Deep N Mukherjee is currently Chief Product Officer, handling product design and analytics in a Indian credit bureau. He has over 14 years of experience in Risk Management and Credit Assessment. Prior to his current role, within Fitch he was in structured finance team. Prior to his organization he was with American Express where he was heading the Institutional Risk Management Team focusing on quantitative risk management. He is also a visiting faculty in finance with IIM Calcutta. He has done his graduation in engineering from IIT, Kharagpur (BTech, 1999) and has obtained his management degree from IIM Lucknow (PGDM 2002).

The more widespread practise is to focus on ‘real GDP’ or inflation adjusted GDP growth. The benefits of this is well documented and widely understood. Economic activity, when not adjusted for inflation, leads to measures such as Nominal GDP (or GDP at current prices). In any economy with high inflation or gradually accelerating inflation, focussing on nominal GDP growth does not reflect the damage to the economy. However, in economics there are no absolutes.

There are economic scenarios where the focus on Nominal GDP is as important as Real GDP. This scenario is specifically one where the Inflation is slowing down sharply or dis-inflation has set in to such an extent that the year-on-year inflation measure is negative. In such a situation which nearly happened in India a few quarters back, the Real GDP growth ( and also applicable for Real GVA growth)  was higher than the nominal GDP(and GVA) growth.

In fact real GDP showed an improvement while nominal GDP showed a deceleration. The stated recovery in real economy was not being experienced in other measures such as corporate earnings, wage growth, credit growth and reduction in NPA of banks.

Abuse of GDP in Economic and Financial Analysis: In pre-2010 period it was not difficult to come across claims in Indian banking sector that if (real) GDP growth is 8%, the Banking sector assets would grow by 2.5 to 3 times. This almost became a common ‘wisdom’ or a rule of thumb. However, such wisdom is not holding good currently since, the real GDP is growing at around 7.5% while the banking sector asset (credit) growth is just 9% to 10%. Anyone with a basic understanding of ‘dimensionality’ would take it as no surprise. Banking sector credit growth is ‘nominal’ in a sense it is not adjusted for inflation. Any attempt to find a correlation between a nominal value (banking sector credit growth in this case which is not adjusted for inflation) and a real value (GDP in this case which is adjusted for inflation) is unsound mathematics and bad economics.

Banking credit growth in India typically has a 1.1X to 1.5X multiplier with respect to nominal GDP growth. Given that the recent nominal GDP growth has been 8% or below, a 9%-10% banking sector credit growth is in line with historical observation.

However, the malady of comparing a real GDP growth to nominal measures is quite widespread and extends to things such as regressing corporate earnings growth (again a nominal measure) against real GDP growth. The lack of usage of nominal GDP even when it is required is very intriguing. Is it because most analysts (and their economist units) have forecast of real GDP growth but no publicly or consensus view on nominal GDP growth? This is surprising.

Specifically, the surprise arises from the observation that for estimating real GDP, the nominal GDP needs to be estimated beforehand.  At least the government agencies which calculate GDP tends to follow this approach.

Real GDP Estimate Unlikely without Nominal estimate: The steps of estimating GDP are as follows. Firstly, the nominal GDP in INR terms of various sectors are estimated.  Nominal GDP estimation uses the existing and current price of various products and services as of the period of calculation. The prices for significant number of the components of the GDP are directly observable and to an extent is experienced by the people.

Subsequently, for each of these sectors a suitable deflator is used to adjust for the impact of inflation affecting that sector. This gives the real absolute GDP component for that sector. Then the real (inflation adjusted) GDP components are added to get the real GDP of the overall economy.

If the estimate of real GDP growth are done systematically and rigorously, then the forecaster would first come up with the nominal GDP growth estimates. However nominal GDP estimates are rarely, if ever, published. For some reason only the real GDP growth rate is shared by most economic forecasters.

However if the forecaster assumes that the inflation rate remains constant over previous year then one may model the real GDP directly from previous years’ real GDP. The implicit assumption being made in this approach is that the GDP deflator remains unchanged from year to year. However, in years when inflation is rapidly falling or rising this quick fix approach of calculating real GDP will provide estimates which are wide off the mark.

Assumption of Money Neutrality and superiority of ‘real’ measures: A relook at the practise of focussing entirely on ‘real’ measures is clearly required for other reasons as well. It comes from the theoretical premise that money is neutral. Joseph Schumpeter, in History of Economic Analysis explained the concept of neutrality of money succinctly. To quote “Real Analysis proceeds from the principle that all essential phenomena of economic life are capable of being described in terms of goods and services…Money enters the picture only in the modest role of a technical device that has been adopted in order to facilitate transactions…so long as it functions normally, it does not affect the economic process which behaves in the same way as it would in a barter economy: This essentially what the concept of neutral money implies”.

It is important to note Schumpeter’s definition which assumes that the money is functioning normally. But money may not be as neutral as classical economists claim. American economist Hyman Minsky argued, “in a capitalist economy resource allocation and price determination are integrated with the financing of outputs, positions in capital assets, and the validating of liabilities. This means that nominal values (money prices) matter: money is not neutral”.

Classical economists propounded the theory that ‘money’ is a representation of value. As per classical economists, money was considered to be a contrivance which facilitated economic transactions / exchanges in the real economy but itself did not impact the elements of ‘real’ economy such as land, labour and the process of production. In effect it highlights the neutrality of money of the real economic process.

Here it may be mentioned that that the way Minsky defined ‘capitalist’ draws on the way Karl Marx defined ‘capital-ism’. As per Marx, in the capitalist system money/financing is required before the production. Money does not appear mysteriously after production just to make the exchange of the product more convenient. This need for capital before production is one of the features of a system which may be tagged as ‘capital-ist’. One may agree that this is the case in India as well.

Monetarists and the Focus on Real GDP: The world is currently leaning on policies which may be defined as “Monetarist”. The Monetarists, among other thing, have a faith that lowering interest rate or increasing the supply of money(or its alter ego-credit) would increase economic activity. Recall near zero interest rate ( and of course negative interest rates) are adopted in some countries with the expectation of reviving their economic activity.

To be fair, monetarists view money to be neutral only in the long term. So one may expect some of the monetarists to be interested in the nominal GDP.

However this brings us to an interesting question. Most economic analysts tracking Indian economy tend to subscribe to the monetarist view. The author conjectures this since a lot of them create eloquent and verbally pleasing arguments of how interest rate reduction may improve Indian economic growth. However where they deviate from true-blue monetarists is that while analysing/predicting economic activity either of next quarter or next year (technically short-term) they use only real GDP growth. Hardly if ever one would find forecasters predicting the nominal GDP growth rate, forget expected value of nominal GDP in INR terms.