How should we measure progress?

There seems to be a lot of talk about progress, or lack of it, at the end of each year. I tend to get caught up in this even though a year is far too short a period to measure the kind of progress that most interests me.

Two years ago I wrote a post entitled ‘What is progress?’ This was the first post I had written with the ‘progress’ label on it. At the time I intended to read several books and articles relating to the concept of progress and then to write something more definitive about the meaning and measurement of progress.

Since then I have read several books and articles about progress – from an historical perspective and looking towards the future – and have written 38 posts related in some way to the concept of progress. However, I don’t think I have written anything as definitive as my first post on this subject.

The main point I made in that first post about progress is that if progress is to have any meaning from a public policy perspective it must mean movement toward a good society or movement from a good society to a better society.

A fairly obvious response that might come to mind is that it could be just about as difficult to define what we mean by a good society as to define what we mean by progress. As things happened, however, I had just spent a few months in 2009 thinking about the characteristics of a good society.

I had reached the conclusion that just about everyone should be able to agree that a good society is good for its individual members. Such a society would enable its members to live together in peace. It would provide its members with opportunities to flourish. It would also provide its members with some security against threats to their flourishing. I had also come to the conclusion that these characteristics of a good society are measurable.

It follows, or so it seems to me, that the best way to measure progress is to bring together relevant indicators of the peacefulness of societies, opportunities for flourishing (including consideration of economic, environmental and social capital indicators) and security (including consideration of security against misfortunes such as ill health and unemployment).

The approach I am suggesting is similar to that followed by the Australian Bureau of Statistics (ABS) in its ‘Measure of AustralianProgress’ (MAP). The difference is that ABS offers a smorgasbord of social, economic and environmental indicators which could, in principle, cover everything that anyone has ever suggested might have some relevance to the question of whether life is getting better. I think attention should focus on indicators that nearly everyone would agree to be closely related to important characteristics of a good society.

I strongly support the ABS’s approach of recognizing that progress is multidimensional and refraining from any attempt to combine indicators into a single measure. It seems to me that so called ‘genuine’ progress indicators which reflect the value judgements of individual researchers relating to such matters as income distribution and environmental values are useless. The relative importance of progress in various dimensions must remain a matter for public discussion and judgement by individual citizens. If a collective judgement is required about the priority that should be given to various dimensions of progress, we have constitutional processes including elections and parliamentary processes to perform this task.

Since the combining of progress indicators must involve individual value judgements, why not just ask individuals to make an evaluation of their own lives (on a scale of 1 to 10), combine these evaluations in some way and use this as our measure of progress? There are several problems with measurement of subjective well-being in this way, as discussed elsewhere on this blog. As I see it the main one is in ensuring that respondents have an appropriate benchmark in mind for measuring progress when they make their evaluations. If you ask people to assess their own lives relative to ‘the best possible life’ as in the Gallup surveys, the results of successive surveys cannot provide a measure of progress because perceptions about ‘the best possible life’ can be expected to rise as a result of progress. If I am climbing a ladder that is attached to a helicopter, my height above sea level depends on the height of the helicopter as well as on my ability to climb the ladder.

So, I think our measurement of progress should focus on widely accepted criteria that are relevant to the question of whether we are making progress toward more peaceful societies that offer greater opportunities and more security. There is also a more fundamental question, however, of whether the institutional drivers of progress – for example, institutional factors leading to productivity improvements - are also moving in the right direction. Perhaps I should write more about that next year.

Have important factors been omitted from the HALE index of well-being?

The aim of the Fairfax organization in sponsoring the development of the Herald/Age - Lateral Economics (HALE)  index of the well-being of Australians seems to have been to publish a broad indicator of social progress in the hope that this will help people to avoid viewing GDP as ‘the supreme indicator of our wellbeing’.

In contrast to some previous attempts to create ‘genuine’ progress indexes for Australia, which seem to have been aimed at maximizing the weight placed on possible negative spillovers associated with economic growth, the authors of this index seem to have adopted a fair-minded approach. However, I still have some concerns about the methodology adopted. I discussed one of those concerns in my last post – namely that it would be desirable for the index to take into account changes in uncertainty about the economic situation if it is to be taken seriously as an indicator of short term changes in well-being. In this post I want to identify important factors that have been omitted from the HALE index that might affect its use as an indicator of longer-term changes in well-being.

It seems to me that the most important factors affecting individual well-being are social capital (respect for person and property, quality of governance, individual safety, inter-personal trust) national security (peacefulness of the international environment, relations with other countries, security threats) physical and financial capital (financial wealth, housing, infrastructure, indebtedness, economic security) human capital (skills, health, personal relationships and emotional well-being) and natural capital (natural resources, environment). The relatively importance of different factors must ultimately be a subjective judgement, but this does necessarily mean that all important factors are taken into account when people are asked to rate their satisfaction with their lives. For example, there is empirical evidence that even though personal safety is obviously fundamental to individual well-being its contribution to measured life satisfaction is negligible in Australia (see, for example, a study I have undertaken using the Australian Centre on Quality of Life data set). One possible explanation is that most people feel so safe living in Australia that safety concerns do not even register in their minds when they are asked about their life satisfaction.

The most obvious omissions in the HALE index are social capital and national security. Those factors are unlikely to affect well-being much from year to year, but their impact over several decades could be substantial. For example, looking back over the last 40 years, there has arguably been a substantial improvement in the well-being of Australians as a result of improvements in relations among countries in the Asia-Pacific region.

Some less obvious omissions in the HALE index may also be important. The starting point of the index, net national income, reflects some flows of services from human, physical, financial and natural capital and one source of change in capital stocks (net investment in physical capital). Subsequent adjustments to take into account changes in environmental capital and human capital are presumably aimed at measuring changes in capital stocks more comprehensively to obtain a comprehensive income measure (based on the Haig-Simons definition of income i.e. consumption plus change in net wealth). I use the word ‘presumably’ because change in human capital from improvements in school education is measured in terms of the estimated effects of an improvement in current PISA scores on long-run GDP, without any discounting to take account of the passage of time required before improved PISA scores could possibly be reflected in the human capital of members of the labour force. It seems to me that, rather than fluctuating widely depending on literacy and numeracy skills of the current crop of school children, the value of human capital stocks probably changes gradually over time as people with differing skill levels enter and leave the labour force.

The market values of some forms of wealth obviously fluctuate fairly widely from year to year, but this is not taken into account in the methodology used in calculating the index. Changes in the value of financial capital and housing are ignored in calculating the index. This raises the question of whether the effects on well-being of such unrealized capital gains and losses are as great as for changes in current income. My feeling is that they are probably not as great. Investors are likely to view capital gains and losses in a different light to changes in dividends. Home owners who obtain unrealized capital gains on their homes would probably not generally feel that there has been much change in their well-being – their home still provides the same services to them as it did previously. Their lives probably remain largely unchanged unless, of course, they run down their liquid assets of borrow funds in order to spend their capital gains.

However, this brings me to what seems to be an important omission in the HALE index - it doesn’t make any allowance for changes in debt levels. Well-being is more closely related to net wealth than to total physical and financial assets. Looking at Australia as a whole, debts cancel out to a large extent – the liabilities of one person are the assets of another – but they do not cancel out completely. Changes in net foreign debt levels may have important implications for the average well-being of Australians. Changes in interest rates on foreign debt should also be taken into account because they influence the extent to which current income is available for purposes other than debt servicing.

Research by the Australian Centreon Quality of Life several years ago shows that people who have difficulty in repaying debt tend to have lower subjective well-being than those who do not have such problems (Survey 11, Report 11, August 2004). In the light of current debt problems in many developed countries it seems remarkable that happiness researchers have not given a great deal more attention to the effects of excessive debt on personal well-being. 

What factors should be taken into account in assessing short term changes in well-being?

This is one of the questions I have been pondering as I have been reading about the Herald/Age - Lateral Economics (HALE) index of the well-being of Australians.

The aim of the Fairfax organization in sponsoring the development of this new index seems to have been to publish a broad indicatorof social progress in the hope that this will help people to avoid viewing GDP as ‘the supreme indicator of our wellbeing’.

The timing of publication – a few days after quarterly GDP data are published – is clearly intended to invite comparison with quarterly GDP data. Indeed, a report in the Sydney Morning Herald makes such a comparison:

‘Wellbeing grew twice as fast as GDP in the September quarter thanks to a big rise in national income from the boom in commodity prices and cheaper imports’.

The HALE index rose by 2.2% in the September quarter primarily because net national income (NNI) is the starting point for calculation of the index and NNI reflects terms of trade movements. I don’t have any problem at all with the idea that well-being is more closely related to NNI than to GDP, but I can’t help thinking that the relationship between well-being and short term fluctuations in the terms of trade must be tenuous, at best.

Perhaps the terms of trade improvement in the September quarter raised the well-being of some people by enabling them to enjoy an overseas holiday that they might not otherwise have been able to afford. People who purchased imported consumer durables might also have benefited. In general, however, it isn’t obvious to me that changes in the terms of trade have much effect on living standards unless they are sustained over several years. It is even possible that short term improvements in the terms of trade could have a negative impact on well-being by adding to uncertainty in the context of concerns about possible effects of increased import competition on jobs in some industries. Such impacts might, of course, be offset by optimism about improved employment prospects elsewhere in the economy.

It seems to me that uncertainty is a factor that should be taken into account in assessing short term changes in well-being. Research based on surveys data relating to subjective well-being suggests that increased uncertainty can have a substantial short-term impact on well-being. For example, Carol Graham has reported that average life satisfaction in the US fell by 11% during the 08-09 financial crisis, mirroring a larger fall in the stock market. However, life satisfaction bounced back to previous levels once the immediate crisis was over, even though the stock market remained relatively depressed (‘The Pursuit of Happiness’, pp 88-89). A fall of 11% in life satisfaction is a very large change in a statistic that is normally very stable over time.

In an earlier post I noted that there was even a blip in life satisfaction data for Australia at the onset of the global financial crisis. A much larger decline in consumer confidence occurred at that time reflecting, amongst other things, increased pessimism about the economic outlook for the next five years. Pessimism about the economic outlook hasincreased again over the last year or so and now stands at levels almost comparable to those during 08-09.

If the HALE index is intended to be taken seriously as an indicator of short term changes in well-being it seems to me that it would be desirable for it to reflect changes in uncertainty about the economic outlook.

Is there a house price bubble in Australia?

An article in ‘The Economist’ last week suggests that the ‘bursting of the global housing bubble is only halfway through’ (‘Economics focus: House of horrors, part 2’, November 26, 2011).  On the basis of the measures used, the authors claim that home prices are over-valued by 25% or more in Australia, Belgium, Canada, France, New Zealand, Britain, the Netherlands, Spain and Sweden.

How did the authors arrive at this conclusion? Two measures of valuation were used in the analysis: the house price to income ratio, which is a gauge of affordability; and the house price to rent ratio, which reflects the relationship between house prices and the benefits of home ownership i.e. rents earned by property investors and rents saved by owner-occupiers.

The reasoning seems OK so far. If the price to income ratio is above an appropriate benchmark of affordability and the price to rent ratio is relatively high compared with an appropriate benchmark of returns available from owning other assets, then there might possibly be some grounds to suspect the existence of a housing bubble.

The critical issue is what benchmark should be used to make such comparisons. ‘The Economist’ asserts: ‘if both of these measures are well above their long-term averages, which we have calculated since 1975 for most countries, this could signal that property is overvalued’. In the chart below I have graphed the data from the table that the authors use to make their assessment.

The chart shows that the price to income and price to rent ratios for a heap of countries, including Australia, are well above long-term averages for the period from 1975 to the present. I think mean reversion (sometimes referred to as regression to the mean) deserves some respect. If we don’t have good reasons to expect a variable to remain substantially above or below its long term average at a particular point, it is often sensible to assume that deviation from the mean is more or less random and that the variable is more likely to return to the mean than to remain at extreme levels.

So, do we have good reasons to expect rental yields (the inverse of the house price to rent ratio) in Australia to remain below their long term average for the period since 1975? In order to answer this question it might be helpful to consider the level of rental yields in Australia at present and how much capital appreciation (expected growth in house prices) is implicit in current rental yields. The underlying reasoning is that if potential home buyers – including investors - perceive that there is likely to be substantial capital gain in the years ahead they will tend to bid up house prices to a greater extent (other things being equal) and thus tend to depress rental yields. You need to work out how much capital appreciation they anticipate in order to assess whether or not their expectations are excessively optimistic.

Current rental yields in Australia - of the order of 3% to 4% in net terms – do not seem to me to imply unduly optimistic expectations about future capital appreciation if we use an annual nominal return on investment of say 8% per annum as a benchmark. One way of looking at this is to ask yourself whether you would expect average house prices and rentals to grow more or less rapidly than nominal GDP. I expect average house prices and rentals to grow more rapidly than nominal GDP in Australia because the effects of growth of population and incomes will tend to intensify the locational advantages of the median house relative to houses in the outer suburbs. A recently published Reserve Bank research discussion paper by Mariano Kulish, Anthony Richards and Christian Gillitzer  (‘Urban Structure and Housing Prices: Some Evidence from Australian Cities’) uses a model to illustrate, among other things, how growth in population tends to raise house and land prices to a greater extent in suburbs that are closer to the CBD of large cities. This is consistent with the empirical evidence presented in the paper that house prices in the inner suburbs in Australia rose by about 1.3% more per annum more than in the outer suburbs over the period 1992/3 to 2009/10.

Why are rental yields in Australia currently so much lower than the long term average over the period since 1975? The most plausible reason, it seems to me, is that as in many other countries high nominal interest rates (reflecting high inflation rates) were suppressing demand for housing over the first half of that period. As inflation rates and interest rates came down, housing affordability improved markedly during the 1990s, but this led to increased demand for housing, a sharp rise in house prices and a decline in rental yields. Mean reversion doesn’t apply in this instance because the mean was distorted.

Why should we expect house prices in Australia to avoid the fate of house prices in the US in recent years? Luci Ellis of the Reserve Bank gave some reasons why the US housing market is different in a speech she made last year. Unlike other developed countries, mortgage arrears on home loans in the US started to rise in 2006, more than a year before the unemployment rate began to rise. The leverage of the housing stock in the US was substantially higher than in Australia before the global financial crisis.

In addition, the decline in housing prices in the US that resulted from the bursting of the housing credit bubble was exacerbated by deflationary monetary policies that led to a major recession. This suggests to me that current rental yields in the US (of the order of 8% to 12% in some areas) should be viewed as being extraordinarily high at present and unlikely to persist in the longer term.

The final sentence of the article in ‘The Economist’ states: ‘A credit crunch or recession could cause house prices to tumble in many more countries’. Well yes, that does seem quite possible. If it does happen, however, I think there is a good chance that rental yields in Australia will eventually return to somewhere near the ‘normal’ levels that currently exist in this country.