Economic Trends & Insights

How Do We Know If An Economy Is Doing Well?

Economic and financial news and analysis often talks as if we can know for sure how well an economy is doing.

Gunnar Jaerv   Gunnar Jaerv · Published on 10 June 2021
   

We hear about growth, contraction, setbacks and upswings. The markets move, or the currency dips. But how useful are the kinds of indicators we hear about on the news? What do economists and financial advisers use to judge the health of an economy?

We also need to drill down even deeper than that and ask what we mean by a flourishing economy, what we’re really measuring and what we mean when we talk about an economy.

This series will introduce and discuss key economic indicators, including an overview of how we assess the economic wellbeing of countries and economic sectors. In the second part of the series, we’ll turn our attention to how we assess the performance of individual organizations, where the rules and the metrics used are different; despite the talk you sometimes hear from politicians, businesses and countries operate on very different rules.

Finally, in the third installment of the series, we’ll turn our attention to the digital assets space and attempt to figure out how we judge the wellbeing of an economy that spreads far beyond national borders, has relatively few conventional companies, and serves as a financial hub for other economic sectors. How can we figure out whether Ethereum is thriving, for instance? Do we need to look at it more like a business, or more like a country? Is there a toolset you can use to gauge the health of a platform, ecosystem, currency or application?

We’ll start at the beginning, with conventional national economies.

Judging the health of an economy: methods and challenges

Ever since the idea of an economy outgrew the “king’s coffers” view of the middle ages, we’ve been looking for ways to understand how the economy as a whole is faring. Typically, a healthy economy has three characteristics:

Growth

US Economic Growth

Here, you can see US economic growth, measured in percentage change in GDP (see below) from the same time last year. The drop in real GDP immediately following the subprime mortgage crisis is clearly visible.

High employment

High employment

Healthy economies are characterised by high employment: low unemployment amongst labour force participants, and high labour force participation with few chronically ill, permanently unemployed or under-skilled inhabitants.

This chart shows the US unemployment rate, segregated by educational attainment. Again, the sharp rise in unemployment following the 2008 crash can be seen, tracking inversely with growth and affecting every level of educational attainment, though some more severely than others.

Price stability

Price Stability

This graph of commercial real estate prices from 2000 to 2016 shows the effects on asset prices of issues in the wider economy. Once more the 2008 crash shows up clearly.

Unemployment, GDP and asset prices show similar trends and affect each other; falling asset prices impoverish businesses which contract, laying off workers whose reduced spending power suppresses aggregate demand.

So for national economies, the pitfalls are sluggish growth, high unemployment and inflation or unstable prices, especially in basics and store-of-value assets. A healthy economy has high single-figure growth, low single-figure unemployment and low single-figure inflation. If you want to see what an unhealthy economy looks like, take the case of the 1970s USA, where it was discovered that you could have both sluggish, barely-there growth and runaway inflation: “stagflation”.

Inflation and Unemployment

Economic growth is usually measured using GDP — Gross Domestic Product. Employment is simply measured using the unemployment statistics; in advanced economies, social safety nets and unemployment benefits also provide a measure of jobless numbers.

Price stability is more complex, but the consumer price index, commodity costs of key goods like grains, and asset prices, especially of illiquid assets or stores of value like land and gold, can offer good guides.

The Soviet Union, for instance, made attempts to conceal from the West the parlous state of its sclerotic command economy; but in fact its obligation to buy American grain surpluses forced it into revealing the real situation.

Within modern economies, consumer-level assets like house prices matter significantly more than they used to since they are the foundation of personal financial stability and hence of aggregate buying power.

National economies and the global economy usually operate on a cycle referred to as the “business cycle,” lasting around four years and involving phases of prosperity, recession and recovery, with an occasional fourth phase — depression — which is usually avoided unless there are serious structural problems with the economy.

Finally, there’s the question of the national debt. This is often used as a guideline for general economic health: a country with low national debt is doing well, while a country whose national debt is multiple times GDP is in trouble.

US Total Public Debt vs GDP

This graphic shows US public debt vs GDP from 1995 to 2020; the effect of the 2008 crash is visible, as is the sharper and more prolonged downward adjustment in GDP arising from the Coronavirus pandemic.

However, these metrics can be simplistic and misleading.

GDP: simply misleading

GDP is the most common bellwether metric for an economy: if GDP is high, that economy is wealthy; if GDP growth is high (and when people say “growth”, this is what they mean), that economy is healthy.

But because it’s so simplistic and because of the way it’s arrived at in the first place, GDP can be misleading.

Economic Avtivity

GDP measures transactions. That makes it a less accurate measure of economic activity as a nation becomes more advanced, service-oriented and financialized. If the only economic activity in a country is the buying and selling of potatoes and sheet steel, we can safely say that a 10% increase in GDP means more potatoes and sheet steel have changed hands; economic activity has increased.

But GDP doesn’t measure several crucial components of economic health. It doesn’t measure illegal transactions, which in some cases, for various reasons, can make up quite a high proportion of a country’s commerce (sometimes for quite anodyne reasons; think of all the transactions that are illegal in North Korea, for instance).

And it doesn’t measure second-hand transactions. A thriving trade in already-built houses and cars doesn’t show up in GDP figures, even though this is important economic activity in people’s actual lives and tells us quite a lot about how much people are spending on cars and houses.

What GDP does not tell us

GDP can be quite inaccurate, leaving out important aspects of an economy. Furthermore, it becomes a less reliable guide the more a society relies on service and financial industries. Suppose you put up a $100,000 deed as collateral on a $200,000 loan, use the loan to invest in stocks worth $200,000 but which generate a 5% return the same year, then repay the loan, all in the same year. You made $10,000, the broker made their fees, and $200,000 of stock changed hands. But this series of transactions added over $600,000 to the GDP, because of the number of transactions involved. (The transactions are unrealistic, but they serve to make the point.)

When more complex financial transactions take place frequently, or when a lot of economic activity consists of moving debts around, GDP can be inflated and give a false impression of the underlying health of the economy.

Debt: it depends who owes who

Debt as an indicator of economic health is potentially misleading. At first glance, national debt-to-GDP ratio is a fairly clear indicator of how well a country’s economy is doing: in the words of NewsWeek’s Lauren Giella, it “indicates how strong a country’s economy is and gauges how likely it is to pay off its debts”.

But that’s not entirely accurate. Here’s US national debt held by the public from 1900 to 2040 (projected), as a proportion of GDP:

Federal Debt

As you can see, it’s projected to rise sharply, though that projection may not come to pass. And debt has been very high before, notably in WWII when it was accompanied by an unprecedented rise in GDP.

Even now, when it doesn’t appear to be funding an economic boom, debt may not be the problem some think it is. The Congressional Budget Office observes that

"

“the debt-to-GDP ratio has no set tipping point at which a crisis becomes likely or imminent; nor is there an identifiable set point at which interest costs as a percentage of GDP become unsustainable”.

National debt isn’t a good indicator of economic health partly because governments borrow in their own currencies, and partly because national money supply arises out of mutual promises to pay between borrowers and lenders.

Focusing on reducing national debt can strangle economic growth, reducing a country’s capacity to service its existing debt and upending the relationship between debt and productivity; it can be like a person who eats less to save money, only to find himself too weak to work.

Government debt isn’t like individual debt because when governments can’t pay, it quickly turns out that the creditor is the national population. A government whose promise to pay is no longer honoured is an economic catastrophe not because it can’t pay other governments, or banks, but because it can’t meet its infrastructure, wage and entitlement obligations to its own people.

But there’s another reason that debt isn’t a great economic indicator in and of itself, and this doesn’t rely on being a sovereign nation borrowing in your own currency. Many countries fuelled stratospheric growth through debt — just look at the relationship between debt and GDP in the USA in World War II.

Impact of WWII

And many companies did too. Some debt-fuelled companies ultimately turned out to be boondoggles, but many more went on to become the businesses that now define our landscapes. Growing fast based on debt is essentially what companies do, and the modern startup process is the same thing but faster.

Productivity

Productivity is a measure of the quantity of goods and services an economy, sector, business or individual worker produces. It’s a common measure of the long-term health of an economy; for instance, the German economy is more productive than the British and has been for many years. Productivity can be measured in several ways; the simplest is:

Productivity =GDP
_____________________
Worker Numbers

In other words, how much productive work does each worker do?

This gives a crucial measure of the health and competitiveness of an economy, regardless of its size. As a rule, what you’re looking for is high per-worker productivity especially in key economic sectors. You’d also want to see high per-worker-hour productivity, which measures how much each working hour generates; this helps clarify whether an economy is highly productive or just working extremely (and perhaps unsustainably) hard.

Working hours vs Labor productivity

Here, we can see that longer working hours and higher per-worker-hour productivity don’t have a completely clear relationship. Working more, or working less, doesn’t always result in higher productivity.

Additionally, high aggregate productivity can conceal differences in per-worker-hour productivity in the same way that calculating mean incomes can elude income inequality.

Generally, well-educated, politically stable countries have the highest per-worker-hour productivity across their economies even if the size of their economy can’t compete with behemoths like the USA or China. And generally, well-tooled, up-to-date sectors or nations with high investment in new plant management techniques and R&D will have higher per-worker-hour productivity.

Judging the health of an individual sector

Everything we’ve said about the wider economy applies, with some caveats, to individual companies. Governments don’t have to check whether they have enough money in the bank before they decide to spend, because they own the bank that prints the money. Businesses don’t own their own banks, but they can spend money they don’t have as well, by convincing investors that their spending decisions are wise and will result in profits.

These companies grew rapidly backed by venture capital (debt, in other words) and eventually became profitable enterprises that richly rewarded their investors, then and now:

VC Backed Exits

However, this isn’t always the case. Consider WeWork, whose valuation has fallen from $47 billion in 2019 to just $9 billion now; driven by venture capital and projected income, the company never made a real profit.

Businesses and sectors can be assessed in terms of financial footprint, profitability, assets value, and more, letting investors and economists alike get a picture of their economic value and wellbeing.

Since we can’t really talk about Siemens or the US agricultural sector having a “Gross Domestic Product”, per se, we have to look instead at other metrics — like market cap, book value, and sales.

Market cap

“Market cap” is total market capitalization, measured in the total value of all shares issued in all companies in a sector. This can be misleading if the investment market in a sector is hot, and might be pulling away from the sector’s real economic value (discerning, predicting and acting appropriately on such trends forms a large part of what the financial sector does). But it does give a clear picture of the financial “size” of an industry or sector.

Market Capitalization

Market cap is just one way to achieve an idea of the financial size of a sector in this way, and comparing it with other such metrics can be fruitful.

We’ll be looking at some of those in the next installment of this multi-part post, where we get into how to find out if a business is performing well.

Disclaimer


This publication is general in nature and is not intended to constitute any professional advice or an offer or solicitation to buy or sell any financial or investment products. You should seek separate professional advice before taking any action in relation to the matters dealt with in this publication. Please note our full disclaimer here.