How GDP conceals inflation

Aug 24, 2016·Alasdair Macleod

There are so many things wrong with GDP, that even mainstream economists are becoming vaguely aware of its shortcomings.

A good friend drew my attention to a Bloomberg article on this subject, which at least shows a growing awareness that there’s a problem. Unfortunately, this awareness does not extend to its underlying nature.

GDP statistics only capture an incomplete snapshot of the economy at one moment in time. Since the economy is continually evolving, that snapshot is immediately out of date, and therefore unfit for the purpose of economic planning. Furthermore, being an incomplete picture of the total economy, GDP badly misleads policy-makers on the subject of price inflation.

This is the topic of this article. We will focus on the relationship between the economy, monetary inflation and price inflation, and show how GDP conceals inflation until it is too late to do anything about it.

The best way to demonstrate this is to start with a theoretical illustration of a sound-money economy, where the total quantity of money and credit is the same for successive years. This is illustrated in Table 1.

Table 1 Sound money exampleYear-end 1Year-end 2
Allocated to: M u M u
Investment through saving 15 13
Production from profits 10 11
Consumption 75 76
Totals 100 100

The total amount of monetary units (Mu) spent in one year is unchanged from year-end 1 to year-end 2, because that is the sound money condition. Everyone earns and spends, in accordance with Say’s law. The totals represent net earnings and profits over the course of one year, spent in the relevant categories.

Neither base money nor bank credit can be expanded. Note that the table represents the whole economy split into three categories, and not conventional GDP sub-components, which only capture spending at final prices for selected capital and consumer goods. The totals represent net annual income allocations into the respective categories in a theoretical economy. The table does not include past accumulations of spending, or prices based on valuations. The table also includes both government and private sectors.

Some money earned will be put aside for investments in the form of savings, mainly destined to finance production, some will be invested directly in production out of business profits, and the balance will be spent on consumption of non-productive goods and services. We will assume purchases of second hand goods are also included in the consumption total. Government spending is included in the model, because it cannot finance its spending through monetary expansion.

The scope is far wider than GDP itself, and captures all economic activity. The total of earnings and profits are the same, because no money enters or leaves the economy. Therefore, the total is unchanged for year-end 2, but its allocation is free to vary from one category to another.

In this example, less money has flowed into investments in Year 2, and the balance has been reallocated equally between production and consumption. In a sound-money economy shifts between these categories tend to be minor and self-correcting. Extra money and credit are not available to support higher prices, and an increase in allocation to consumption, financed by a reduction in investment through savings, will find a new balance through higher interest rates for savers. This is why sound money is always, in the absence of an exogenous shock, accompanied by a high degree of economic stability.

Unsound money, credit cycles, and price inflation

Phase one: suppressing interest rates

Having set the scene with a sound-money example, we can now use this framework to move on to the contemporary fiat money environment, and put it in the context of a business cycle. Business cycles are without doubt driven by the ebbs and flows of money and bank credit, as we shall see. Those of us who have experienced several business cycles should be able to recognise how they generally progress as described below.

Business cycles can be broken down into distinct phases. Following the previous cycle’s crisis phase, Phase 1 is the central bank’s suppression of interest rates and forced expansion of money supply, the purpose of which is to rescue the banks and to keep business trading. Phase 2 is the initial recovery in consumer spending, which begins to drive up interest rates, and the rate of price inflation. Phase 3 is characterised by accelerating price inflation and rising production costs, as businesses scramble to acquire the resources to meet demand. And lastly Phase 4 is the inevitable financial crisis, as the malinvestments over the cycle come home to roost.

I have changed the accounting period to phases (P1 etc.) to reflect the fact that the duration of different phases of a business cycle varies considerably, and I have redesignated the investment-through-saving category to net movement into the financial sector, to reflect this sector being the source of expanded bank credit.

Table 2 shows the effect of injecting extra money into the economy during Phase1 (P1), which can be either in the form of bank credit or narrow money.

Table 2 Increasing money-total by 10%StartP1
Allocated to: M u M u
Net movement into the financial sector 15 28
Production from profits 10 5
Consumption 75 77
Totals 100 110

For clarity of illustration, I have assumed a starting-point consistent with an economy untrammelled by monetary expansion, typified by our sound-money example above. Therefore, the Start column reflects a normal economy previously running on sound money, rather than the post-crisis condition that normally applies.

Phase 1 reflects the initial monetary stimulation. I have assumed that most of the extra money supply in P1 has been created and remains in the financial sector, which accords with contemporary experience following the Lehman crisis.

The investment world of today has been radically changed. With sound money, higher interest rates attract a greater allocation into savings. The opposite is now true with unsound money. Lower interest rates, imposed on the market by the central bank, distort asset values, making them rise. This has the effect of encouraging money to flow into purely financial activities, at the expense of the other two categories. This is the basis of all asset bubbles, and why they are not concurrent with an improvement in economic activity. Today, interest rates are depressed to such low levels, that rather than invest in production from profits, companies have even been borrowing to buy their own shares. This is reflected in the lower spend in this category in Table 2, which is redirected into financial activities.

Money allocated to consumption rises slightly, but not to the extent hoped for by the central bank. Today, this is reflected in moderate price inflation, which in practice is dumbed down through hedonics and other statistical devices, to show an artificially low rate. It should be noted that the volume of goods and services exchanged does not necessarily increase in this environment, only prices change. This explains persistent underemployment, and perceived spare production capacity, while financial speculation produces the best returns on money.

However, money beginning to move into consumption is easy to visualise, starting with an elite minority, who have benefited from rising asset prices and have increased their spending. This effect is most marked near financial centres, where bankers, lawyers and other financial service providers spend their earnings and profits not only in those locations, but within commuting distance and in fashionable holiday resorts. Anyone outside these hot-spots finds them noticeably expensive.

Phase 2: asset deflation and price inflation

Table 3 illustrates the next phase.

Table 3 Increasing money-total by another 10%StartP1P2
Allocated to: M u M u M u
Net movement into the financial sector 15 28 11
Production from profits 10 5 10
Consumption 75 77 100
Totals 100 110 121

We now move into Phase 2, where yet again bank credit and narrow money have increased a further 10%, to total 121 monetary units. In this case we have assumed that increasing price inflation, together with signs that consumption has stabilised and improved slightly, lead to financial markets discounting a rise in interest rates. Financial assets lose bullish momentum and begin to decline, reducing the attractions of investment through saving, relative to other activities. The new money invested to keep inflating the asset bubble becomes insufficient. Asset inflation then reverses into outright asset deflation. The expansion of bank credit becomes the principal driving force in the expansion of the financial sector’s input by the end of Phase 2.

Falling stock and bond prices lead to portfolio losses. Investors respond by reducing their savings allocation to minimal amounts, and by reallocating the surplus on a growing preference for goods and services. The central bank’s policy of financial and monetary stimulation finally seems to be working, but investment in productive capacity always lags. The result is prices for goods start rising at an unexpected pace, forcing a reluctant central bank to belatedly increase its interest rates by more than it would like. This benefits production margins, and businesses begin to set aside more profit for product development and capacity expansion. But it is too little, too late.

Phase 3: production costs rise steeply

Table 4 illustrates Phase 3, when producers who have previously underestimated the strength of the recovery, discover their error.

Table 4 More rapid monetary expansionStartP1P2P3
Allocated to: M u M u M u M u
Net movement into the financial sector 15 28 11 20
Production from profits 10 5 10 10
Consumption 75 77 100 110
Totals 100 110 121 140

They begin to realise that growing consumer preferences for goods and services over money is driving up prices faster than anticipated, making an expansion in productive capacity appear more profitable. While interest rates began to rise in Phase 2, it does not appear to be too late to expand production profitably. Businesses need to borrow from the banks to finance their planned industrial investment, because the available set-aside from their profits turns out to be insufficient. The banks are themselves more confident in the economic outlook, and are prepared to compete with each other to lend money. This they do, expanding bank credit accordingly. It is the expansion of bank credit driven by the market which accounts for the sharp rise in Phase 3’s total bank lending to 140 monetary units.

However, businesses find themselves increasingly constrained in their additional investment by rising raw material and commodity prices, bottlenecks in the supply of semi-fabricated capital goods, shortages of skilled labour and growing pressure for higher wage rates. Try as they might, they cannot respond adequately to the increasing demand from consumers, so prices continue to rise more rapidly.

An increase in prices is the only way the available volumes of products and services can be reconciled with the increasing money-flows in the overall economy. Employment levels remain disappointing, due to underinvestment in training and development of the new skills required by the market.

Phase 4: the crash

The last phase is a financial crisis, as the monetary distortions and imbalances of the previous three phases suddenly correct themselves. It is the final proof, if it was needed, that you cannot fool everyone all of the time with unsound money.

Table 5 Credit contractionStartP1P2P3P4
Allocated to: M u M u M u M u M u
Net movement into the financial sector 15 28 11 20 -10
Production from profits 10 5 10 20 -5
Consumption 75 77 100 110 105
Totals 100 110 121 140 90

Price inflation had risen in Phase 3, accompanied by an acceleration in demand for bank credit. Rather than discourage bank lending, the central bank had no intention of raising rates to the point where its expansion became limited. Instead, the central bank takes comfort that its earlier monetary policies are being rewarded by increased economic activity, but are vaguely aware of the dangers of “over-heating”. Even though price inflation is too high for comfort, and rising interest rates seems to have had little effect, the central bank is wholly unprepared for what is to follow.

Phase 4 describes the end-of-cycle crash. Surely, we recall the securitisations of the 2005-07 years, when bank lending was augmented by off-balance sheet lending, followed by the great financial crisis. That is where we were in Phase 3, moving into Phase 4. The accumulation of debt over the previous phases of the cycle had become too great to bear. Phase 3 started with optimistic business assumptions about returns on capital, which never materialised. Decisions then had to be taken, either to write off the new investment, or to soldier on. Most enterprises soldiered on.

The result is that the final turn of the interest rate screw now threatens a wave of bankruptcies. Businesses abandon investment plans and reduce existing capacity, extracting capital to pay off bank loans. Phase 4, the crisis, is underway. Bank credit begins to contract as the commercial banks, spooked by the turn of events, try to protect their highly-geared balance sheets by calling in loans where they can. Asset values fall rapidly, perhaps with no bids in the market, as collateral is called and put up for sale.

For the first time in the cycle, there is a sharp contraction of the total monetary units earned and spent across the whole economy.

The last time we hit Phases 3 and 4 remains etched in the memory. The exact causes vary from cycle to cycle, but who can forget the run up to the Lehman crisis, and the crisis itself? And who can forget the financial euphoria in the dot-com bubble, the subsequent halving of the stock market, and the feeling in 2002 that the financial world was on the verge of falling apart?

The severity of the crisis is proportional to preceding distortions, and the weight of unproductive debt being carried. This has been growing over successive credit cycles, because central banks have rescued the banks in every crisis.


We need to add an additional observation, and that is the Phase 4 crisis is never permitted to happen, and that each succeeding cycle starts with unfinished business. Successive rescue attempts by the central bank become progressively larger in scale as a result, and this can be confirmed by observation. This being the case, not only will there be another Phase 4 crisis to prevent, but it will almost certainly be on a greater scale than that of the last one. The underlying theme in our credit cycle model is of the importance, not only of the expansion of bank credit, but its augmentation by inter-sectorial flows. In our theoretical model, Phase 2 suggests that flows into consumer spending are enlarged by flows that otherwise would have gone into the financial sector. So far as I am aware, there is no recognition of this inflationary effect in mainstream economics, which goes a long way to explaining why economists rarely foresee the consequences of their monetary policies.

The US economy, in my estimation, is either at the end of Phase 1 or entering Phase 2. The monetary expansion following the Lehman crisis has been far greater that the model suggests, with the M2 measure of money increasing by 67% since then, compared with only 10% in the model. The consequences as we progress are likely to be correspondingly more dramatic.

It also seems reasonable to suggest that the beginning of a rising interest rate trend in Phase 2 will lead to an unprecedented backwash out of financial markets, bringing the timing of the succeeding phases and the eventual crisis forward in time. This likelihood certainly accords with the scale of the bubble in sovereign bond prices, and the consequences when they correct. Our model shows that redirected fiat currency flows that would have gone into the financial sector will be redirected into consumption, accelerating price inflation very rapidly.

The sheer weight of unproductive debt now being rolled over appears sufficient to stifle the progression of the credit cycle through its succeeding phases. In short, we are probably moving towards the next crisis in foreshortened timescales.

While we can theorise about phases in a credit cycle, there is always the possibility of a financial or banking crisis interrupting their development. That possibility, emanating perhaps from Europe, must be becoming more likely by the day.

i See

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