A new approach to measuring the economy
In simple economic terms, Ed Milliband’s pledge to freeze energy bills is daft. Politically, however, this promise is astute. It parks Labour’s tanks on the important electoral battle-ground which the cost of living is likely to become.
Milliband has identified a critically-important anomaly. How can it be that, whilst the economy of the country is improving, the prosperity of its people is not? And, for that matter, what, exactly, is prosperity?
Obviously, prosperity isn’t simply a matter of money, but of what it can buy. On the basis of simple mathematics, the average wage earner is worse off today than he was in 2007. Over the last five years, average wages have increased by 10% whilst the cost of living, measured using CPI, has risen by 17%. The average worker is slightly better off over a ten-year period, though, because the increase in wages (of 36%) has exceeded CPI inflation (29%).
This simple calculation, of course, poses more questions than it answers, not least because it takes no account of debt, of taxation or of the cost of essential purchases. Since 2002, the costs of gas (+179%), electricity (+108%), water (+68%), council tax (+49%) and food (+43%) have all out-grown the 36% increase in wages.
Even the most orthodox economist would concede that GDP (gross domestic product) is a very unsatisfactory measure of prosperity. Being a measure of ‘flow’ rather than ‘stock’, it ignores items such as increases or decreases in debt or in natural resources.
But it has serious shortcomings even as a measure of flow. If the government employed large numbers of people simply digging holes, and equally large numbers following them around and filling the holes in again, recorded GDP would increase. If a river is polluted by an industrial accident, the resulting clean-up boosts GDP. Recorded output would benefit, too, if a crime-wave prompted the government to employ more policemen.
If the logic of GDP is followed to the letter, then, a country can increase its prosperity by creating useless make-work schemes, polluting its environment and encouraging crime. Prosperity can also be created by reckless borrowing (since this is not counted in GDP). Put this way, the conventional, GDP-based measure of prosperity is a nonsense.
Adjustment for changes in economy-wide prices – measured using the GDP deflator – introduces yet further complications. Between 2002 and 2012, the nominal value of British GDP increased by 46%, corresponding to real growth of 16% after adjustment for aggregate inflation of 26%, or 2.3% per year. But, given the soaring cost of essentials – which rose by 62% over the same period – how valid is that calculation of the change in the general level of costs?
Obviously, a new approach is needed, and this must begin with a definition of prosperity. My definition, which begins at the level of the individual or household, is this – prosperity is a function of incomes after the deduction of essential outgoings.
The outgoings of the individual or household can be divided into two categories. One of these is “non-discretionary”, comprising essential spending over which the individual has little or no choice. Food and water are obvious examples. The remainder is “discretionary” spending capability, being purchasing power that the individual can spend as he or she chooses.
According to this definition, a person whose income rises does not necessarily become more prosperous. Rather, what really determines prosperity is the difference between income on the one hand and essential spending on the other. As a definition, “prosperity increases when incomes out-perform the costs of essentials such that the scope for discretionary spending improves”.
Unlike conventional analysis, surplus energy economics is consistent with this logic. The costs of most essential purchases – including fuel, power, food and water – are linked very strongly to energy costs. If energy costs rise, then, the cost of essentials rises too.
In 2002, the average British wage would have purchased 1,076 barrels of oil at the prevailing price. By 2012, that figure had slumped to just 328 barrels. A reduced rate-of-exchange between incomes and primary energy necessarily means that the cost of the most energy-intensive purchases must out-grow incomes, and that is exactly what has happened.
Here’s a final thought. Discretionary income – that is, income net of essentials – doesn’t just measure the prosperity of the individual. It also measures, for the economy as a whole, our capability to save and to invest. This is a very good reason why measurement of the economy based on the cost of energy is so important.