We Are What We Measure

The current economic mess has many alleged causes, from greedy bankers and over-generous Chinese lenders, to financially illiterate home buyers and regulators asleep at the wheel. Yet the crisis also revealed, and was in part due to, the limitations of the economic data we have relied on since the Great Depression. Celebrating ever-rising Gross Domestic Product (and for that matter rising corporate profits and share prices) blinded us to the increasingly serious risks we were taking.

We have been here before. One of the least heralded, but most important, lessons from the Great Depression was the need for better data about the economy. Catastrophically bad decisions were taken by policymakers because the economy had essentially been "driving blind." This led economists on both sides of the Atlantic to do Nobel Prize-winning work creating the first comprehensive measures of national income. These measures of Gross Domestic Product (GDP) ushered in dramatic improvements in economic policy. Today, in the aftermath of a crisis that demonstrated the unreliability of GDP and many other economic performance indicators, a similar effort is now needed to create statistics capable of guiding us through a 21st century in which the relationship between economic growth and social progress and well-being seems certain to become increasingly complex. There are promising signs that this data revolution is beginning, led by an unlikely quartet: French President Nicolas Sarkozy, British Prime Minister David Cameron, Nobel Prize-winning economist Joseph Stiglitz, and the Organisation for Economic Co-operation and Development (OECD). But there is a long way to go and a fierce debate lies ahead.

"Lies, Damned Lies"

It is easy to deride statistics as too boring to matter, or as "lies, damned lies." Yet what we measure is an important reflection of how we understand the world and how we make choices. Indeed, the foundations of modern economics were laid in the 17th and 18th centuries during the great economic debate between mercantilists and free traders about how to measure the well-being of a nation. The former advocated tariffs and other restrictions on trade to limit imports, boost exports, and maximize the flow of bullion into an economy. The free traders rejected the idea that prosperity should be measured in reserves of precious metals and argued that such obstacles to commerce harmed the welfare of everyone. Ultimately, the free traders prevailed, with an argument most famously articulated by Adam Smith in his 1776 treatise, An Inquiry into the Nature and Causes of the Wealth of Nations.

Yet Smith's insight—that a country's wealth lay not in hoards of gold and silver but in its productive potential—drew substantially (and without attribution) on evidence from the work of statistician William Petty, who a century earlier had estimated not only England's national income but its total net worth, including the value of labor. By reframing what was meant by economic success, he dealt an important blow to the mercantilists long before Smith delivered the coup de grace. Like the struggle between mercantilism and free trade three centuries ago, the fierce debates over the fallout from the global financial crisis are also rooted in conflicting ideas about measurement.

Toxic Market Hypothesis

Toxic assets may be the symptom of the current economic crisis but the root cause was toxic ideas. One such idea—the Efficient Market Hypothesis (EMH)—was the product of academic economics in the 1960s and 1970s. It was soon popularized in a simplified form by business schools, taking hold on Wall Street and then among policymakers, who embraced it in an almost dogmatic fashion. The EMH helped to underpin the widely-held view in the corridors of political power and on the trading floors that, as long as quarterly profits, stock prices, and GDP were rising, all was well within our economic system. How wrong that proved to be.

Those profits—along with share values and national income—disappeared in a puff of smoke in the fall of 2008. Even Alan Greenspan, the economic guru who had presided over the...