Friday, December 19, 2014

The Importance of NGDP Growth (as a number, not an economic target)

In this post, I'll talk about something that rarely goes discussed: what the nominal GDP (NGDP) growth actually tells us. Usually when people use GDP growth, they use real GDP (RGDP) growth and find RGDP by using NGDP and subtracting inflation--usually measured by CPI. However, NGDP tells us something very valuable: it tells us the nominal value of the economy at a given point in time. So what does NGDP growth tell us? It tells us the shift in the nominal value of the economy per unit time. In other words, it tells us, in nominal terms, the growth of the real economy, and thus the nominal return of real assets on average.

Why is the nominal return of real assets so important? There's several reasons why it's important:
1. It's the growth rate of the real economy
2. It's the "opportunity cost of capital"--by the opportunity cost of capital, I mean that it is the return capital would receive instead of being put to use somewhere else (like foreign assets, government bonds, equities, etc.)
3. The real cost of transferring capital is ALWAYS the nominal return of real assets because it is the opportunity cost of capital

Many people including economists (particularly statists, socialists, and others who subscribe to authoritarian economic ideas) often claim that when the government issues zero interest loans all the time and all the government has to do is invest in anything that returns more than 0%. Of course, such ideas are complete and utter nonsense because they don't account for the real cost of transferring resources.

It's important to note that the real cost of transferring capital is ALWAYS the NGDP growth rate. In order for a project to be economically justifiable, the increase in productivity generated by the asset must be larger than the NGDP growth rate, not cost of the liability created (assets and liabilities must be created simultaneously).

The Relationship Between the NGDP Growth Rate and Interest Rates:
Now that we have a basic idea of why the NGDP growth rate is so important, we can now move on to what interest rates tell us. For the sake of simplicity, I will be talking about the short term money market rate of interest.

Recall that a traditional bank makes money by charging interest on long term loans by paying out interest on deposits. Bank deposits don't have a term period and are short term liabilities. Basically, (traditional) banks are long the longer end of the yield curve and short the shorter end of the yield curve.

Since NGDP is the nominal return of holding real assets and the growth of the economy and an (weighted) average return of real assets, we must compare the short term interest rates to the NGDP growth rate in order to determine the real effects of interest rates. Recall that the money market rate of interest is effectively the same (assuming a negligible risk spread, which is usually the case) as the return of holding deposits. Note that bank deposits are the primary monetary assets. In other words, bank deposits are money (not the bank reserves, like most people think).

If the return of holding monetary assets is higher than the NGDP growth rate, the sector that's long monetary assets will see the percentage of the income they hold go up while other sectors must see the proportion of the income they hold fall because the growth rate of the real economy in nominal terms is the NGDP growth rate. If the return of holding monetary assets is less than the NGDP growth rate, the sectors long monetary assets will see their share of the pie fall.

Remember that we can separate an economy into roughly three sectors: households, corporations, and governments. The household sector is the primary sector that is long monetary assets while corporations/governments are almost always short. Therefore, the cost holding short term interest rates below NGDP growth is primarily borne the household sector.

Note: The sophistication of the financial system matters in terms of how much households lose out on negative real lending rates (interest rates minus NGDP growth). If there's sufficient sophistication and diversity in a financial system/economy, households have alternatives to place their savings into equities, capital backed assets, etc.. Therefore, the impact of interest rates also depends on the financial system. A country like the US imposing negative real lending rates won't see the same depreciation in the household share of income than a country like China with the same negative real lending rates.

P.S. I've had final exams and been slammed, but now they're over and I've had about a week to recuperate. I'm starting to get a lot of writing done and will probably have several posts up over the next couple of weeks.

No comments:

Post a Comment