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Will the Living Standards Framework replace budgetary analysis?

Published in The National Business Review (Auckland), 13 April 2018

According to Oscar Wilde’s play, Lady Windermere’s Fan (1892), “a cynic is a man who knows the price of everything and the value of nothing.”

This quip has since migrated to refer to the economics profession.

It tells us much about how economics is perceived. Not just as an overly technical, mathematical and calculating exercise but also as an amoral, or even immoral and downright cynical way of looking at the world.

Nothing seems to confirm such prejudices more than the way economists measure an economy’s output: GDP. And thus, moves away from GDP toward happiness, wellbeing or living standards are presented as a way of humanising economics. But are they really?

It is worth rehabilitating GDP. At its core, calculating national income has always been an attempt at measuring progress. It started with William Petty (1623-87), one of the first modern economists.

Petty tried to figure out the empirical relationships between economic development, a country’s wealth and the satisfaction of its people. If you like, it was a 17th century Living Standards Framework, which he called Political Arithmetick (sic).

After Petty, economists like Adam Smith, Thomas Malthus and Arthur Cecil Pigou all suggested how a nation’s wealth can be measured. Alfred Marshall (1842-1924), one father of neoclassical economics, later explained that economics “examines … the attainment and use of the material requisites of well-being” (emphasis added).

If you are familiar with the history of economics, you would never for a second believe economists were just a bunch of cynical number-crunchers. Economics was a moral endeavour to improve the lot of humankind. It was a subset of moral philosophy. Measuring national income and output were mere tools in this endeavour.

The profession’s focus did not change with the formalisation of national income as GDP, which happened in the 1930s. Even the economist most responsible for what is now known as GDP, Simon Kuznets (1901-85), was outspoken against the uncritical use of national income as a substitute for the welfare of a nation.

The discussions about the limits of GDP are therefore not new. They started with the person who gave us GDP. Mr Kuznets objected strongly, for example, to including government spending in measuring GDP because “the final goal of economic activity is provision of goods to consumers.” Governments, on the other hand, spent money on police, law enforcement and the military which had no direct value to consumers, necessary for society as they may be.

Economists have always known of the limitations of GDP and its predecessors as a measure of progress (more so than politicians). Economists nevertheless continue to use GDP not because it was flawless (which clearly it is not). They only realise that it is a useful shortcut to understanding and tracking economic activity as the condition of creating prosperity. And GDP correlates positively with most (if not all) of the things people care about such as health, education and the environment.

Which leads us to the government’s moves toward using the Treasury’s Living Standards Framework as a central focus of next year’s budget.

Because the Living Standards Framework is a way of saying there is a world outside not captured in pure GDP figures, it does not tell us anything new. Economists know of it, and good economists would not take GDP as the only measure of a country’s success.

We should take the minister and the Treasury’s declarations on moving beyond GDP with a grain of salt. There is more rhetoric than substance in such statements.

What is more worrying about the Living Standards Framework is that it could be interpreted as an alternative not to GDP but to budgetary analysis itself. Budget proposals should be evaluated on their net benefits, and cost benefit analysis is the key tool in the economists’ toolbox for this purpose. It requires identifying and comparing alternatives to pinpoint both worthwhile investment and waste.

The Treasury has a mainstream manual for doing such cost benefit analyses. The problem is not with the manual but with its application, or rather non-application. Cost benefit analyses consider all costs and benefits to those affected, even if intangible or unquantifiable. What could be broader? It already encompasses all the issues the Living Standards Framework purports to be about, making the latter redundant.

So the best thing the Living Standards Framework could do is complement a mainstream analysis by putting more structure around the discussion of intangible considerations. But it cannot substitute for it. That is because it provides no framework for choosing between various indicators when they conflict, as they will.

Many non-economists distrust cost benefit analyses because they know that things that can be quantified may not be the most important things. This is a valid criticism except it does not get you far. As prices can be observed but values are always implicit, we will always face the same problem under any other policy evaluation tool. To dismiss or discount cost benefit analysis because it uses price information is to throw the baby out with the bath water.

Perhaps the correct way of looking at economics would therefore be to regard the economist as a social scientist concerned so much about values that he or she does their best to price them.

The Treasury should do the same and clarify the relationship between its Living Standards Framework and mainstream cost benefit analysis.

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