Key Performance Indicators for an Economy

 

GDP

National Income is a metric of the flow of money in an economy represented by its goods, services, and wealth in a given period of time. It is essentially the same as National Output and National Expenditure, and is sometimes used as equivalent to Gross National Product (GNP.)

In most economic discussions, GNP is adjusted twice. Firstly, economists tend to strip out net income earned abroad from GNP. This gives a figure for Gross Domestic Product. This is useful for economic studies because it focuses the analyst on what is going on within the economy. Secondly, economists usually adjust the nominal, ‘raw’ GDP figure for price changes, which leaves ‘real GDP’ as the key figure.[1]

Change in Real GDP is therefore the most used and important indicator economists use. It tells the examiner about growth and allows for assumptions about the economic cycle.

Real GDP tells economists about the accumulated flow of money around an economy but it does not really give an indicator of the relevance of the national wealth to the population. A small country with a moderate GDP is in a better position in many ways, for instance, than a country with a large population which has what seems to be a high GDP. This means that many economists find Real GDP per Capita (Real GDP divided by population) as a more useful metric than GDP itself.

Equally, GDP figures are based on taxation and legal surveys. A country with a large illegal ‘shadow’ economy has of course more income and wealth in it than the official figures would suggest. GDP figures are also not representative of purchasing power parity when compared between countries, and so any comparison based on an exchange rate of currency has to be dealt with carefully. Finally, comparisons of GDP over time can be made but become more difficult as the time period is extended. This is because of different social structures, expectations, and outcomes over time, and is a more complicated version of the problem that arises when income inequality or comparisons between countries are taken into account.

The Price Level, Inflation, Deflation, and Disinflation

The ability to calculate the price level is essential to the economy. The price level represents the average price of goods and services in the economy. In the UK, the Consumer Price Index is used to measure the level of the most popular consumer items. It is calculated by a central exercise every month in which the Office of National Statistics asks some 20,000 consumer outlets for the price of a representative ‘basket’ of 700 goods. The basket is regularly checked for how representative an item is—for instance, there is no sense in tracking goods that are obsolete or out of fashion, or not tracking items which people are buying. Within the basket, each item is given a weighting which reflects the importance of that good to consumers. So, if, for instance, consumers spend on average 5% of their income on clothing, the weighting of clothing is 0.05. A 10% change in clothing prices will therefore result in a (10*0.05) .5% change to the price index.

CPI is calculated as a geometric mean and, sometimes, housing costs like council taxes and mortgages or rents are added to it, giving a CPIH figure (the H is for Housing costs). This is different from an older calculation, which looked at households rather than individual consumers call the Retail Price Index. The RPI was also calculated using a weighted basket of goods and services, but did not cover all consumers, or tourists, and was generated as an arithmetic mean. This made it (usually) higher than the CPI, and not always as reliable. Sometimes, housing costs were added to it to make RPIX, and, occasionally, attempts were made to exclude taxes from it too. From 2021, the Office of National Statistics does not use RPI, but HM Government and the Courts do, for a few calculations.

There are other measures of the price level, but these are usually much narrower and much more a tool for analysts in addition to the CPI. These include producer price indexes and House Price Indexes.

It is important to remember that, when politicians and economists talk of deflation and disinflation, or use terms such as ‘reflationary policy’ or ‘deflationary policy’ they have specific meanings. For instance, deflation means a fall in average prices and is usually a bad thing. If an economy was in trouble, with unemployment rising and GDP falling, a fall in the price level might occur because consumer demand fell, and because stores went for permanent sales and ‘dumping stock’ to achieve revenue maximisation at cost or below cost prices. This is not a good thing.

Disinflation, on the other hand, refers to a situation where the CPI is low or falling compared to previous levels, but still positive. It tends to occur when new technology or economic growth, or lower energy or food prices, or global trade gains, lower costs for producers, even though consumers feel richer and therefore spend more.

Deflationary Policies are not connected with the price level directly. Rather, they seek to lower Aggregate Demand to take inflationary pressure out of the system. Similarly, Reflationary Policies exist to try to raise AD at times of depression or recession when Demand has declined or suffered a shock.

Unemployment, Employment Levels, and Patterns of Employment.

Not having a job is an obvious normal definition of being unemployed. In economics, there are several metrics. The two most important ones are The Claimant Count and the Labour Force Survey (sometimes known as the ILO measure.)[2] The first metric counts the number of people taking unemployment benefits. This is flawed since not all people do, or can, because of savings or background. The ILO measure surveys a representative sample of the workforce every three months. The sample is normally composed of around 85,000 people from an economy, and the standard to define unemployment is that they have been out of work for four weeks and are seeking, and able to commit to, work within the next two weeks.

Two separate metrics are the number of people in jobs, known as the employment level, and the number of job vacancies.  Taken together with the Unemployment measure, they give a good indication of the direction of the economy, the size of structural unemployment, and any indications of technological or frictional unemployment. Unemployment measures are seasonally adjusted and lagged so they should not be relied on as a ‘snapshot’ of the economy right now, but rather, of what was happening several months ago, and of the direction of growth.

There is also a problem in economies when counting the illegal economy (or the Shadow economy), which means that unemployment is often an estimate. In addition, underemployment, when people are working jobs that do not reflect or pay for their abilities, or part-time, and regional unemployment are problems in unemployment figures. This means that figures can vary, wildly; the United States has six official measures of unemployment (from U1 to U6) and they are often separated by ten to fifteen percentage points.

If the ILO measure and the Claimant Count are very similar, this is a bad sign that unemployment is widespread throughout the economy and that there is little frictional unemployment. It normally suggests that a deep cyclical downturn is in progress.

Investment levels and the relationship between capital investment and national output.

Equality

Economics is a social science which does not often acknowledge the normative nature of some of its assumptions and explanations. Most observers, and many critics of ‘mainstream economics’ would suggest that economists should develop a measure that explains what it is like to live within an economy, and whether an economy works for the people within it. A picture of this could be compiled, as detailed below, from measures like a compounded ‘happiness index,’ a ‘misery index,’ and by non-quantitative opinion polls. Growth, jobs, steady inflation, low real interest rates, social mobility, and stable home ownership as well as stable population growth and the empowerment of women are also measures.

Two key indicators of the health of an economy, however, are the distribution of wealth and the distribution of income. These are normally measured by the same tools—Lorenz Curves, Gini Coefficients, and Quintile or Decile Analysis.

Wealth and income are different things. Wealth is a stock and represents the accumulated fixed assets of an economy. It is not liquid, and can be borrowed against or shared in ownership. The role of land, buildings, and property rights in an economy is very much conditioned by the law and culture of the country, but no economist would question its importance. If one group, individual, or group of companies or people own the vast majority of the wealth, it is very difficult for those who have none to achieve social mobility, to gain property of their own, or to escape debt.

Income is a flow and is best represented by money, though digital alternatives which function like money are emerging. Income in kind is a term for being paid in commodities, just as barter and service exchanges can represent a kind of income. Economists just tend to estimate the money value of these things.

People can be wealth-rich and income poor, and live from rents and borrowing against assets, or occasional sales (like British aristocrats in the later twentieth century, who owned great palaces but who had little income in many cases.) Similarly, a worker in a financial centre who had a high income but didn’t own their flat or save their money would be income rich and wealth poor.

Lorenz curves plot the income or wealth of all households on a cumulative basis against a ‘line of equality.’ This line shows what would happen if everyone had equal wealth and income; fifty per cent of the households would own fifty per cent of the wealth or income and so on. A second line, showing the real distribution is then drawn onto the graph. The bigger the area between the real distribution and the line of equality, the bigger the gaps between rich and poor. A Gini Coefficient can then be calculated, in which the area between the lines in A, the area between the lower line and the axes is B, and the coefficient is A/(A+B). If the Coefficient is 0, absolute equality reigns; if the Coefficient is 1, there is absolute inequality. Most developed economies come in around 0.3.

Quintile and Decile analysis are the same sort of thing. Quintile analysis ranks incomes between highest and lowest, and then divides the population into five equal groups of 20% each. By looking at the share of income the bottom 20% of the population have, and what share the top 20% have, and the gap between them, an economist can get a sense of inequality. Decile analysis does the same thing, but with 10% bands.

Inequality tends to hold societies back. It creates externalities in health, crime, and pollution, encourages the bulk of the population to buy inferior goods, makes it difficult to accumulate and spread capital across society, depresses middle- and working-class investment, and encourages debt rather than savings.[3] Unequal societies also tend to be ones associated with monopolies and oligopolies based on vast economies of scale, low quality products, or labour exploitation because, once established, no one can compete except other large companies and individuals.

Levels of Debt

Economists are concerned with different sorts of debt. National Debt is the stock of debt owed by all government bodies, including local and regional governments, as well as the national one. It is usually raised by selling bonds to market entities like banks and pension funds. The important figures are not just the level of the debt alone, and the interest owed on it, but the ratio of National Debt to GDP.

If the market believes that governments are not exercising discipline over budgets and that they will cause inflation, or that they are relying on rolling forward debt rather than balancing budgets, markets will demand a high interest rate on the government bonds.

Markets might also drop the currency, and remove capital from the country. All of these actions could in theory cause a balance of payments crisis or a budget crisis in which living standards dropped and the options available to government became very limited.

National debt or ‘public sector debt’ is therefore a major problem for governments. The interest on the debt alone, even at low levels, is often a problem—in the UK, for instance, interest payments on the national debt are currently running at levels equivalent to all spending on the police or education. Very few countries have ever run large national debts, and persistent budget deficits (different things) and not suffered a large fall in living standards and pressure to raise taxes and cut spending. Worse, if Government is borrowing from the markets, banks and individuals will find that the interest rate on private debt rises because of crowding out. In this process, the amounts of money available for the private sector decline, leading to the remaining money becoming more expensive to borrow—‘crowded out.’

In western societies, and the UK and USA in particular, private debt is both a response to, and a cause of, inequality. Mortgage debt, which is taken out to purchase housing, is very vulnerable to interest rate rises and, if restricted to those with existing money, tends to concentrate property in few hands whilst excluding the young and poor, who are forced into rental or emigration. Student debt is a serious cause of malinvestment and restricted growth in the USA, and increasingly in the UK.

The US and UK have also developed a ‘precariat’ of people on previously good salaries in professional jobs who, without credit, overdrafts, or loans, would be within a matter of months of homelessness. This in turn would increase the burden on the state and represent a waste of resources and underemployment. There is substantial evidence that private debt also fuels consumption of imports and an overreliance on service industries.

There are great benefits to a flexible system of debt based on public and private borrowing, not least of which is a tendency of the availability of debt initially to allow people to try to ‘even the playing field’ of life by allowing for property purchases and higher education. If the debt is not repaid by higher future earnings, and accompanied by gains in productivity, however, it becomes a social constraint which eventually starts to choke off innovation, mobility, and enterprise, to drive up interest rates, and to impoverish society.

Other Economic Metrics

Economists can use other metrics to assess levels of national income and the health or direction of economies. Some of them are tied to the indicators above. Terms of Trade, for instance, measure the ability of a country’s exports by value to pay for its imports. They are defined by an index of output prices over an index of import prices over time. It used to be thought that, if a country invested in service industries over industrial ones, or industrial ones over agricultural ones, its productivity would rise. This would mean that it earned more from its exports, which would improve in competitiveness against other countries, and therefore that its terms of trade would improve. There is now dispute over this idea.

 

Saving, Levels of Saving, and the Ratio of Savings to Household Disposable Income are usually seen as important things. This is because savings are translated into investment by functioning financial institutions. Investment is by definition a sustained addition to Long-run Aggregate Supply which allows for more GDP, disinflation, and higher living standards. This process leads to improvements in the terms of trade if capital gains become productivity gains. Societies which prioritise saving also tend to be less prone to demand-pull inflation because household saving is ‘negative consumption,’ and they are also able to cope with health or employment shocks, or the need to provide pensions in the future, more easily in theory than those societies which do not prioritise saving.  

There is a quirk of societies like the USA, the UK and Australia, which is that savings tend to increase during bad times and to be run down during odd ones. Large parts of the world, including many EU societies, can be said to take the opposite approach, and to save during good times, which is more logical. Societies with high levels of household saving are also less prone to dependence on credit, and less unequal.

Exchange rates, whether adjusted for Purchasing Power Parity or not, are rarely used as a metric of economic health or analysis. If they are fixed, pressures on the exchange rate have implications for fiscal or monetary policy, and if they are floating, they are not central to the economy but reflect other things, like trade, the balance of payments, or overall foreign investment. They become very important if a country has a structural deficit in the balance of trade because of an inelastic demand for imports, or if it owes other countries or international banks money in a foreign currency. Similarly, the components of the Balance of Payments—the current account, or Balance of Trade, and the financial and capital accounts—tend to show the effects of policies or other factors, rather than to be causes of issues.

Wider Measures: The Human Poverty Index, the Human Development Index

The United Nations, and various bodies interested in international development, often prefer an HDI over GDP as an initial marker. HDI is an indicator of human development. It multiplies three indexes-- life expectancy, income, and years of schooling (real and expected)—and then finds the geometric mean. This figure is then used to compare societies. An HPI uses education indices, nutrition and child mortality, and a number of ‘deprivation factors’ relating to things like access to clean water, sanitation, housing, and media, to generate a figure for a society. Both HDI and HPI are very valid figures, but neither can be generated for all societies yet as they rely on efficient and rigorous data collection.

 

 

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[1] Remember, anything with ‘real’ in front of it in economics has been adjusted for inflation. The best alternative example is maybe real interest rates. These are nominal interest rates minus inflation; for instance, 5% interest rate with a 3% inflation rate leaves a (5-3) 2% real interest rate. This is useful with GDP because anyone can make it look as though GDP has grown by simply printing more money or raising prices. In real terms, however, this is worse than useless, so the ‘real’ figure is used.

[2] The ILO is the International Labour Organisation, based in Geneva, Switzerland. All EU members use the ILO measure.

[3] Poorer people cannot afford cleaner technologies or lifestyles and may, if their own life is shortened by poverty, not see the point of them anyway. Unequal societies also tend to have lower average life expectancies, which is a waste of human resources, more dependency, and, by definition, less social mobility. This then places an emphasis on productivity through lower wages and costs, rather than the improvement of output, leading to a decline in efficiency, exports, and competitiveness. A ‘vicious circle’ then emerges in which people and economies become too poor to break out of poverty whilst a small group of rich people and companies disassociate themselves from the society and tax revenues.