Monday, October 10, 2011

Wealth and GDP

"Political Economy is defined as the science of wealth" wrote Francis Wayland in 1870 (Wayland was Yale University's first professor of Political Economy). Adam Smith wrote "An Inquiry into the Nature and Causes of Wealth of Nations" in 1776 inspired by a group of mainly French economists called the Physiocrats. The Physiocrats (who could probably be considered the first economists) proposed that all material wealth came from the development of land.

A question is: does the classical view of wealth production provide any insight into the modern conception of GDP and economic activity?

Wealth Defined by Classical Economists

Wealth from a Classical sense (classical economists are economists from the 1700's before the mid 20th century) was defined on a national level as, according to the classical economist Jean Baptiste Say (1821) in his Letters to Malthus on Political Economy. Say asked and answered a series of questions in these letters concerning wealth. Say defined Wealth as "Whatever has a value; gold, silver, land, merchandise..." and then defined Value as "[A product] having utility." Value was conceived of as mainly a product with "utility," and utility was viewed as having a both subjective and a non-subjective element in so far that, according to Say, utility drives value as "persons are then to be found who are in want of this thing (with utility); they desire to have it from those who produce it."

The subjective element of wealth -- wealth as defined that is deemed useful by potential customers in the classical economic tradition, to the extent that they will pay for that item -- is interesting in so far that wealth has to be something not already extremely abundant and/or provided by nature (classical economists asked "if I hold a glass of water, is this wealth? The accepted answer, after much debate was no, in so far that water is already in abundance).

Further wealth could hold significant value, but if this value was not recognized by consumers or if the necessary infrastructure was not in place to realize this value, then perhaps the item would not have value. One could think of, for example, petroleum oil in the 1800's, at first was considered a nuisance for agriculture and therefore did not represent wealth.

Alfred Marshall, John Maynard Keynes' mentor at Cambridge University, in the late 19th century proposed the concept of supply and demand curves for products summing up the idea of price (value) as the intersection between supply and demand for the product.

On a national scale, Jean Baptiste Say defined the "wealth of nations" as: "(A wealthy nation) in which many things of value, or more briefly, many values are to be found." But Jean Baptiste Say did not formalize a measurement system for quantifying a country's wealth -- this was not to be performed until the 1930's under the economist Simon Kuznets (to be examined below).

One last interesting point is that classical economists stated that wealth could only cocur with the legal right of private property: Jean Batiste Say asked in his Letters: "Can Riches Exist without property?" and answered "No, as richest represent property."

Classical Economists on How Wealth is Produced:

The next question is, according to classical economics, how is wealth produced? The production of items of value (note Say did not cover services in detail, or even conceive of services as a major portion of the economy) was split by Say into three separate activities in his Letters (1821):

1. "Cultivation," by which Say meant the production of resources and commodities, agriculture and mining and resource extraction -- Say began with this activity in so far Say was influenced by the Physiocrats, who stated that all value came from land.

2. Manufacturing -- the conversion of resources to a usable end product -- Say expanded and improved upon that all value came from land only by expanding value added to manufacturing.

3. Commerce -- the distribution of manufactured and processed products to the end customer. One can think of modern retail chains, grocery stores and online as falling under this designation of commerce.

Say noted that each of these three steps in the economy was necessary for the completion of the next step, in so far that manufacturing could not occur without cultivation or resource extraction and commerce could not occur without manufacturing or processing. Say did not discuss trade in detail -- whether one step could be outsourced to another country sustainably.

Two questions come to mind: first, would all new industries (from technological advances) since 1821 fit into these three steps in terms of producing value? And second, how would services fit into Say's 3 step framework?

Major advanced such as the cotton gin and steel industry, the Bessemer Steel Process, the steam engine would all fit in very well within Say's Framework. The textile industry, revolutionized by the cotton gin and the spinning jenny -- told resources in the form of raw cotton and manufactured these into clothes, then distributed these clothes to the end customer.

Industries invented in the 20th century such as the computer industry would also fit in, albeit with a more substantially available raw material (semiconductors are made from silicon -- sand, and also energy - from coal and natural gas) and an interesting "manufacturing" process, if one can view production of software or the "soul" of a computer as "manufacturing." (taking prewritten logic commands and constructing them to give instructions, on a silicon base). Technology consulting companies such as EDS could be viewed as providing both manufacturing (programming of local data processing for banks, for example) and commerce -- directly providing a service to the end customer.

One can see that much of our "service based" economy can be viewed as really either processing and/or commerce. Currently retail is classified as services and IT work is also classified as services in modern GDP accounting.

The modern finance industry, one could say is meant to assist the other segments of society. Warren Buffet has stated that the "raw material" of banks is "capital" by which they make loans (end product) in which the capital would not be dependent on physical raw materials (even software depends on silicon, but in modern banking money can be created by the central bank). I am not sure how to classify finance according to Say's three part system, but would lean towards finance supporting other industries, not as an industry in and of itself (one could also make this case with legal services).

The modern health care industry -- which accounts for upwards of 15% of US GDP -- does not exactly follow Say's threefold method -- more thought on this by the author is needed.

To sum up, classical economics was the study of wealth by which a country produced and distributed items of perceived utility, by a three step process of gathering resources by the land, processing these resources and then delivering these products to the end customer. We will next see how this view fits with modern GDP theory. Note that classical economics did not focus in any significant way on debt -- Say did mention national debts, but only in passing, and also did not focus on income distribution -- what would occur if a small percentage of the population owned most of the wealth? Say did not address this in detail, nor did Wayland or John Stuart Mill. ONe would have to wait for economists in the early 290th century such as John Maynard Keynes and Mickal Kaleci to discuss the distribution of wealth.

Modern Gross Domestic Product Defined

Classical economics did not provide a substaniative calculation procedure to determine the size of the overall economy -- before the invention of the gross domestic product methodology in the 1930's economic activity was roughly gauged by production of key outputs such as steel and/or by the unemployment rate. Modern conceptions of gross domestic product are generally based on theories of the early 20th century economist Simon Kuznets: consumption is calculated by utilizing the formula Consumption = income - savings (income both salaried and capital gains and profits can be obtained by tax records). GDP is then calculated by the formula GDP = net domestic consumption = C + I + G + (X-M), which theoretically equals net domestic income (aggregate salaries plus capital gains and profits) which also theoretically equals net domestic product (aggregate hours worked times productivity). The fact that the three equations for GDP must equal each other is the reason, according to Kuznets, that GDP account is refered to as the "National Accounts" (similar to the accounts, balance sheet, cash flow and income statement of a business).

Gross Domestic Product calculations do not focus on the conception of wealth as utility per say. One could conceive of an economy mainly driven by the production and sale of tulips at a very high price, which would result in high sale prices and therefore high salaries and therefore high GDP. However this economy would soon collapse -- once consumers realized tulips are plentiful and don't have much intrinsic utility (cannot be eaten, made clothes out of, etc).

GDP calculations do not give too much indication as to the utility of GDP -- not to say that classical economics provided significant insight into the economy as utility, but at least classical economics would indicate the citizen to consider the functionality of goods produced. Modern economics reports one number, GDP, without much discussion of its underlying "value." An economy producing very high amounts of "intrinsic utility" items, such as food in a period of food, energy, clothing and transport, in a period of surplus of these items (meaning the items sell at a low price) mean that the GDP calculation for this economy would be low, despite the high "real" living standards and relatively high sustainability.

There is a sense Modern GDP accounting has well known shortcomings -- it does not typically (except for certain countries like Norway) account for resource base depletion, GDP only accounts for economic activity in constant currency (so if the currency depreciates by a significant margin it is unclear if GDP is really declining), related to resources the sustainability of GDP is not indicated, nor is the overall debt level of the economy. GDP also does not measure the distribution of wealth in the overall economy -- it seems a country would be "richer" overall if more of its citizens enjoyed a wider range of its products.

It seems that the production of goods and services in Say's three economic productivity dimensions that have higher "utility" that satisfies "needs" -- clothing, shelter, nutrition,

1 comment:

Pawan said...

I checked out your blog. Really cool stuff. I also spent a few minutes on their blog. Thanks for sharing.