The Wealth of Nations

By July 10, 2012Blog

About the Author

Dedicated to Professor Gautam Kaul, who taught me that finance is about so much more than money, and for whom finance = love.

Bravo! The United Nations has created a methodology for building balance sheets for countries and it includes measurements of human, natural, and manufactured capital. It’s called the Inclusive Wealth Index (IWI).

Why is this important? Up until now, the global standard for measuring economic wellbeing has been Gross Domestic Product (GDP) – a measure explicitly not intended to assess a country’s overall welfare yet routinely interpreted as a proxy for economic health. Despite voluminous critiques of GDP, no viable alternative has been created…until now.

The key distinguishing feature of the new approach is its measurement of a country’s wealth as a stock of its assets. It attempts to tell us how much human, natural and manufactured capital a country has at the time of reporting. This is akin to balance sheet accounting for companies and consistent with the way that we think of an individual’s net worth. The question we ask is: how much do we have?

GDP asks a very different question: how much did we make? It measures the flow of goods and services produced within a country in a given period. It is akin to a company’s income statement or an individual’s paystub. This distinction is paramount, especially when accounting for the stock of natural capital which often diminishes in the context of economic growth.

The report could benefit from greater clarity and specificity on which parts of natural, human, and manufactured capital can be effectively substituted for one another. It discusses problems with substitution, noting that “a large part of what nature offers is a necessity and not a luxury.” Yet its index construction combines all three forms of capital and tracks changes in total capital stock as if all capital was substitutable.

A quantitative assessment of substitution potential would enable a future-oriented perspective. One could assign higher discount rates to assets with higher substitution potential and project the flow of value from all assets in perpetuity. Those assets which are “necessary and not a luxury” would be assigned low discount rates in accordance with their irreplaceability. This would increase the present value of their perpetuities.

For example, if we take recent estimates of the “free” goods and services provided by our natural living infrastructure, at $72 trillion per year, and divide this by a 1% discount rate, the present value of the perpetuity of our ecosystem services exceeds $7 quadrillion. As our discount rate approaches zeroto reflect intergenerational equality and a lack of substitution potential, the value of our perpetuity approaches infinity.

This approach takes us beyond balance sheet accounting, but a truly long-term perspective on human wellbeing and measures of sustainability requires valuation of the future. The IWI is a welcome addition and a significant improvement on GDP, despite the constraints of its mark-to-market accounting for the value of natural resource commodities. The deeper question of substitution potential calls for rigorous quantitative analysis and the report’s aspiration for a long-term perspective calls for a methodology that includes assessments of future value.

With the Inclusive Wealth Index, we have moved from measuring how much we make to also measuring how much we have. Let us now dare to measure how much we will have in the future.

For more information on the UN’s Inclusive Wealth Report:
http://www.ihdp.unu.edu/article/iwr/
http://www.economist.com/node/21557732

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