The Slow Recovery, Simplified & Rounded

Not everybody waits like me every morning for the latest stat on how the economy is doing or every straw in the wind. Most people are more likely than I am to have a life.

When I speak to such people in audiences, I have the uneasy feeling that sharing the detailed results of my activities along those lines does them no favors. You need a broad skeleton, or outline in your head, to stick new information to, even if the need for simplicity and memorability must overcome precise accuracy in framing that outline.

Here is one way I like to describe the economy in recent years in an idealized way to make it easy to remember. Using the equation of exchange for a framework, I point out that the money supply (I use the M2 version) has been growing around 7 percent per year in recent years, but that the velocity of money has been declining around 3 percent, for a net increase in total spending of 4 percent, which is the same as the growth in nominal GDP.

(Note to readers: you probably realize that the growth of M1 has been considerably faster than the growth of M2, but that doesn’t matter much since, given that nominal GDP is what it is, it just means that the M1 velocity is proportionately lower than M2 velocity.)

The approximate and rounded 4 percent number for total spending or nominal GDP may be off a little depending on the year, but I like to use it anyway because it enables me to say that that 4 percent nominal GDP growth is split about evenly between 2 percent real growth and two percent inflation. One reason that is important is that most people have heard that we have a “2 percent economy,” meaning, 2 percent real growth. That number anchors all my arithmetic to a number they already know, sort of.

(The actual real growth number in the recovery years is closer to 2 ¼ than 2, but that makes the inflation number or the nominal GDP number, or both, much more difficult to remember.)

I don’t feel too bad rounding a 2 ¼ percent real growth rate down to 2 percent, because it’s been closer to 2 percent recently (and the inflation rate has come down as well). In fact, the 3 different estimates of fourth quarter 2013 real GDP have all rounded to 1.9 percent growth for the year 2013—sometimes we got to 1.9 percent by rounded down, sometimes by being rounded up.)

One reason for using the equation of exchange as the framework for discussing the broad macro economy is that most audiences, given my background, expect me to discuss the Fed’s quantitative easing, and why it hasn’t done more harm and why it hasn’t done more good. I have to acknowledge that a 7 percent money growth rate sounds pretty high, and it is for normal circumstances, but not if it has to be netted against a 3 percent decline in the velocity of money (7 – 3 = 4). People generally understand, intuitively, that money numbers must be adjusted for velocity.

(What I usually try to avoid, unless pressed by a smart aleck in Q&A, is acknowledgement that since the velocity number is derived by dividing the nominal GDP growth number by the money supply growth number, it always works out perfectly. More sophisticated audiences—by that I mean more smart alecks—might  jump to the conclusion that if the velocity number jumps around a lot, then maybe money isn’t the right focus. Maybe animal spirits are more dependable.)

Since I’m up to that point in the narrative, I might as well state for the umpteenth time in this forum that the Fed’s quantitative easing didn’t create a booming economy and/or roaring inflation is that for all the asset purchases, 7 percent money growth in an environment of an average 3 percent decline in velocity just isn’t much money growth given the tremendous slack in the economy. Most commentators have just assumed, wrongly, that massive bond purchases have created boatloads of new money. “If we haven’t had the inflation yet, we will soon.”

This is a good place to acknowledge that this is not the way Janet Yellen thinks about the economy, yet she reaches the same conclusion that inflation is not a clear and present danger. She gets there, not by considering the money growth numbers, but by focusing on the slack in the economy in terms of unemployment and capacity utilization and focusing on the “output gap,” the difference between the economy’s actual production and its potential production. One minor problem she’s had recently is that, as we approached 6.5 percent unemployment, which the FOMC had set forth as a key threshold for considering higher interest rates, she had to acknowledge, at least implicitly, that unemployment has fallen largely for the wrong reason—labor force dropouts.  As for me, I’ll keep watching the money supply numbers, with one eye on velocity, or which is the same thing, nominal GDP.

 

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  1. D. Acemoglu says:

    The economy is recovering slowly but the budget cut is still ongoing.