How important are national accounts estimates? Describe some strengths and weaknesses of national accounts measurements
National accounts estimates are used to estimate the economic performance of a country and also to provide an indicator for the level of welfare in a country. National income in a year is the main indicator of interest and measures of national income break this total down into the various components and sectors that contribute to the total figure. This is primarily useful as a measure of welfare and economic development – the level and growth of national income is often one of the key targets of government officials and policy makers. This allows us to compare income of a particular across time as well as to compare the income between countries. In addition, there are also other indicators such as balance of payments, inflation and unemployment which provide further information about the state of the economy in question and allow us to make further inferences about welfare in the economy. So national accounts are primarily important because they provide a measurable indicator of welfare in a country that allows comparisons that facilitate policy evaluation. In fact, as Holcombe (2004) points out – national income accounts were created specifically for this policy purpose. This essay will consider each type of national accounts in turn and consider its importance through an analysis of its strengths, it will then criticize national accounts and highlight some weaknesses with the approach.
In an economy, the total income of all individuals must be spent on some good or service produced in the economy. Thus total income, total expenditure and total production are identical. We can consider the national income of a country by adding up all the income streams from factors of production (income approach). This will include total wages from labour, the total rent from land and capital and profits from enterprise. The figure we obtain for national income would then be identical to that if we calculated total expenditure for that country (expenditure). This we can do by calculating the sum of consumption, investment, government spending and net exports. We must deduct expenditure on imports since these do not count as expenditure on goods within the country. We can also calculate national income by adding up the value of total production from different sectors in the economy (production approach). Looking at the national accounts in these separate ways allows us to decompose the total into various component parts, allowing an analysis of the most important contributors to national income which can provide information for appropriate policy decisions. For example, recognizing that investment forms only a small part of national income may lead policy makers to be concerned about future growth. Recognizing that income accrues mostly to land holders may imply a particular distribution of income across social groups and have implications for social and economic policy. National accounts that reveal that electronics make up a large proportion of production will lead policy-makers to be particularly concerned about shifts in demand for electronic goods. The components of national accounts are thus useful as data which help formulate policy and to predict the impact of shocks to the economy.
There are different national income accounting figures that one can consider. The most common are gross domestic product and gross national product. Gross Domestic Product is a measure of the total production that takes place in the geographical region which is the country in question, whereas Gross National Product measures total production that is owned by citizens of the country. In other words, GDP includes all foreign direct investment in a country which is in fact owned by foreign individuals or firms, whereas GNP would exclude the value of foreign owned domestic production but include all outward foreign direct investment by the country’s own citizens. Net national product (NNP) is a measure of GNP minus depreciation of the existing stock of goods and services. To make this measure even more representative of welfare, direct income taxation can be subtracted from this measure of NNP to get personal disposable income, which is the total sum that citizens actually get to spend on goods and services.
There is also the question of whether goods are measured at their market value or at factor cost. The market value includes all indirect taxes and subsidies by the government and the expenditure approach to income would capture GDP at market value for this reason. The more appropriate measure is GDP at factor cost which will be captured by the income approach to national income. However in practice it is often easier to measure expenditure and taxes and subsidies have to be netted out of this measure to obtain GDP at factor cost.
In order for national income to be a good proxy for welfare, further adjustments have to be made to the national income figure. First, there must be an adjustment for the population of a country in order to accurately represent the welfare of each individual in a country. So the relevant measure is not national income but national income per capita. Secondly, prices might vary across different countries, or even across time due to inflation, hence a nominal $10b GDP in two separate countries does not make its citizens equally well off if prices in one country are much higher than in the other. Likewise for comparison across time. Thus for inter-country comparisons we have to adjust for “purchasing power parity” – this adjustment makes it such that countries with the same GDP adjusted for purchasing power parity will be able to purchase the same bundle of goods. For across time comparisons, a GDP deflator has to be multiplied to the nominal GDP to give the “real” income levels.
What arises from the previous paragraphs is that the measures of national income are flexible and are sufficiently clearly defined to provide a good approximation of the well-being of a country once necessary adjustments are made. It is possible to make objective comparisons between countries and across time which is a valuable tool for policy makers to measure progress. These are the strengths of national income accounts and are the reason why they are important for policy makers.
Let us now turn to some weaknesses of national income accounts as a proxy for the welfare of citizens. The first problem is that of measurement error. Statistics on levels of production, income and expenditure are often less than accurate and indeed the 3 approaches often yield different estimates. One reason for this discrepancy may be the household production sector. GDP only measures goods sold in the market, however, many goods, particularly in developing countries, are produced and consumed by the same household so the goods that citizens enjoy may exceed what is reflected in GDP figures. Illegal activities which are by definition hard to track, generate income for citizens but this is not reflected in national accounts. In countries where drug production is high like Columbia and Afghanistan, the figures may be significant. Ravallion (2003) finds a significant difference between national accounts measures of “private consumption expenditure” and micro-level household survey data in developing countries. The above two problems are typically most severe in developing countries but there is additional problem of valuing government provided goods and services which are not explicitly put on the market and sold. Some economists argue that government output that is not marketed should be completely excluded since they are a form of intermediate good which are not included in national income accounts but there is an obvious problem of how to treat government expenditure and how to value it appropriately. Direct measures of factor cost could be used but they may underestimate the true value of these goods to the users. While any estimate suffers from problems of measurement, circumstance may make national income accounts unhelpful in evaluating levels of welfare – we have to be aware of the possibility that they do not provide the whole picture.
The second problem has to do with undesirable goods. The costs of cleaning up pollution or rebuilding a country after a natural disaster add to national income but do not add directly to welfare. The third weakness of national income statistics is that it does not take into account non-economic indicators of welfare including human rights, equality, health and broader measures of standards of living. The United Nations Human Development Index is an alternative measure of wellbeing and includes life expectancy and education standards as key factors. The fourth problem is that national income measures do not take into account the extent to which production is depleting the existing stock of natural resources – which in fact hamper future production possibilities. National income is a static measure of welfare rather than a dynamic one. There have been recent suggestions to include a measure of “environmental NNP” which better accounts for the depreciation of the natural capital stock. The final problem as emphasized by Holcombe (2004) is that national income accounts fail to fully incorporate technological and quality improvements since they only measure the quantity of output produced – given that most of economic growth is fuelled by technological progress, this failure can severely underestimate the extent of welfare improvements over time.
Let us not turn to other measures besides national income that are measured under the national accounts. The first is the balance of payments – this measures the economic activity with respect to the rest of the world. The current account measures the difference between export and imports of goods and services while the capital account measures flows of capital in the form of investment between countries. In an increasingly globalised world, the balance of payments figures are particularly important as they reflect the extent of borrowing of the country with respect to the rest of the world. A large current account deficit implies that the country as a whole is consuming more than it is producing since imports are a consumption of foreign goods while exports are production sold to other countries. This is often counterbalanced by an inflow of investment into the country – essentially a loan from other countries. A large current account deficit, such as the US current account situation at the moment, could be a cause for concern since it implies a high level of borrowing which may be unsustainable. At the same time, it is a weakness of balance of payments accounts that they do not tell us the full picture. A current account deficit which is financed by an inflow of capital is not necessarily undesirable if the borrowing is used for worthwhile investments. The balance of payments, by themselves do not tell us if the current account deficit is desirable or not.
The second national accounting figure of interest is inflation. Measures of inflation usually look at the price of a basket of goods which represents the average consumer’s expenditure over time. This is important because it informs individuals about what the “real” value of their income is. Besides its implications for the real value of income, inflation is also a concern because high levels of inflation introduce uncertainty into the economy and often are a disincentive to save since one’s savings are gradually eroded over time by inflation. Low savings rates can hamper growth while uncertainty can reduce the level of business activity and investment. Inflation estimates also provide a benchmark for policy makers to make monetary policy commitments – in particular inflation targets which have become common amongst many central banks. Once these commitments are made, the effectiveness of policy makers can be measured according to the inflation in the next period. Targeting helps dampen inflationary expectations which can be crucial in restraining inflation.
However measurement of inflation is difficult, in particular there is a question of what the “basket of goods” should be. The General Index for Retail Prices (RPI) considers a representative basket of household consumption whereas the GDP deflator takes as its basket the whole range of goods and services across the economy. There is an additional problem when the composition of consumption changes. If the average individual consumes a lot of meat for example, an increase in the price of meat would severely affect his real income, however if over time he changes his preferences and consumes less meat, then the “basket of goods” used to calculate the price level should be adjusted to reflect my consumption pattern. However, say the average consumer continues to enjoy meat but due to increasing price of meat he decides to change to eating vegetables which are cheaper. The price index that adjusts the basket of goods would then underestimate the level of inflation because prices have indeed gone up but that has caused consumers to purchase relatively cheaper goods. Neither a fixed basket or an adjustable basket provides a precise measure of inflation. The second problem is that of quality improvements. An item such as a mobile phone is a very different item as a mobile phone 5 years ago in terms of its features. Thus what appears to be a price increase may actually result from higher quality products being provided at higher cost. The third problem from a policy perspective is that inflation accounting does not tell policy makers about the causes of inflation and hence cannot inform them about the best solution to inflation.
Unemployment figures represent the number of workers in the economy willing and able to work and is usually measured by the number of people actively searching for work. This figure is important because unemployed individuals represent potential labour that can be employed for productive activity and underutilizing them in a waste of resources. In addition, unemployment has serious social and political repercussions and possession of a job is seen as a means to a steady income is perceived as one of the basic measures of well-being.
National unemployment figures can be deceptive though since they are defined as individuals “actively seeking work” – however many long term unemployed may stop looking for work out of frustration. Studies (Gregg and Wadsworth, 1999) have found that although the UK has had a good record of low unemployment in the last half a decade, there have been an increasing number of economically inactive individuals, particularly in the North and in blue collar jobs. Many of these workers have obsolete skills, mostly resulting from the decline of the coal mining industry. National figures also disguise regional disparities which may be of concern.
In conclusion, national accounts provide us a snapshot of the economy over a particular period of time, however, whether the account of interest is income, balance of payments, inflation or unemployment there are tricky measurement issues to consider which can seriously bias the estimates. The data, while useful as a reference point and evaluative tool for policy makers, do not always unambiguously point to definitive judgment about the desirability of a particular situation and can almost never tell us about the causes and solutions to problems with the economy.
References
Parkin and Bade (1988). Second Edition, Modern Macroeconomics. Phillip Allan. Chapters 3-6.
Burda and Wyplosz (1997). Macroeconomics: A European Text. Second Edition. Oxford Univeristy Press. Chapter 2
Gregg, P. and Wadsworth, J. (1999), “Economic Inactivity” in P. Gregg and J. Wadsworth (eds.) The State of Working Britain (Manchester: Manchester University Press).
Holcombe, R. (2004). National Income Accounting and Public Policy. The Review of Austrian Economics. 17:4, pp. 387-405.
Ravallion, M. (2003) Measuring Aggregate Welfare in Developing Countries: How Well do National Accounts and Surveys Agree?. The Review of Economics and Statistics. MIT Press. 85:3.