Source: Yianis Varoufakis: Lies, Damn Lies, and European Growth Statistics
ATHENS – “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. Consider the hypothetical depiction of a deflationary economy in the table below.
From Year 1 to Year 2, the country’s money income (N) shrank by 2% (from 100 to 98), while the index of average prices fell by 1% (from 100 to 99). In the following year (Year 3), the recession deepened, with a further 2.04% drop in money income (from 98 to 96) and an even larger fall in prices as deflation hit 6.06%.
This is the picture of an economy sliding from recession toward something reminiscent of depression: falling incomes and even faster declines in prices. But look at the last row: “Real” national income seems to have rebounded dramatically in Year 3, having risen by a healthy 4.28%!
But it is a mirage – an illusion caused by falling prices. Put simply, in deflationary economies, where people and the state bear significant debts, only increases in money (as opposed to real) income are cause for celebration.
One may retort that an increase in real national income, R, is always good news, even if money incomes are falling. For if prices (P) are falling faster than money incomes (N), surely this means that we can afford to buy more for less. Is this not a good thing?
It certainly is – but only in the absence of the usual spanner in the works: debt. When people and governments are deep in debt, and as long as they pay positive interest on that debt, declining money income is a recipe for collective insolvency.
This is what was happening in Greece in 2014, when R had risen by 0.8% but P had fallen by 2.6%. It is also what was happening in Cyprus during the last quarter of 2015, with R at 0.4% in January 2016 but P at -0.75%. Indeed, much of the European periphery is caught in a deflationary mire, with money incomes falling, debts skyrocketing (as a share of money incomes), and banks drowning in non-performing loans that prevent them from lending even to profitable enterprises.
For several years now, Europe’s policy leaders have been paralyzed. They have invested too much political capital in their failed policies to attempt to reverse course. But no one should be fooled by statistical legerdemain: Focusing on real national income data during a period of deflation is merely an effort to repackage an economic depression as a great success story.
Read more at https://www.project-syndicate.org/commentary/europe-real-national-income-mirage-by-yanis-varoufakis-2016-03#etBq988kE5lCsGp7.99