The Economy: 3. Economic Growth and GDP

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Welcome to Understand the Economy, the show that cuts through the fog of financial jargon to the crisp, bright daylight of understanding the world around us.

Economics isn't just about money.

It's about how we live, whether we're using our resources to make the world a better place or to trash it, about who gets what and why.

Today we're going to explain growth.

What does it mean when we hear that the economy is growing?

Why does it stop growing?

And what does that mean for us?

And that GDP figure, what is that?

Maybe we should start with GDP.

It stands for gross domestic product, and it's an attempt to measure the size of the economy by adding up the total value of all the goods, for example a hairdryer and services, for example a haircut, produced in the country.

If we make more things, or the things we make are more valuable, then GDP gets bigger, and that's growth.

And for nearly a century, the standard way to measure the size of an economy has been to calculate gross domestic product, or GDP.

So how do we measure GDP right now in modern Britain?

Darren Morgan is the Director of Economic Statistics Production and Analysis at at the Office for National Statistics.

And he told me how they calculate GDP.

So the first way we do it is the production approach.

How much is produced?

So for example, how many cars roll off the production lines?

How many operations are being done?

How many advice lawyers are giving or architects?

It's the full spectrum in terms of goods and services being produced in the economy.

So for example, a car manufacturer will use a large number of parts to make a car.

And what we do in terms of those parts, we subtract the value of those parts that are making up that car, because if we didn't, we would have already collected information on when those parts were made by another business,

and then we would also count it again when we measure the value of the car that's leaving the production line.

We make sure anything that's being used up in that production process, we subtract to make sure that we don't double count.

The second way we measure GDP is how much money is being spent.

So that's households spending money in shops perhaps, businesses investing in the future, and how much government is spending on public services.

And the third way we measure GDP is how much income is being generated.

So this is wages, the households, profits made by businesses, and the tax take by government.

And it's whether we are measuring it by how much has been produced, how much is being spent, or how much income is being generated, all three have to add up to the same number.

Why did we start to measure the economy in the first place?

We're very used to talking about the economy, saying the economy is struggling or the economy is growing.

For much of history, though, none of those words and phrases would have made any sense.

Dr.

Victoria Bateman, an economic historian at the University of Cambridge, explains that it all started because someone fancied starting a war.

So in the 1660s, King Charles II is war-hungry.

He's thinking of launching attacks on the Dutch fleet.

But to do so, he has to work out whether he can afford the ships and the cannons and the other weapons that are required.

So along comes William Petty.

And he is a man with many hats.

He's a medic, he's a landowner, and he's also an economist.

And he's tasked with estimating how much more the king can, in a sense, afford to spend on war, afford to spend on things like ships and cannons.

And so William Petty sets about estimating how much people are earning in the economy in order to see whether people can bear the extra taxes that the king would need to charge in order to pay for his expensive ships and his many, many cannons.

And then, as we approach the early 20th century, we have a new set of wars being raged.

World War I, World War II is coming up soon.

And in between those, we have the Great Depression.

And that creates a second impetus to measure what's happening in the economy.

Because what's different about the wartime economy is this is, in a sense, an economy under the control of government.

So, whereas before the war, you had factories making everything from clothing to biscuits,

those factories are now turned to the war effort.

They're churning out tanks, they're churning out guns.

So, there's less food and clothing production.

So, by trying to measure the economy, economists can then advise government in terms of what rationing is needed in order to ensure that spending is in line with the available goods and services.

Victoria Bateman.

So, governments have tried to estimate the size of the economy in an attempt to figure out how much tax they might be able to levy and how many weapons could be produced, but also to understand whether the economy was malfunctioning and whether some kind of policy change might help.

Dimitri Zengelis is an economist who co-founded the Wealth Economy Project at the University of Cambridge.

They look into ways of measuring wealth that take into account social and natural resources.

Dimitri, governments don't need to set rations at the moment.

So what do they do with this number today?

What do they learn from measuring GDP?

Well, so in the longer term, what governments tend to want to do is show that they can expand GDP because they think it's a good thing.

More people earning more, making more things.

And therefore, you know, you can showcase how good you've been at improving people's incomes relative to what they were in the past and perhaps relative to other countries so you have a sort of comparative uh you know beauty contest of performance in gdp the problem is that gdp isn't all that people care about they care about other things too in the shorter run you can actually get a sense of you know it's a gauge if you like it's a finger on the pulse of how the economy is doing so if you're worried that there might be a recession and you get some alarming numbers about you know factory production going down or people earning less and less, that might tell you something about what your policy response should be in order to try and preempt both a decline in incomes and perhaps more worryingly, a rise in unemployment.

I think the received wisdom is that governments are trying to make the economy grow, and if the economy grows, that's good.

Is it always good?

No, it's not always good.

If your growth is generated through activities which are unsustainable, such as depleting and running down your environment, that's not good both because we care about the environment and because the environment is a crucial source of future growth so that's one of the problems

it's also got some quirks in it in that it can actually reflect things which you really don't want so if you have unemployed resources unemployed people and buildings and factories sitting around which are underused one way you can generate gdp is to have a little war or you might just happen to have an earthquake, as was the case in Kobe in Japan in the mid-1990s.

That generates a lot of activity in reconstruction and rebuilding, which generates GDP.

But nobody in their right mind would say that, well, that's a good idea.

Why don't we improve growth by

starting triggering wars and earthquakes?

So you want a dashboard of indicators to allow you to take an informed view not only on the level of where things are, but but how they are changing and how you can compare them with other societies.

So think yourself back to your old job.

I know you used to be head of forecasting at the Treasury, that you're in the Treasury and you forecast that there's a recession coming.

The recession is, as you know,

growth is going backwards.

Growth is negative.

The economy is going to get smaller.

If that looks like it's going to happen,

governments presumably want to prevent that.

What can they do to prevent a short-term fall in growth, a recession?

So one of the things that's really important to be clear about, even though income, expenditure, consumption are things that we all understand as individuals or as households, is that economies don't behave like households.

You have this very strange effect, for example, called the paradox of thrift.

What does that mean?

It means that if people start getting a bit gloomy and despondent and they worry about their incomes next year, they will start to spend less.

If they spend less, shops will start to make fewer retailers and manufacturers will see their profits go down.

If their profits go down, they might start, they might stop hiring workers and they might even sack some workers.

So unemployment goes up.

If unemployment goes up, people

start to spend less and banks don't want to extend lending because they're worried they won't get their money paid back.

When you get all of this happening simultaneously, you can get this multiplying, reinforced, negative feedback.

which very quickly generates a recession.

So what can government do about it?

Well, it can do a number of things, but foremost amongst this is it can offset that change in private spending and activity by spending a little bit more itself relative to what it taxes.

It does that by borrowing, but it's a good idea for the public sector to borrow to provide jobs and activity and consumption and production when the private sector is not.

The other thing

that is an important

qualification.

It's not that the government borrowing to spend money always improves growth.

It's specifically when the private sector is slack, when the economy is underperforming, the government can take up that slack.

Indeed, and therefore,

the reverse is also true.

Sometimes the private sector can become overconfident, spend more than the economy's capacity to produce.

That feeds into inflation.

And there's a strong argument for the government to take out some of that activity by maybe taxing more than it spends.

So that's absolutely right.

It's about fine-tuning that balance between public spending and public taxation in order to offset as best you can some of the changes and volatility and activity of the private sector.

Why might cutting taxes actually boost growth and why might it fail to do so?

Right, so cutting taxes can, in certain circumstances, boost growth.

Let's take corporation tax.

You know, if you want to attract investment, if you want a firm to build a factory and employ jobs in your country, taxing them less is likely to make that more attractive as a proposition.

And corporation tax is a tax levied on profits.

You're basically saying if you make money, you keep more of it.

You keep more of the money.

That's right.

Now there's a problem here, however.

Nobody in their right mind taxes just for the hell of it.

Well, some might, but you know, the reason most governments tax is often to provide services which are also very important in generating growth and activity.

So for example, to stick with the

example of a firm firm wanting to invest in a factory in the UK, that same firm will want to invest in a country that's got good infrastructure, that's connected,

railways, broadband connections, and a workforce that's highly skilled and educated.

All of that requires public spending, and that public spending has got to come out of something.

It either comes out of taxes or it comes out of borrowing, and it can't all come out of borrowing.

So, you know, the government has a balancing act in which to think about how much it taxes whilst keeping people and businesses in sort of productive activity.

And should I gather from this example then that cutting some taxes is more likely to boost growth than cutting certain other taxes?

Aaron Powell.

income taxes, if the government reduces taxes from a relatively low level, you might decide that you can make the same amount in terms of take-home pay by working a little bit less because taxes are a bit lower.

And that's not good for GDP.

What you're saying then is you can cut taxes and use that to encourage people to work more and boost GDP or you could cut taxes and people will work less and GDP will fall and it all depends on the situation, what's being taxed, what the rate of tax is and so there's no hard or fast rule that just says cutting taxes is good for growth or bad growth.

That's right.

And it matters what the starting point is and what the particular tax is.

Dimitri Zengelis, thank you.

So GDP is a measure of the value of everything being produced in the economy.

But it's a measure that leaves a lot out, from unpaid domestic work to the beauty of our poetry.

But enough of that tree hugging, get your red braces and your pinstripe suit, because next episode we'll be covering markets.

We'll explain bonds, guilts, stocks, and shares.

Until then, you can find more episodes of Understand the Economy on BBC Sounds.

Understand the Economy was presented by me, Tim Harford, and produced by Phoebe Keene.

The researchers were Drew Hindman and Mariana Brain.

The editor was Claire Fordham and it was mixed by Gareth Jones and Nigel Appleton.

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