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The deteriorating economic outlook

 
 
 
 
 
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The third and final estimate (until the annual GDP revisions) of first quarter 2014 real GDP growth released June 25 by the US Bureau of Economic Analysis was a 2.9% contraction in GDP growth, a 5.5 percentage point difference from the January forecast of 2.6% growth. Apparently, the first quarter contraction was dismissed by those speculating in equities as weather related, as stock averages rose with the bad news.

Stock market participants might be in for a second quarter surprise. The result of many years of changes made to the official inflation measures is a substantially understated inflation rate. John Williams (www.shadowstats.com) provides inflation estimates based on previous official methodology when the Consumer Price Index still represented the cost of a constant standard of living. The 1.26% inflation measure used to deflate first quarter nominal GDP is unrealistic, as Americans who make purchases are aware.

A reasonable correction to the understated deflator gives a much higher first quarter contraction. The two main causes of inflation’s understatement are the substitution principle introduced during the Clinton regime and the hedonic adjustments ongoing since the 1980s that redefine price rises as quality improvements. Correcting for excessive hedonic adjustments gives a first quarter real GDP contraction of 5%. Correcting for hedonic and substitution adjustments gives a first quarter real GDP contraction of 8.5%.

Realistic economic analysis is a rarity. The financial press echoes Wall Street, and Wall Street economists are paid to help sell financial instruments. Gloomy analysis is frowned upon. Even negative quarters are given a positive spin.

Years of understatement of inflation has resulted in years of overstatement of GDP growth. Thinking about the many years of misstatement, we realized that the typical computation in nominal terms of the ratio of debt to GDP is seriously misleading.

Consider that debt is issued in nominal terms and repaid in nominal terms (except for a few Treasury bonds with inflation adjustments). However, nominal wealth or nominal GDP overstates real economic strength. The debt is growing, but both the nominal and real values of the output of goods and services are not keeping up with the rise in debt.

To understand how risky the rise of debt is, nominal debt must be compared to real GDP. Spin masters might dismiss this computation as comparing apples to oranges, but such a charge constitutes denial that the ratio of nominal debt to nominal GDP understates the wealth dilution caused by the government’s ability to issue and repay debt in nominal dollars. We know that inflation favors debtors, because debts can be repaid in inflated dollars.

The graph below shows three different debt to GDP ratios. The bottom line is nominal debt to nominal GDP, the financial press ratio. The middle line is the ratio of nominal debt to the official measure of real GDP. The top line is the ratio of nominal GDP to Shadowstats’ corrected measure of real GDP that puts back in some of the inflation that is no longer included in official measures. The basis for this corrected measure is also 2000, but as the GDP number for 2000 is lower due to correction, this graph begins with the ratio at a slightly higher point.

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