Nick Rowe raises an interesting question about the chart I posted earlier appearing to show that the performance of the pre-2010 Greek economy was, while hardly stellar, nothing like the train-wreck you might expect based on the public discussion surrounding the Greek financial crisis. The question, as I understand it, boils down to this: could the microeconomic effects of Greek government borrowing (i.e. its impact on relative prices) affect the measurement of macroeconomic variables (particularly real GDP)? And, if so, should the effects be regarded as "fake?"
I think the answers are "yes" and "no," respectively.
The "yes" part is fairly easy to see. French and German banks loaned money to the Greek government that, otherwise, would have been loaned to and spent by somebody else. There's every reason to suppose that the different "candidate spenders" would have bought different things, so the choice of spenders has an effect on the relative prices of stuff they buy.
Changes in relative prices affect real GDP. The effect is most visible in cross-country comparisons on a purchasing power parity (PPP) basis, but it also plays a role in "longitudinal" real GDP within a single country.
To see how this works in the cross-country case, consider Saudi Arabia. The real value of its output in any given year depends rather a lot on the real price of a barrel of oil. A real rise in the price of oil (i.e. in increase in the nominal price of oil that outpaces the rise in the general price level) makes Saudi output more valuable, in terms of the goods and services produced by the rest of the world, even if the quantity of oil in that output is unchanged.
The effects of relative price changes on longitudinal real growth rates within a single country are more roundabout. Conceptually, a national real GDP growth rate is a weighted average of the growth (in quantity) of output of each good and service produced. We naturally want to weight each product-level growth rate in accordance with the importance of that product in the overall economy. That, it turn out, we usually measure by the share of each product in nominal output, which may be affected by its price.
Considering the Saudi example again, a rise in the price of oil (if not completely offset by a reduction in quantity) would increase the weight of the oil industry's growth rate in the calculation of the national growth rate. If the output of that industry is rising faster than average (1), this will tend to raise the measured growth rate of the country, but if (as is entirely possible) output of the oil industry is growing slower than average, an increasing price will tend to decrease the measured growth rate of the country as a whole.
The take-away is that real GDP is always and everywhere affected by the relative prices used to calculate it. (The difference between nominal and real GDP is not that the latter excludes the influence of relative price changes, but that it excludes the influence of changes in the general price level, i.e. inflation. (2) )
Does that mean that real GDP is "fake?" Only if you imagine that real real GDP would be somehow unaffected by relative prices. But how could that be? How do you add up the quantities of compact cars, bars of soap, and haircuts an economy produces every year without relying on relative prices? (My proposal to measure the output of all goods and services in metric tons, thereby giving proper meaning to the term "weighted average," has so far garnered little support.)
But what about the real question: would balancing the Greek government budget inevitably reduce the Greece's real GDP vis-a-vis the rest of the EU, on a PPP basis, even if the impact on aggregate demand was fully offset?
I think the answer is no. Even assuming, as Nick suggests, that balancing the Greek budget would reduce domestic demand for Greek tradeables enough to lower their EU-wide prices, it's not clear what the impact of the offsetting increases in aggregate demand would be. If, as seems plausible, that the offset came largely in the form of increased demand from the rest-of-the-world for Greek exports, the price of Greek tradeables might not fall after all, and might even rise.
The bottom line is this: if "austerity" is simply a re-arrangement of aggregate demand for Greek goods and services (i.e. a change in who does the spending and in the mix of what they buy), as it should be, there's no reason to assume that the reallocation has to lead to a net decline in relative, PPP-based GDP.
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(1) I.e. the weighted average growth rate of all other industries.
(2) I think Nick may have inadvertently muddied the waters here by thinking about the question through the prism of exchange rates. The Canadian example with which he begins his post involves an across-the-board change in all prices (because they are measured at a market exchange rate which has fallen). Naturally, that change appears "fake," just as if we decided to measure GDP in pennies rather than dollars ("Look! It's up by a factor of 100!"). But the difference between a change in the price level and one in relative prices is a crucial one in this context.
Thanks for the response!
ReplyDelete" If, as seems plausible, that the offset came largely in the form of increased demand from the rest-of-the-world for Greek exports, the price of Greek tradeables might not fall after all, and might even rise."
That sounds a bit like what Paul Krugman calls "The Doctrine of Immaculate Transfer". We need a fall in the relative price of Greek exports to get that increased demand for Greek exports from the rest of the world. It won't happen by itself.
Not exactly. To clarify, when I write, "increased demand," I don't mean "increased quantity transacted due to a rightward shift in the supply curve." I actually mean an increase in demand -- i.e. a rightward shift in the demand curve, raising both quantity transacted and price.
DeleteNevertheless, I do agree that this is something unlikely to happen by itself. Unless someone, somewhere takes specific policy action to make sure that the reduction in aggregate demand that accompanies a reduction in the Greek government budget deficit is offset by increased demand elsewhere, the outcome will (as we have seen) be a bad one for Greeks. However, once we're into a demand-constrained economy, the subtleties of PPP measurement are second-order issues at best. So I tend to think about the latter within a "full employment guaranteed somehow" equilibrium framework.
Hi JEC
ReplyDeleteReally important issues you weite about. Congratulations.
But, sure there is a but, what about the role of debt that is huge especially in single currency zone. The problem with debt that stays the same while income falls is even bigger in a single currency zone then with fixed exchange rate zone.
In such environment where income falls while the debt that such falling income is supposed to support damages to human lives is tremendous.
I see that you think in terms of loanable funds so think if greece did not borrow funds those same funds will be borrowed by somone else from banks.
Loaning from banks is not like that, there is no preset amount of funds at banks.
My borrowing does not prevent others to borrow, even the opposite is the case. More borrowing allows and encourages even more borrowing., not as you claim that there is a limit on loanable funds, there is not. Only limit on borrowing is willingness of borrowers to apply for a loan at given conditions.
Thanks for commenting!
DeleteI should say that I think I agree with you about the problems that can be caused by nominal debt, particularly denominated in a currency the country doesn't control. I haven't really written about the topic yet, but I hope nobody interprets that as an indication that I don't think it's important.
On the loanable funds theory: I'm actually not using such a framework, but I can see how my post might read that way. (This post is a very short summary of a much longer post that will probably never see the light of day -- because who would want to wade through it? -- that goes into a lot more detail about the toy model I'm using to think through the issue.)
For this particular purpose, I'm thinking in terms of a comparative statics framework starting from a full-employment equilibrium. The model doesn't have any real finance in it at all; what I'm really modelling is a negative demand shock in one country and an equal positive demand shock in the other. Here's one way to think about it: Real output can only be consumed once; equivalently, real income can only be spent once. Lending simply transfers the right to consume output from one entity to another. You can transfer the right any number of times -- i.e. no limit on total lending -- but you can still only spend it (in real terms) once.
Hope this clarifies!
Ok
ReplyDeleteSo you are using a form of fiscal theory of price level, that liquidity affects the price of particular items tending to go back into equilibrium with all items. That is a dangorous ground for mainstream economics. Then you can argue that taxing doesnt change people's ability to accuire things (of real value) . In other words, comparring states where there is no tax with those with taxes and equal incomes, all other elementals being equal. Due to equilibrium tendency those states will consume equal real GDP in PPP levels (or as you prefer GDP measured in weight) even tough one has taxes.
Conclusion that taxes have no effect on real GDP can be taxing on mainstream economics or neoliberal dogmas. Only change in tax can afect real GDP, not tax per se.
So, only change in government borrowing can afect real GDP not a constant levels of borrowing.
Another issue is that such effects have a one trajectory when inflation is present and another with no inflation. With inflation increase in borrowing keeps real GDP in equlibrium(other prices can stay still while particular can move up).
Without inflation, (due to fixed private debts) production will be cut instead of not rising prices while more essential stuff like food will be produced at the same levels. Less essential production will dissapear.
This leads me to conclude that afect of the chart in previous post where real GDP grows in Germany while fals in Greece is produced more by emigration to germany and by relativity of averages in a total, not so much by increased production per se on elementals independently of each other.
Emigration moves demand, not in this case economics. All due to old private debts with falling incomes.
Next conclusion shall be that to prevent emigration level of private debts must keep growing not to change equilbrium and that old debts can be payed off only with new debts.
Then the question what is real and what is fake is answered by ability to borrow more to pay off old debts, not to put preassure on demand. To grow debts you have to grow incomes not come to realization of what is supposedly "fake". Financial crisis that started the unemployment growth is inability to refy old debts.
The problem in financial sector is what starts the trend of falling production by jumping out of previos equlibrium and emigration.
The problem in EZ financial sector caused the shift in real GDP relationship of Germany and Greece.