GDP, yet would generally be judged to have higher well-being. Monetary cost may not be a good indicator of value. For example, public services are included in GDP at the cost of production yet this might differ quite significantly from the amount the service users would be willing to pay for the output if it was provided 22

30 through the private sector instead. Contrast UK and US levels of healthcare spending: it is higher in the US yet health outcomes are worse on average. In addition, there are theoretical issues with summing measures of individual well-being (eg, consumption expenditure) and using them as a measure of overall social welfare. 22

31 The scope of economic activity which is included in GDP, using the current European national accounting rules, can be summarised as The production of all goods whether supplied to other units or retained by the producer for own final consumption or gross capital formation, and services only in so far as they are exchanged in the market and/or generate income for other economic units. GDP is therefore intended as a complete measure of the human production of goods but a less comprehensive measure of services. It excludes the value of most voluntary work and unpaid domestic activities such as cooking, cleaning and childcare. One consequence of this is that GDP increases if someone starts to employ a cleaner or child-minder rather than doing this work themselves. GDP and national accounts do not fully recognise the importance of human, social and natural capital to economic activity. For example, the national balance sheet is largely restricted to manufactured assets, financial assets and financial liabilities. Yet other assets ones on which monetary values cannot readily be placed provide vital underpinnings to all production: human skills and ingenuity; social relationships and trust; and natural resources and ecosystems. The national accounts are also unable to monitor important characteristics of the economy such as its stability and resilience. In the run-up to the 2008 financial crisis, headline economic indicators suggested that the economy was performing strongly. A 23

32 more comprehensive picture of economic performance revealed worrying signs that the economy was becoming increasingly unstable, such as rising levels of consumer debt, increasing withdrawal of household equity, and the growing reliance of the banking sector on securitisation. Focusing on measures such as GDP can encourage actions that improve apparent short-term performance whilst undermining the system s ability to function well over the longer-term. 23

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34 This talk is part of ICAEW s project So what is economic success? Going beyond GDP and profit. The diagram is an extract from the project prospectus, available at It maps out various questions that we are considering. Today s talk ismainly within Box 3: How are our current measures calculated? (GDP only). It also touches on Box 4: What are current measures strengths and weaknesses. 25

35 We are hosting a discussion event centred aroundbox 2 ( what do we mean by economic success? )in Liverpool on 1 July2014 as part of the International Festival of Business. Please come and join us, or contribute your thoughts via our online discussions, accessible via the link in the prospectus. 26

36 The project forms part of ICAEW s Sustainable Business Initiative.There are several channels you can use to keep in touch with our sustainability projects. 27

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39 Sources: ONS, United Kingdom Input-Output Analytical Tables 2005 and ONS, The Blue Book, 2011 Edition Notes: 1. Final Consumption Expenditure 2. Non-Profit Institutions Serving Households (eg charities) 3. Producers' gross trading profits, including self-employed income 4. Taxes and subsidies paid by producers and not linked to the amount of production, eg business rates 5. Taxes and subsidies linked to the amount of production, eg Value Added Tax, excise duty 30

40 Sources: ONS, United Kingdom Input-Output Analytical Tables 2005 and ONS, The Blue Book, 2011 Edition Notes: 1. Final Consumption Expenditure 2. Non-Profit Institutions Serving Households (eg charities) 3. Producers' gross trading profits, including self-employed income 4. Taxes and subsidies paid by producers and not linked to the amount of production, eg business rates 5. Taxes and subsidies linked to the amount of production, eg Value Added Tax, excise duty 31

41 Sources: ONS, United Kingdom Input-Output Analytical Tables 2005 and ONS, The Blue Book, 2011 Edition Notes: 1. Final Consumption Expenditure 2. Non-Profit Institutions Serving Households (eg charities) 3. Producers' gross trading profits, including self-employed income 4. Taxes and subsidies paid by producers and not linked to the amount of production, eg business rates 5. Taxes and subsidies linked to the amount of production, eg Value Added Tax, excise duty 32

42 The graph illustrates the different impressions that various income measures can give, using data for the UK from 2000 to The three measures are taken from the national accounts and are economy-wide statistics averaged across the population. Total GDP increased by 20% over the period (after adjusting for inflation), but population also increased by 6.5% so GDP per capita increased by only 12.6%. Gross Disposable Income increased by almost the same percentage as GDP over the period, but it followed a notably smoother pattern, suggesting that factors such as higher net transfers from government (benefit payments less taxes) had shielded households from the worst effects of the 2008 financial crisis. The actual experiences of individual households can diverge significantly from the national average, especially in periods when the degree of income inequality is changing. GDI is households Gross Disposable Income, which is GDP adjusted for items such as net transfers from government. 33

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