We need new ways to measure the 'weightless' economy

You can see the computer age everywhere but in the production statistics ... our understanding will have to change

One of the world's wisest economy watchers, Alan Greenspan, has grown extremely interested in the bits of the economy that we do not actually see because they are difficult to measure. It sounds an abstruse subject, but Mr Greenspan's interest is in itself a signal that this could be important for policy in future. The Bank of England has been looking into the same question.

The issue is this: official statistics are very good at measuring the parts of the economy that are shrinking in importance, namely agriculture, mining and manufacturing. The monthly figures for UK industrial production, due today, will generate a lot of attention in the City and the press because they are there; but they are not very significant.

Our statistics are not so good at measuring the great bulk of national output. In particular, more and more value is being created by the service industries. This category lumps together relatively low-value services like hairdressing with high-value "intangible" ones - or "weightless" activities, as I'd prefer to call them - such as computer software, telecommunications, biotechnology advances and entertainment.

In his recent testimony to the Senate budget committee, Mr Greenspan discussed the findings of the Boskin committee. This group of economists concluded that the failure of the consumer price index to take account of improvements in quality in items such as computers and other electronic goodies means that US inflation has been overstated by a full percentage point. Follow-up work by economists at investment bank Kleinwort Benson in London concludes that the bias is no different in the UK.

Professor Danny Quah of the London School of Economics, an expert on weightless economics, says: "The measurement point on relative upwards and downwards biases is just something that has got to be right. Much less clear, for now, is what these magnitudes are: economic reasoning tells us the sign, but no more."

If prices have been overstated, that means the real value of output has been understated. For real growth is calculated by adjusting the easily measured nominal value of output for price inflation.

The Federal Reserve Board has looked into whether published price, output and productivity figures actually make sense. In his testimony the chairman reported that the figures for real output and productivity in the service sector of the economy were implausibly weak. They indicated falling productivity, or output per hour, in services at a time when the returns to owners of service businesses had been steady. It makes no sense to think that services have been getting less and less efficient for the past 20 years, Mr Greenspan argued.

The mis-measurement of prices would appear to be the most likely explanation of the anomalies. It would answer the well-known quip of economist Robert Solow that "you can see the computer age everywhere but in the productivity statistics".

The Fed chairman believes there could be more big gains in productivity to come from computers, drawing the analogy with the spread of electric motors. These were a well-known technology in the late 19th century but were used as one part of steam-driven production systems. It was not until factories gradually converted from vertical processes last century to horizontal ones in the early 20th century that companies began to replace steam with electricity. Businesses do not take the fullest advantage of new technology until they replace existing factories and machinery.

Mr Greenspan made it clear that he was not trying to argue that if inflation was lower and real output higher than we have all thought, then there is no need to worry about inflation. Changing the measurements would also raise the estimate of the economy's potential output growth, so the Fed still needs to worry about how close to capacity business is operating.

But some of the policy implications of inadequately measuring weightless, or intangible, activity are spelt out in a new paper from Britain's Office for National Statistics. The paper points out that while there has always been a dimension of weightlessness to the economy, it has increased recently. Statisticians have had difficulty keeping track.

Some experts have suggested re-classifying activities as manufacturing, services and information, as opposed to just manufacturing and services. Manufacturing involves physical goods, services a clearly linked transaction between a provider and a consumer. The ONS paper lists the unique characteristics of the information sector arising from the weightlessness of its output. Information output can take variable forms. There need be no direct contact between provider and purchaser, and the location of the economic activity is uncertain. Its value does not lie in its tangible properties. It is easy to copy and easy to distribute. Distributors can easily add value to it.

It is clear that this is nothing like the sort of economic output we are used to thinking about. In many ways it resembles classic public goods such as defence or education, which share some of the same characteristics. Indeed, education is likely to share more and more of the technological characteristics of the information industries.

In principle, the ONS reckons, as long as the commercial transactions concerned can be recorded, it does not matter for compiling national accounts in current price terms whether they take place on the Internet or down at the local shopping centre. But there are several thorny conceptual problems for monitoring the economy.

For one thing, if there is no direct link between producer and consumer, then production and consumption do not have to occur in the same place at the same time. How is international trade to be measured if information output is accounting for a growing share of the economy? How are we to tell where information has originated?

It is particularly hard to construct a price index for information output, and correspondingly difficult to deflate its nominal value to get a measure of real output. One reason is the fact that charges to consumers of information goods are often flat fees - a television licence, an Internet connection fee, a software licence fee. It is very hard to price the subsequent number of transactions. In addition, information products are very varied and change quickly. It will become increasingly difficult to identify a single cost of living index, and harder to measure and target inflation.

More fundamentally, the output of the information industries is not very dependent on physical processes, the transformation of materials. It will become increasingly difficult to record the value added in the sector. For example what is the economic value added in a derivatives trade? It is near impossible to say. The spread of electronic money - at a speed which will surprise most people - will make the notion of a money supply just as elusive.

Official statisticians plan to explore the possibility of reclassifying the economy into manufacturing, services and information. They would certainly like to improve data collection. With the question of intangibility or weightlessness steaming up the policy agenda it is clear that our measurement and understanding of the economy will be changing radically.