Yanis Varoufakis, a former finance minister of Greece writes on how the recent stats showing growth in Europe are all wrong.
What he shows is how people are getting even elementary macro wrong. There is confusion between nominal and real growth. In times of inflation, one looks at real growth but in times of deflation, one should look at nominal growth:
“Greece has at last returned to economic growth.” That was the official European Union storyline at the end of 2014. Alas, Greek voters, unimpressed by this rejoicing, ousted the incumbent government and, in January 2015, voted for a new administration in which I served as finance minister.
Last week, similarly celebratory reports emanated from Brussels heralding the “return to growth” in Cyprus, and contrasting this piece of “good” news to Greece’s “return to recession.” The message from the troika of European bailout lenders – the European Commission, the European Central Bank, and the International Monetary Fund – is loud and clear: “Do as we say, like Cyprus has done, and you will recover. Resist our policies, by electing people like Varoufakis, and you will suffer the consequences of further recession.”
This is a powerful story. Except that it is built on a disingenuous lie. Greece was not recovering in 2014, and Cyprus’s national income has not recovered yet. The EU’s claims to the contrary are based on an inappropriate focus on “real” national income, a metric bound to mislead during periods of falling prices.
If asked whether you are better off today compared to a year ago, you would answer in the affirmative if your money income (that is, its dollar, pound, euro, or yen value) rose during the previous 12 months. In the inflationary times of yore, you might have also accompanied your response with the (reasonable) complaint that increases in the cost of living eroded your increased money income.
To account for this gap between your money income and your capacity to buy things with it, economists focused on your purchasing power by adjusting your money income for average prices.
A country’s aggregate income is measured in a similar way. Economists begin by summing up everyone’s money incomes to derive nominal Gross Domestic Product – or, for the sake of simplicity, the country’s total money income (N). Then they adjust N for changes in average prices (P) by dividing N by P. This ratio is the country’s “real” income (R = N/P).
During inflationary times, the purpose of calculating the figure for real national income, R, was that it stopped us from becoming overexcited by reports that money income had increased substantially. For example, at a time when average prices were rising by, say, 8%, a 9% increase in money income translated into a mere 1% real growth rate in our capacity to buy stuff.
So, clearly, in inflationary times, the number for real national income, R, was the one to look at before rejoicing that the economy was growing. Only when R rose strongly did we have good cause to believe that economic activity was rising. But in periods of deflation (when prices are falling), like those encountered in Greece and in Cyprus today, R can be deeply misleading.
Well, anything can happen during these times..