The Phaserl


How GDP Conceals Inflation

by Alasdair Macleod, GoldMoney:

There are so many things wrong with GDP, that even mainstream economists are becoming vaguely aware of its shortcomings.

A good friend drew my attention to a Bloomberg article on this subject, which at least shows a growing awareness that there’s a problem. Unfortunately, this awareness does not extend to its underlying nature.

GDP statistics only capture an incomplete snapshot of the economy at one moment in time. Since the economy is continually evolving, that snapshot is immediately out of date, and therefore unfit for the purpose of economic planning. Furthermore, being an incomplete picture of the total economy, GDP badly misleads policy-makers on the subject of price inflation.

This is the topic of this article. We will focus on the relationship between the economy, monetary inflation and price inflation, and show how GDP conceals inflation until it is too late to do anything about it.

The best way to demonstrate this is to start with a theoretical illustration of a sound-money economy, where the total quantity of money and credit is the same for successive years.

The total amount of monetary units (Mu) spent in one year is unchanged from year-end 1 to year-end 2, because that is the sound money condition. Everyone earns and spends, in accordance with Say’s law. The totals represent net earnings and profits over the course of one year, spent in the relevant categories.

Neither base money nor bank credit can be expanded. Note that the table represents the whole economy split into three categories, and not conventional GDP sub-components, which only capture spending at final prices for selected capital and consumer goods. The totals represent net annual income allocations into the respective categories in a theoretical economy. The table does not include past accumulations of spending, or prices based on valuations. The table also includes both government and private sectors.

Some money earned will be put aside for investments in the form of savings, mainly destined to finance production, some will be invested directly in production out of business profits, and the balance will be spent on consumption of non-productive goods and services. We will assume purchases of second hand goods are also included in the consumption total. Government spending is included in the model, because it cannot finance its spending through monetary expansion.

The scope is far wider than GDP itself, and captures all economic activity. The total of earnings and profits are the same, because no money enters or leaves the economy. Therefore, the total is unchanged for year-end 2, but its allocation is free to vary from one category to another.

In this example, less money has flowed into investments in Year 2, and the balance has been reallocated equally between production and consumption. In a sound-money economy shifts between these categories tend to be minor and self-correcting. Extra money and credit are not available to support higher prices, and an increase in allocation to consumption, financed by a reduction in investment through savings, will find a new balance through higher interest rates for savers. This is why sound money is always, in the absence of an exogenous shock, accompanied by a high degree of economic stability.

Unsound money, credit cycles, and price inflation

Phase one: suppressing interest rates

Having set the scene with a sound-money example, we can now use this framework to move on to the contemporary fiat money environment, and put it in the context of a business cycle. Business cycles are without doubt driven by the ebbs and flows of money and bank credit, as we shall see. Those of us who have experienced several business cycles should be able to recognise how they generally progress as described below.

Business cycles can be broken down into distinct phases. Following the previous cycle’s crisis phase, Phase 1 is the central bank’s suppression of interest rates and forced expansion of money supply, the purpose of which is to rescue the banks and to keep business trading. Phase 2 is the initial recovery in consumer spending, which begins to drive up interest rates, and the rate of price inflation. Phase 3 is characterised by accelerating price inflation and rising production costs, as businesses scramble to acquire the resources to meet demand. And lastly Phase 4 is the inevitable financial crisis, as the malinvestments over the cycle come home to roost.

I have changed the accounting period to phases (P1 etc.) to reflect the fact that the duration of different phases of a business cycle varies considerably, and I have redesignated the investment-through-saving category to net movement into the financial sector, to reflect this sector being the source of expanded bank credit.

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