No alternative to inflation
Every budding economist is taught the distinction between nominal variables (expressed in terms of contemporary cash values) and real variables (adjusted for inflation and expressed in constant-dollars).
An oil price of $50 per barrel in 1980 is not the same as an oil price of $50 a barrel in 2009 because inflation has steadily eroded the purchasing power of the currency in the intervening years. Moreover, economists are taught that real values are more important than nominal ones — because “money is a veil” (to use the phrase of the Austrian economist Joseph Schumpeter).
Prices are important because they perform a signaling and allocating function, encouraging supply and rationing demand. What matter are relative prices not absolute ones.
If all prices and wages double, there is no impact on the distribution or quantity of production and consumption because the relative prices remain unchanged. Money is a veil and focusing on nominal values risks succumbing to money illusion — believing that purchasing power or wealth has increased simply because it is expressed in more units of a devalued currency.
When the US Department of Commerce releases its updated National Income and Product Accounts at the end of each month, investors focus on the real growth rate in GDP, adjusted for inflation. You would be hard pressed to find the nominal GDP growth rate on dealing screens, or for that matter in the Commerce Department’s press release.
But surely that doesn’t matter, because we are only interested in how much output is produced, how many cars, how many homes, not their selling value.
Because one set of important relationships in the economy is almost always expressed in nominal terms, not real ones: debt.
If household incomes double in nominal terms, and the price of a representative basket of goods also doubles, purchasing power has not changed. But the proportion of household income spent servicing and amortizing old debts is halved.
Nominal values become crucially important in a dynamic economy where time as well as price is important, and where debt contracts such as mortgages and firm loans are fixed in nominal terms rather than indexed.
Prices have two functions: a static function allocating resources among producers and consumers; and a dynamic function generating incomes, saving and a flow of payments on debt contracts. For the static function, what matters is real or relative prices. But for the dynamic one, nominal prices are more important because they determine the sustainability of the fixed debt contracts.
NOMINAL GDP GROWTH STALLS
The nominal income or cash flow received by households determines how easily they can repay debt contracts fixed in nominal terms. In the same way, the nominal income or cash flow received by companies determines how easily they can repay debt contracts in fixed currency.
At the most general level, nominal GDP is in some sense the “national cash flow” — and determines how easily the economy as a whole can support an overall debt structure fixed in nominal terms. Nominal GDP growth becomes exceptionally important, especially at times when debts are at a high level.
The attached charts show quarter-on-quarter and year-on-year growth in GDP in both nominal and real terms since 1947.
Chart 10 (below) shows the quarter-on-quarter growth in real GDP (expressed at annualized rates). Real GDP growth is very variable. Declines in real GDP during recessions are common. Real output has fallen in 37 quarters since 1947 (about 15% of the time) and risen in 207 quarters (about 85% of the time).
But look at Chart 11, which shows the quarter-on-quarter growth in nominal GDP. Nominal output has only fallen 13 times since 1947. The last quarter-on-quarter decline in nominal GDP was in Q3 1982.
Before that, you have to go back to Q4 1960 to find a quarter in which GDP declined in nominal terms.
Chart 12 shows nominal GDP growth on a four-quarter or year-on-year basis. Nominal GDP growth has not been negative year-over-year since Q1 1961.
From the late 1960s through until the current decade, relatively high rates of inflation ensured that GDP continued to grow in nominal terms even when it fell in real ones during cyclical recessions. Even during the deep recessions of the 1970s and 1980s, nominal GDP was generally growing because the decline in real output was more than offset by relatively high rates of price and wage inflation.
Payment ability for households which experienced unemployment and firms that experienced a sharp drop in demand for their products was often severely impaired. For these few, homes were often repossessed and individuals and companies could be made bankrupt.
But for the majority of households that remained employed, and for companies that experienced only a moderate decline in demand, wage and price inflation continued largely unabated, continued to raise their nominal cash flows, and make it easier to pay off debts incurred during the previous boom.
The combination of falling output with rising prices (labeled “stagflation” ) is usually seen as the worst possible outcome for the economy. Well, the worst except one: debt-deflation.
Because stagflation in the 1970s and 1980s ensured that, for most people, the real burden of debt remained manageable, or even improved, despite the recessions. The misery was borne by the minority of workers who became unemployed and the minority of firms that became insolvent. For the rest, inflation continued to boost nominal cash flows and increase debt-service capacity.
The strong, consistent growth of nominal GDP between the late 1960s and the late 1990s was mostly the product of persistent inflation. Before the mid 1960s, in the 1940s and 1950s, inflation rates were much lower, and nominal GDP growth was much more variable, turning negative on ten occasions between 1947 and 1960.
But in the current lower inflation world, the risk of nominal GDP turning negative has increased. During Q4 2008, nominal GDP growth turned negative for the first time in 25 years. Inflation (essentially zero) was not enough to offset the decline in output in real terms (-0.9% compared with the previous quarter).
Output looks set to decline further in Q1 and probably Q2 2009, and price inflation will probably turn negative. So at some point during H1 2009, nominal GDP growth will turn negative year-on-year for the first time since 1961.
NEED TO REKINDLE INFLATION
It is the sudden shrinkage of GDP in nominal terms which presents the greatest threat to the solvency of the banking system and the rest of the economy in the coming year. Because if GDP starts shrinking persistently in nominal terms, the already high burden of servicing debt contracts fixed in nominal terms will rise further.
Every job that is lost and every factory that is closed or put on short-time reduces real output. But every wage cut and price reduction is also reducing the cash flows which households and firms need to pay their debts, deepening the crisis.
Governments and central banks are now under intense pressure to sustain nominal GDP, and restart nominal growth, by boosting employment and fueling at least a modest pick up in inflation.
The target is shifting from restarting real growth to restarting nominal growth. Economist Samuel Brittan has written previously in the “Financial Times” about the need for the government and the Bank of England to have a target for nominal GDP growth (rather than a narrow focus on consumer price inflation). But the same is true for the other G20 economies.
Fiscal and monetary policy needs to create enough real demand and inflation; sustain employment and wage levels; raise output and prices.
In some sense, rekindling inflation has become a necessary and inevitable part of the solution to the current crisis.