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May 16, 2022
ECONOMY EDITORIAL FINANCE&BANKING OP-ED OPINION POINTS OF VIEW

Leonardo Badea (BNR): Assessing the effectiveness of public policies: between the need for complementary GDP indicators and the topicality of the “veil of ignorance” principle developed by Rawls

I believe that one of the most critical topics of academic research and debate on public policy is that of their ultimate purpose. However, unfortunately, this beneficial discussion for the general public and for policymakers, which is the basis for understanding the implications of the social contract (and I dare say even the obligations arising from it, for both parties), is less present in the public space and the media.

Most economists are preocuppied to maximize social welfare, given the existing distribution of resources. Nevertheless, most often, their interest is channeled towards the economic efficiency of alternative options, leaving the discussions on equality, redistribution, or freedom of choice in the area of political confrontation. However, it is almost impossible today to separate economic efficiency from social equity goals in any current economic policy debate because most (possible) public policy adjustments, unfortunately, involve winners and losers among the members of society.

Although for several years now the discussion on how to assess the success or failure of any of the public policies has become more diverse, in practice, the most common means or indicator used for this purpose remains the analysis of the dynamics of economic growth more precisely the growth rate of real GDP. This is a convenient solution but loses sight of many important aspects of the modern and complex society in which we live. The growth of real GDP is not a relevant measure from the perspective of increasing social welfare. Economists have known and recognized this for a very long time, but that does not stop them from using real GDP dynamics as a convenient abbreviation, although deeply imperfect.

In theory, economists accept that GDP is not an ideal measure of progress within society. Critics point out that it includes the results of activities with negative connotations or resulting from negative developments, such as arms production or reconstruction after a natural disaster. Simon Kuznets, often referred to as the “father of GDP,” argued that advertising spending also should be excluded. In addition, GDP does not reflect the costs of externalities such as environment degradation. More and more representative voices today challenge the status of GDP as a benchmark for justified reasons related to neglecting the externalities of unbalanc2ed growth such as environmental costs, deepening unequal income distribution and wealth in most communities.

For all these are reasons, it is reasonable to believe that GDP growth tends to overestimate the overall progress of the society. But this is not the entire picture, because, on the other hand, GDP mainly includes activities that involve trading (on the market) at a specific price and therefore excludes important unpaid activities, such as caring for children or the elderly at home or volunteering. According with Diane Coyle, author of “GDP: A Brief but Affectionate History”, evidence from surveys of how people use their time suggests that if they were valued at market rates, these activities considered part of the “informal economy” would significantly increase the perceived size of the economy. Also, GDP does not accurately measure the benefits to consumers of creation and innovation, although they have a substantial positive impact on human well-being.

These concerns about the usefulness of GDP as an indicator of the success or failure of state policies have led to the emergence of several alternative approaches, not to replace GDP but for complementarity.

Since 1990, the United Nations has initiated the calculation of a human development index and an annual detailed analysis report on the subject. The Human Development Index (HDI) is based on the work of Nobel laureate economist Amartya Sen (1983), who states that what matters for economic and social development is people’s “capabilities” reflected by their skills and use of the resources available. According to him, not only conventional measures such as GDP per capita are relevant for capacity assessment, but also other more structural indicators such as income distribution, education, the acces to critical technologies and use of modern ones, health and longevity etc. This is why HDI include most of what was mentioned here. It also has the benefit that it allows to track progress over time for one country or to make comparisons. By the way, in 2019, Romania ranked 49th out of 189 countries and, at the same time, was one of the 66 countries with a very high level of human development (Norway ranks first).

Statistical institutes in many countries, such as the United Kingdom, Canada, and New Zealand, have also begun publishing quarterly sets of welfare statistics. In the case of New Zealand, these tools go so far that these tools can be calibrated differently by visitors to their dedicated websites, thus becoming interactive tools fully adapted to new digital technologies and the different information and evaluation needs of society. On the other hand, the Netherlands has been calculating a living conditions index since 1974.

Given the nature and complex implications of the topic, more recently some economists have argued that a whole “dashboard” of indicators for guiding government policy should be considered, rather than trying to combine each measure of interest into a single index. A key factor in this was the report of the Committee on Measuring Economic Performance and Social Progress, led by another Nobel laureate in economics, Joseph Stiglitz, which also included Amartya Sen, Jean-Paul Fitoussi and many other prestigious economists. Published in September 2009, the report has given new impetus to the international movement of academics, civil society, and governments to build and use indicators that reflect a broader view of well-being. The report emphasized the need to distinguish between current benefits of economic activities and long-term sustainability. It also concluded: “Since no single measure can sum up something as complex as the well-being of members of society, our measurement system must comprise several different measures.”

The report has been very influential and has led many international organizations and national statistical offices to develop more comprehensive approaches to measuring economics and well-being. An important example is the OECD’s Better Life Index, which is based on eight quality of life indices and three condition indices describing the current situation, and four dimensions of resources for maintaining or improving it in the future (including the need for environmental conservation). A similar approach is taken by Eurostat, the palette of indicators regarding the emergence of social welfare being much broader and more detailed. Better Life Index is a set of social indicators that measure what life is essentially like for individuals, in dimensions not reflected in a country’s GDP data, however it still omits some important aspects, such as equal treatment of minorities of any kind, the difficulty of taking cultural differences into account, as well as the difficulty of unanimously defining the concept of “life satisfaction.” Other researchers (for example Forgeard et al., 2011) also studied approaches to measuring well-being and concluded in support of the use of a broader range of indicators.

One key aspect of social welfare which caught a lot of attention related to the debate about measuring economic progress is the distribution of income. Especially since the publication of Thomas Piketty’s book “Capital in the 21st century”, the discussions about the efficiency of public policies are less focused on real GDP growth and more one income and wealth distribution, trying to reflect the proportion in which the benefits of economic growth are felt by different categories of people. The online database which accompanies the book offer arguments in support of the conclusion that there has been a sharp rise in income inequality in many countries since the 1980s.

The World Inequality Database shows the differences between the total income accumulated by people in the top 10% and that accumulated by people in the second half of the distribution. The data available here show that in Romania, the difference between the cumulative incomes of each of the two categories of people increased significantly between 1980 and 2019. This evolution is presented below at some critical moments during this period:

1990: top 10% = 25.68% vs. lower 50% = 27.09%

2000: top 10% = 37.57% vs. lower 50% = 19.18%

2007: top 10% = 45.04% vs. lower 50% = 14.17%

2019: top 10% = 41.46% vs. lower 50% = 15.14%

It is observed that income inequality increased dramatically immediately after 1990 and until 2007. Between 2007 and 2019, the situation improved, but not significantly. If we draw a parallel with the evolution of the same period in developed countries, we notice that things are not much different. At the same time, it is noticeable that the differences between rich and developing countries have decreased throughout the period. In most countries we analyzed, income inequality increased between 1990 and 2019. In developed market economies, inequality was already higher compared to Romania in 1990 and subsequently increased at a much slower rate. For Romania, the trend of increasing income inequality was faster immediately after the fall of the communist regime and until the onset of the global financial crisis (2007).

Many economists’ approach related to the effect of inequality on social welfare was influenced in part by John Rawls’s thesis on the “veil of ignorance.” This was one of the main theories developed by the famous American philosopher in his book A Theory of Justice (1971). He wondered what distribution someone would think was right if they could not anticipate what social category they would later fall into (whether chance and their own choices would lead them to a prosperous financial future or fail in poverty). Following this path of argument, he concluded that public policies should aim to maximize the income of the most disadvantaged people – the “maximin” principle. Rawls acknowledges that inequalities are natural and necessary in society but believes that some inequalities are just and others are not. According to his writings, just inequalities result from the work and own efforts of individuals. From this perspective, Rawls has a different approach compared to some libertarian philosophers (e.g., Robert Nozick, 1974) who argue that there are no unjust inequalities: life outcomes are decisively determined by people’s decisions and individual effort and its’ entirely up to them to achieve a better status. However, Rawls argues that random facts such as the place or family where somebody is born and the resources available to him or she during early years of life are sources of unfair inequality in society. Therefore, a just society should build mechanisms to correct this in an objectively and non-discriminatory manner. According to him, the decision-makers should make choices thinking from the perspective of the poorest members of the society, thus ensuring the best possible results for the most disadvantaged.

For several economists, this is considered to be a priority and more constructive than approaches aimed at penalizing the rich, especially in the context in which the gains generated by entrepreneurial ability, investment intelligence, acquisition through education and training of special skills, or simply hard work and honest work, are seen as a vital stimulus for growth.

I think this is one of the most constructive and valuable perspectives we can have, including in the current debate on policies to reduce income inequality centered on higher rates of high income (or high wealth) taxation. However, regardless of the solution adopted, it is evident that we must take social welfare into account when analyzing the economy’s evolution because today, as in the past, inequality maintains its growth trend. Moreover, in the modern world, the effects of inequality of opportunity between individuals in the competition of life are becoming more evident.

Also, from this perspective, the usefulness of GDP as an indicator for any purposes related to assessing the dynamics of the classical economy is undeniable. At the same time, however, the structural changes it has undergone in recent years, significantly accelerated by the pandemic crisis, as well as the need to reflect more on social welfare in the construction and evaluation of the effectiveness of government policies, force us to follow a whole set of complementary indicators.

 

 

*Leonardo Badea, Professor, Ph.D. is  Member of the Board and  Deputy Governor of the National Bank of Romania (BNR)

 

References:

 

Coyle, D. (2014). GDP: A Brief but Affectionate History, Princeton NJ and Woodstock, UK:Princeton University Press.

Forgeard, M. J., Jayawickreme, E., Kern, M. L., & Seligman, M. E. (2011). Doing the right thing: Measuring wellbeing for public policy. International Journal of Wellbeing, 1(1), 79-106.

Le Grand, J., Propper, C. and Smith, S., (2008) The Economics of Social Problems, London: Palgrave Macmillan, 4th edition.

Nozick, R. (1974). Anarchy, State, and Utopia. New York: Basic Books.

Piketty, T. (2013). Capital in the 21st Century. Cambridge, MA: President and Fellows, Harvard College.

Rawls, J. (1971). A Theory of Justice. Cambridge, Mass.: Harvard University Press.

Sen, A. (1983). Development: Which way now?. The economic journal, 93(372), 745-762.

Stiglitz, J. E., Sen, A., & Fitoussi, J. P. (2009). Report by the commission on the measurement of economic performance and social progress.

UNDP (United Nations Development Programme). (1990). Human development report 1990.

*** http://hdr.undp.org/en/composite/HDI

*** https://www.oecdbetterlifeindex.org/#/51111111111

*** https://wid.world/

 

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