What our wellbeing says about the economy

July 30, 2009

peter-dixon- Peter Dixon is a guest columnist, the views expressed are his own. He is global financial economist at Commerzbank -

The popular image of economists is one of pointy-headed analysts, poring over data and running models in order to make predictions about the future which will invariably prove to be wrong.

While this is a distortion of the truth, the economics profession has not helped itself in recent years by cloaking analysis in pseudo-scientific terms, making it inaccessible to those without the necessary degree of mathematical training.

Although the great crash of 2007-08 has done nothing to enhance the reputation of economists’ ability to predict the future, it has opened up a debate about the nature of research undertaken in the economics and finance professions.

At heart economics is a social science –- the study of how people behave –- and finance is merely an extension of this. In recent years, the finance industry has paid greater attention to theories of behavioural finance whilst economics literature has gone back to its roots in an attempt to look more closely at the concept of utility. Common to both fields is the notion that an individual’s wellbeing is not necessarily best measured by standard pecuniary measures, and that we need to take greater account of other “psychological” factors.

This may suggest that the conventional way of assessing economic wellbeing by measuring income (or GDP) rather misses the point.

However, the literature on the economics of wellbeing does find a strong link between survey-based measures of happiness and macroeconomic aggregates, so all is not lost.

Back in the 1970s, the economist Arthur Okun inverted the concept of happiness to define a misery index. This was derived simply by adding together the inflation and unemployment rates which, 30 years ago, were deemed to be the biggest problems facing consumers.

With inflation these days being far less of an issue, the index as originally specified is running at 40 year lows. We have thus constructed an augmented misery index for the UK which accounts for household wealth, both in the forms of housing and other financial assets, in an attempt to guage wellbeing by an extended range of financial variables.

The augmented index is currently at similar levels to those achieved in the recessions of the early-1980s and early-1990s, which suggests that while household sentiment is depressed, it has not collapsed to anything like the same extent as in financial markets.

But since the damage done to household balance sheets, and slow progress in the labour market, may well act to raise household misery levels over the course of the coming quarters, it is likely that although the worst of the recession is behind us, any recovery will be a very slow haul.

Although individual wellbeing may not adequately be captured by financial variables alone, corporate wellbeing is still judged against the yardstick of profitability.

Earnings reports this week alone show that 28 FTSE-listed companies overshot relative to expectations versus 13 undershoots which is clearly positive news.

Moreover, in contrast to the situation for households, corporate profitability (excluding banks) has not slumped as badly as in previous recessions.

Perhaps one reason for this is that the share of corporate profits in national income has risen in recent years while the share of wages has fallen. In other words, corporate profits have held up as wages have been squeezed. The wage squeeze is likely to continue beyond the end of the recession, which bodes well for corporates but not for heavily-indebted –- and increasingly miserable –- households.

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