• Sergio Focardi

Too bad, we are missing a good opportunity

Inflation and fear of recession are now current topics of political and economic discussion. Speaking of inflation, in two years we have gone from worrying about missing inflation to worrying that inflation is getting out of control. On the economic level, the invasion of Ukraine, theconsequences of the economic sanctions imposed on Russia, but above all the rise in interest rates have created the feeling that we are heading towards recession. In fact, both the Fed and the ECB have raised interest rates suggesting that there are likely to be further hikes.


So why did we open this post by saying that we are missing an opportunity? Because if we want to overcome the recession narrative, we need to change the basic concepts with which we study economics. Current economic concepts were developed when economies were fairly static systems. Today, economies are complex evolutionary systems that change qualitatively at a fast pace. To make economic decisions, one must understand the complexity and qualitative aspects of modern economies.


In a nutshell

After the 2007-2009 crisis, financial policies were put in place to protect financial markets. These policies led stock prices to spectacular growth, three times faster than the nominal growth of the economy. In the same period, the real economy underwent an economic and social crisis that led to growing income inequalities and allowed large sections of the population to be cut off from the active economy. At the same time, environmental damage has grown to perhaps irreversible levels. The international situation degraded, perhaps also under the pressure of the race to secure control of natural resources.


This post discusses the conceptual changes needed if we want to progress towards a more inclusive welfare state and avoid environmental catastrophe. We can summarize them as follows:

  • The traditional concept of economic growth as quantitative growth must be abandoned.

  • We can define the monetary value of economic output but we must use a concept of inflation different from the classic one

  • We need to look at the qualitative aspects of the economy.


Financially and economically unsustainable situation

To put this debate on a solid footing we must first observe that the current situation is financially and economically unsustainable. Let's start with some facts. If we look at the Federal Reserve Economic Data (FRED) website, it is easy to see that US nominal GDP in the period from the end of 2009 to the end of 2021 grew by 64%, or 4% per annum. For comparison, real GDP grew by 29% or 2% per annum over the same period. Overthe same period, population growth was 0.5% per annum, so nominal GDP per capita grew by 53% while real GDP per capita grew by 19%.


Now let's look at the SP500 index. This index grew in the same period from the end of 2009 to the end of 2021 by 427% or 13% per annum. The SP500 index represents the market capitalization of 500 companies considered representative of the American market. The global capitalization of the American market grew by 353 ̈% or 11% per annum. At the end of 2021 the ratio (market capitalization/GDP), often referred to as Buffett's ratio, was about 200%. That is to say, the market capitalization was twice the nominal GDP. These data, accessible to all, refer to the USA but similar data apply to Europe.


From this data we see that in the last twelve years the market capitalization of stocks has grown at a rate three times higher than that of the economy.


Now it is easy to understand that this situation is financially unsustainable. The stock market cannot grow exponentially at a rate three times that of the reference economies. If it did, the ratio (Market capitalization)/GDP would reach ever-increasing values and therefore become unsustainable. In fact, the value of a stock is the sum of the expectations of all future cash flows generated by the stock discounted with a discount rate that takes into account uncertainty.


Now, how did it happen that the stock market grew so rapidly? Essentially because large flows of monetary profits have been created. [1] In turn, monetary profits are due both to the indebtedness of wage earners and to Quantitative Easing operations. In order for capitalization to grow indefinitely relative to GDP, it would be necessary to artificially create the expectation of ever larger profits completely disconnected from the real economy.

Now these facts are well known to economists and political and economic decision-makers. These decision makers know that they can't let inflation get out of control, but they know very well that reducing credit and eliminating quantitative easing at the same time can create a financial crisis. If we look at the chart of the SP500 index we see that it is formed by periods of rapid exponential growth punctuated by crises. In the current year (2022) the SP500 index began a rapid decline that led it to lose 20% of its value. If we continue as in the past, we are likely to face the alternation of crises followed by unsustainable growth.


What should change?

First of all, it must be realized that the economy is not a homogeneous system but it is a complex system formed by highly heterogeneous elements. Products and services of modern economies are highly heterogeneous and cannot be aggregated. You can't put bananas, laptops, cruises and the tens of thousands of other products created by a modern economy together. Growth cannot be conceived as the growth of the quantities produced.

We need to find other possible forms of aggregation. We can aggregate through prices by forming GDP that is the sum of all final transactions in a certain period, say a year. GDP is the value of an economy's output. But in this way we form nominal GDP. If we want to study growth, and therefore compare GDP at different times, we have to build real GDP.

Economic theory and economic decision-making assume that real GDP is proportional to the amount of output. But this is not true. To define real GDP we need the concept of inflation. But inflation is a complex concept that depends on the quantity and quality of output as we will see below.


The many fallacies of the concept of inflation.

Inflation is defined in textbooks and manuals as the change in the price of goods and services. Now, in dramatic cases of hyperinflation, prices all change in the same direction, that is, all prices rise very rapidly. In these cases, inflation is a well-defined concept. But, thankfully, hyperinflation is a rare phenomenon. In the most common cases that apply to modern economies, inflation is not a well-defined concept for several reasons.


First of all, in normal times prices do not all vary in the same directions. Some prices go up others go down for various market reasons. Products and services are heterogeneous, and the variables that measure their quantities cannot be aggregated. Determining the value of changing heterogeneous variables is the problem of creating indexes. Now it has been known since the beginning of the last century that the problem of indices has no solution. Not only is there no unique index , but it is also not possible to define simple criteria that all "good" indices must meet. So to define an index of the change of the prices of stable goods and services that remain constant over the observation period is partly arbitrary. In practice, many indexes were proposed according to the needs of those who proposed them.


Now, even assuming that we can define with some criteria an index of price change, there are two other problems much more difficult to deal with. First of all in modern economies in any reasonable observation range, let's say a year, products and services change qualitatively. Qualitative changes can be not only technological changes but also changes in terms of image and usability. Qualitative changes produce price changes that cannot be considered inflation or deflation.


But not only do some products change qualitatively but some products stop being marketed and are replaced by new products. Calculating the inflation of sets of products and services subject to change and substitution implies defining a metric of qualitative change and substitution. This metric does not exist in mainstream economics.


In practice, statistical institutes define at each period a basket of goods and services that are fairly stable and that they consider representative of the consumption of average households. For these baskets they calculate the price index, the Consumer Price Index (CPI), typically using the Laspeyres index, or the Paasche index, or the Fisher index which is the geometric mean of the other two. Using this index they calculate inflation over the entire economy.

This method tends to overestimate inflation because price changes due to qualitative changes are calculated as inflation. More precisely, this procedure calculates a number that depends on price changes due to both inflation and qualitative changes. Clearly if inflation grows and approaches hyperinflation this procedure works well because then really all prices change because of inflation.


Now it can be argued that households really experience inflation when they see the prices of consumer goods rising. First of all, households do not have the statistical tools to evaluate the price index. In addition, households perceive inflation if, given their income, they cannot maintain the same social position. Qualitative changes do not affect a family if it cannot afford them. So inflation calculated by economists conceptually is a different thing from that perceived by households.


The concept of inflation cannot be applied to qualitatively changing products and services. Since highly innovative products and services make up a considerable fraction of all products and services, it seems reasonable to conclude that inflation is not uniform throughout the economy. There are sectors of consumer goods to which the concept of inflation can be applied and other sectors to which it cannot be applied.


Inflation as a descriptive parameter of the economy

Therefore one can tentatively conclude that using a single inflation value for the entire economy does not reflect the real situation. High inflation values apply to goods and services consumed predominantly by low- and middle-income households but do not reflect the situation of high- and very high-income households. High- and very high-income households are mainly exposed to price changes due to the qualitative or symbolic change in what they consume. The higher the level of income, the lower the perception of inflation because the qualitative change is correctly appreciated.


How to separate inflationary goods and services from others is a matter of debate. In some recent articles, my co-authors and I have proposed to use the complexity measures introduced by Hidalgo and Hausmann[2]. However, it is possible to introduce other criteria. It is important to understand that high- or very high-income households are actually only marginally subject to inflation. The growth in the value of their consumption is mainly linked to qualitative or symbolic improvements.


In summary, what should be done?

Treating inflation as a single uniform parameter for the whole economy and combating it with another single parameter for the whole economy, the interest rate, is an action that has negative consequences on the weakest sections of the population. Today, companies are, in aggregate, net creditors and therefore are not negatively affected by the rate hike. By contrast, the general public is a net debtor and suffers from rising rates because credit becomes more expensive in addition to the contraction of economic opportunities. Raising rates to reduce demand and reduce inflation mainly affects lower- and middle-income population groups along with small businesses


Today it would be necessary first of all to understand that economic growth is partly qualitative. The decoupling of economic growth from the use of natural resources required by the European Union Green Deal requires a growing commitment to recognise qualitative changes as genuine growth. Inflation today is overestimated because qualitative changes are counted as inflation and because we arbitrarily apply the same inflation rate to the most creative parts of the economy.


If we consider the contribution of qualitative growth, it is unlikely that we can assume that the economy will be going into recession. However, the changes required cannot stop at accounting for growth and inflation. The goal of decision makers today is to reduce inflation without provoking a financial crisis. It is understandable, but it should also be clear that the financial mechanisms that led to the present situation can no longer be used. Finance must be an instrument of the real economy. Credit creates purchasing power. This fact makes it a very powerful but potentially dangerous tool.


At a glance

Capitalism associated with the democratic system have demonstrated the ability to create wealth and well-being. One of the social foundations of the capitalist system is the concept of "trickle down", that is, the notion that the capitalists' gains eventually result in benefits for all. Over the last century, capitalism has developed in a situation of fundamental limitation of productive capacities. To produce in large quantities required the joint effort of an entire population. The concept of productivity was fundamental because high productivity offered a competitive advantage.


But in the last thirty years these considerations have lost value. Automation has made it possible to reach unthinkable levels of productivity and globalization has made it possible to relocate production to remote regions where labor costs are very low. At the same time, information technology has made it possible to create completely virtual financial systems. Money can be created with incredible ease. We had an example of this with Quantitative Easing where trillions of dollars or euros were created simply by writing numbers in certain computers.


Of course it is crucial that decision makers understand the changes but perhaps it is even more fundamental that the objectives of economic and financial decisions are discussed.

[1][1] A tutorial on these topics will be available on your website by June 24 [2] The Publications section provides details on publications

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