Economics 1: GDP, inflation and money

by George Hatjoullis

[One criticism from my few readers has been that often I drift into areas inaccessible to the uninitiated. This series of blogs will attempt to provide an initiation in economics for those willing to persevere. The economics series of blogs is meant to be educational but has the usual Gestaltz twist.]

A common term that is encountered in the news is GDP. It stands for Gross Domestic Product and, as the name implies, is meant to represent the total output of an economy. A year is the most common time unit across which it is measured but quarterly is also popular. Measuring output is not as easy as it sounds. By and large it ignores output that is not the result of an economic transaction. So if you clean your own house, cook your own meals, repair your own property, maintain your own garden and manage your finances you will not be contributing to GDP. The black economy also does not impact GDP. People often engage in the black economy when they pay cash and the transaction is not recorded anywhere. Bitcoin transactions may also boost the black economy. Quality changes over time may also not be captured by GDP. A car today is not the same as a car 20 years ago. GDP is a fairly limited measure of output. For completeness one should note that GDP reflects output within a national boundary, irrespective of who owns it. So Nissan cars are included in GDP. Gross National Product (GNP) attempts to measure output owned by citizens and entities of a specific nation irrespective of where the production takes place.

Economic success or failure is measured by how fast GDP is growing. The limitations of GDP as a measure of the collective economic well-being of a nation are considerable. It does not measure how ‘happy’ is the society. A measure of happiness might also take into account work fulfillment and leisure. A trend towards more leisure might slow economic growth especially if the leisure is used to carry out activities previously measured as output (child-care, gardening, care for the elderly etc). If the trend to leisure is a choice it may enhance social happiness. No doubt economists would still bemoan the loss of potential growth.

Potential output is another concept beloved of economists but difficult to measure or even define. Potential output is the maximum GDP that can be produced if all resources are fully employed. Potential growth is a concept of some ‘natural’ rate at which this maximum can grow. Measuring potential output is difficult. It is usually identified after the event (ex post) by the behaviour of inflation (another concept that must be defined). A sustained period of output growth at above potential will lead to accelerating inflation. At the moment inflation appears not to be accelerating in most nations and indeed is showing disconcerting signs of decelerating and raising concerns about deflation. This is why central banks everywhere are taking such pains to print money (also to be defined) and keep interest rates low for the foreseeable future. Looked at like this one can see that potential output is a redundant concept. It is conceptually entirely captured by inflation.

Inflation is a tricky concept and has been repeatedly discussed in the many blogs on Gestaltz. After the event it is measured by the performance of various price indices. However, it is a state of mind and thus a ‘before the event’ concept (ex ante). The modern economy is a money economy. Economic activity is mediated by a medium of exchange that also serves as a unit of account and store of wealth. Money represents a claim on GDP. You can exercise that claim today (medium of exchange) or tomorrow( store of wealth). The unit of account function is either trivial or more complicated. The price of GDP can change so the value of money in terms of how much of GDP it can buy may vary. Inflation expectations will affect individual behaviour in relation to holding money unless inflation is expected to be, on average, zero. If inflation expectations are positive and accelerating, then individuals will, other things being constant, minimise holdings of money balances and assets denominated in money. If expectations are negative and accelerating then individuals will, other things being held constant, maximise holdings of money balances. In the former case the ‘real’ value of money is declining and in the latter case it is rising. The behaviour is thus ‘rational’.

[An aside on ‘things being held constant’ or ceteris paribus. This pops up in economics a lot. Even in a deflation there may be other reasons for reducing money balances. The point is to illustrate how the deflation expectations will influence choice rather than the actual decision arrived at after taking all possible influences into account. So mentally we keep these other influences unchanged. Of course, they never are unchanged and economists often forget to reintroduce them but that is different problem.]

We know need a quick introduction to the monetary system. The central bank can print money. Any liability of the central bank is money. The way the system works is that the central bank provides such liabilities to the deposit taking banking system in the form of loans. The deposit taking banks use these central bank liabilities to fund loans to the non-deposit taking sectors by providing them with deposits that they can draw on. These loans expand the money supply because money is just a liability of the banking system (a deposit). The whole process is constrained in various ways and the details differ from country to country but in essence that is all there is to it. The most serious constraint is the leverage ratio. This relates to the amount of capital that each bank must have. There is a requirement that a certain percentage of total assets must be held in the form of capital that is available to compensate creditors (like depositors) if the bank’s assets should become non-performing ( i.e. be worth less). If a bank has to improve its leverage ratio it can raise more capital (e.g from shareholders) or it can reduce assets (i.e loans). After 2008 banks systematically reduced loans in order to meet regulator demands to improve the capital base as a % of assets. Fewer loans to Small and Medium businesses was the result.

The central bank can lead the banks to water but it cannot make them drink. The central bank can encourage banks to lend but it cannot force them to do so. Governments do occasionally try a more forceful approach. If the banking system breaks, credit growth may not be adequate and constrain economic activity. Moreover, it can reinforce deflation. Recall that in a deflation individuals are inclined to hold money balances. They want to hold deposits with banks. They want to lend rather than borrow. The central bank can encourage banks to take central bank liquidity and make loans to individuals but they cannot force them to do so. If the banks have capital problems and/or cannot find enough eligible people to lend to, they will not take the loans from the CB. If in addition they have customers that want to build up money deposits they will find themselves overly liquid and even less inclined to take up CB liquidity. This should sound familiar to anyone vaguely aware of what has been going on since 2008.

For those still struggling with the idea of deflation the recent experience with Bitcoin provides a useful illustration. The explosion in the dollar price of Bitcoin is a form of deflation in the Bitcoin economy. People wanted to hold Bitcoin balances so they offered more claims on global GDP in exchange. In a deflation individuals are keen to acquire money balances (Bitcoin) in exchange for goods and the price of money in terms of goods rises. The central bank can try to influence the supply of these money balances but if the system will not create the desired balances the deflation will persist. In the case of Bitcoin there is no CB, but only a mining programme. The higher price has encouraged more mining but there is a limit to the speed of mining. Demand for Bitcoin exceeds supply and deflation in the Bitcoin economy is the result.

The advent of so-called quantitative easing was an attempt by CBs to circumvent the banking system and create money directly. In principle QE purchases assets from the non-deposit taking institutions and thus places CB liabilities directly into the economic system. In practice the main asset purchased is government debt, which is widely held by deposit taking banks, so the effect is open to debate.If the CB really wants to increase the money supply in a banking constrained environment then it should simply directly finance government spending. It provides the government with an overdraft. The government spends by writing cheques on this overdraft. Those that cash the cheques get deposits at banks. Deposits grow as required. It really is that simple. Inflationary? Of course, but that is the whole point. We started in deflation recall!

So to recap:

1. Economists are obsessed with GDP growth and GDP potential. However, operationally GDP potential is proxied by Inflation.

2. Inflation is about individual desire to hold money balances.

3. Central banks can influence but not determine the supply of money. Deposit taking institutions are crucial to the creation of money.

4. Broken banks may restrict the ability of central banks to create money requiring more imaginative and taboo forms of CB activity.

5. Monetary financing of government expenditure is the most effective way for a central bank to directly increase the supply of money.