In the 1990s blockbuster, The Matrix, the protagonist Neo is asleep at their computer after a hard day of “hacking” (such a quaint notion of hacking in Hollywood back then).

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This was, of course, a veiled reference to Lewis Carroll‘s book  Alice in Wonderland, a mathematician, that some people have speculated was written to express the possibility of a black hole existing in the universe before one was detected. I make no such claims, but it’s an interesting narrative.

So why do I bring up this incredibly dated movie analogy, you ask? I’ve had several recent conversations with people on the economy and, to them, as they look at statistical data coming from various official sources it simply does not make sense.  To them 2 + 2 = 5.

During times of economic decline there are incentives to to increase the money supply to hide real economic fundamentals.  Indeed, Keynesian Economics is built upon this premise.

Real versus nominal terms

In order to really understand how the economy functions we need to make a distinction between the real economy, and the financial economy.  To be precise the real economy is the portion of economic activity that occurs due to the input of labor, capital stock (machines, factories etc.)  The portion of the economy which isn’t “paper”.

Nominal is the entire economy in aggregate which is the financial (monetary) economy, plus the real economy.

Mainstream Economists (and financiers), for instance, make a distinction between real and nominal interest rates:

[(1 + i)/(1 + pi)]  – 1 = r

Whereby it is commonly understood that inflation must be removed from the nominal interest rate to obtain the real yield, r.  This is shown above, with  being the nominal interest rate (consider it like the interest paid on a savings account) divided by the rate of inflation, pi.

(In case this is news to some people, yes you can be receiving a negative real yield on a bank account balance with a positive interest rate.)

Bringing us back out our Matrix analogy, yes in economics, the Matrix may really “have” a lot of us, in the sense that a massive push in monetary creation could hide the underlying REAL economic decline. If you feel poorer than you did in 1998 when you go to the grocery store, despite raking in the cash, it might be that your inflation-adjusted income hasn’t kept up in terms of purchasing power.

Evidence of economic decline in the real economy

If you want to hear how fantastic the economy is doing, just go sit and listen to any elected politician. They’ll tell you about how many new jobs they have added. How the economy has grown as X percent. How things literally, are just amazing since they were elected. The purpose here is to examine those underlying statements critically, even if trying to distinguish between the real and monetary economy is something similar to reading tea-leaves.  So where to start.

Commodities

Well, you can see my post on commodities for one, specifically the Bloomberg Commodities Index. Some industrial metals like copper and silver as well as other commodities like lumber, rubber, aluminium etc. Are all necessary in production.

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As mentioned, just one of many tea leaves. Why? Inflation can be negative.

Freight

Freight generally is a measure of the degree of intercontinental trade flows, or very loosely the the degree of globalization. See the Baltic Dry Index, for instance, as one indicator. Which, despite the name, doesn’t just cover the Baltic sea.

20150206_bdiy

This is arguably even more telling than commodities, as globalization tends to lead to economic growth.

Power Consumption

Yet another tea leaf in the real global economic scene, and I would hazard caution when examining energy as technological advancement tends to reduce unit usage, and has shown to do so significantly in developed worlds.

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The scale on the left, incidentally is in 3% growth terms. A better, and more thorough man than me (with more free time on their hands) would do research into the industrial component of the consumption. But not only is finding Chinese data difficult, nobody can actually agree on how accurate the data is in the first place thanks to a lack of transparency.

Monetary Aggregates

So what about the monetary portion of the economy right?  Well, someone (Yardeni) has painstakingly tried to aggregate global money supply across the major economies too. See here for the original paper.

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Note: that “money” is not an easy distinction to make in economics so there are multiple measures (M0, M1, M2, M3 etc. it is not a static definition). The M2 shown here is cash and deposits plus an aggregate which varies, depending on the central bank in question. Anyway, this loosely shows bank deposits and the more easily convertible (short-term maturity) elements of the money supply.

The trend is a deflationary one.

Conclusion

The broad trend since 2009 however, seems to be thin global growth (at best) in the real economy. With growth most likely coming out of the East, if anywhere.  A retracement of the highly globalized economy which occurred in 2007 would explain why so many people in the West seem to be struggling.  The deflationary trend in the final part suggests that the global economy might be hitting the skids now, with deleveraging occurring in the financial economy.

I’ll take a specific look at the nation level (UK and US) in another post.

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3 thoughts on “Follow the White Rabbit…

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