According to a new Economic Letter from the San Francisco Fed, we may be failing to account for the economic growth brought about by creative destruction. The authors write,
[O]ne needs to keep in mind that measured productivity growth is designed to capture growth in market activities. Thus, it may not fully capture the growth in people’s economic welfare because it misses out on important dimensions such as increasing lifespans and rising home production. So, even if the measurement is correct, a slowdown in measured productivity growth does not necessarily reflect a slowdown in welfare growth. For example, many recent IT innovations involve nonmarket activities such as time spent on social media and time saved from shopping online. Although these areas may improve welfare, they have not historically been covered by productivity measurements, so ignoring them cannot directly contribute to any growing understatement of market-sector growth.
This Economic Letter focuses on measuring growth from innovation in parts of the economy that have traditionally been within the scope of productivity measurement. Past research has found that measurement problems in the IT sector associated with market production and offshoring activities cannot explain much of the growth slowdown (see Aghion et al. 2017 for references). In this Letter, we consider whether errors in measuring innovation outside the IT sector can explain the substantial slowdown.
They continue,
When a product disappears without being replaced by a new version from the same producer in the same location, the BLS typically fills in or “imputes” the missing price and then starts tracking a new item. In particular, the BLS imputes inflation for the disappearing item to be the same as inflation for similar products that remain on the market. The BLS resorts to such imputation roughly twice as often as it directly estimates quality changes (Aghion et al. 2017).
In doing such imputation, the BLS assumes the inflation rate is the same for changeovers from old to new producers as it is for all surviving items. This may not be an accurate assumption of the true values. Research since Schumpeter (1942) highlights growth driven by so-called creative destruction. Under creative destruction, new producers replace existing producers precisely because they introduce a product with a lower quality-adjusted price. The items that survive are those that do not experience creative destruction. Most of these surviving items have not been updated at all, according to the BLS. Hence, by using the inflation of surviving products to approximate the inflation rate of products that disappear, the BLS could be overstating the inflation rate of the disappearing products.
To quantify the extent of missing growth caused by imputation bias, in Aghion et al. (2017), we and our colleagues analyze the market share of incumbent producers—that is, the sales of incumbents relative to total sales. When two products have the same quality, the producer who sells at a lower price will sell more and hence have a higher market share. More specifically, a product whose price relative to its quality—quality-adjusted price—is lower will have a higher market share. By this logic, the market share of incumbent products shrinks when their quality-adjusted prices increase relative to products made by new market entrants. Imputation assumes that these inflation rates are the same, so that incumbent market shares should be stable. If instead incumbent market shares tend to shrink over time, then this would be a sign that imputation overstates the inflation rate for creatively destroyed products, leading to an understatement of growth. The more incumbent market shares shrink, the larger the bias.
Their measurements yield two main findings:
- “First, we estimate missing growth to be about 0.6% per year on average from 1983 to 2013. By this estimate, roughly one-fourth of true growth is missed.”
- “Second, while there are fluctuations, no clear trends emerge for missing growth. In particular, missing growth has not systematically increased over time, as reflected in the true growth series. There is a substantial decline in productivity growth post-2004 even after adjusting for missing growth.”
They conclude,
[W]e find that missing growth has been relatively constant over time, so true productivity growth has slowed, even after accounting for this bias. Although the bias does not explain much of the sharp decline in productivity growth, its magnitude is economically significant—nearly 0.6% per year on average, or about one-fourth of true growth.
Measuring real growth properly is useful for addressing a host of questions. For example, existing studies use measured inflation to calculate the real income of children relative to their parents. Chetty et al. (2017) find that 50% of children born in 1984 achieved higher incomes than their parents at age 30. Adjusting for missing growth would raise the real income of children about 17% relative to their parents, increasing the fraction of those who do better than their parents by a meaningful amount. Thus, to the extent that inflation is overstated due to imputed values, a larger fraction of children appear to be better off economically than their parents. This improvement in economic welfare can shine a bit more positive light on current conditions, despite the gloom of slower productivity growth.