The hopeful message for the global economy from monetary and leading indicator data – see yesterday’s post – contrasts with consensus gloom, epitomised by the IMF’s latest World Economic Outlook (WEO), containing downgrades to the organisation’s global GDP growth projections for 2012 and 2013. The IMF claims that fiscal consolidation is exerting a much larger drag on economic expansion than previously assumed by itself and other forecasting bodies. Analysis by its chief economist, reported in Box 1.1 on page 41 of the WEO, suggests that the “fiscal multiplier” – the percentage impact on GDP of a change in the “structural” budget balance of 1% of GDP – averaged as much as 1.7 across a group of 28 economies in 2010-11, compared with an expectation among forecasters of about 0.5.

Fiscal tightening is scheduled to continue in 2013, with the IMF projecting a 1.0%-of-GDP fall in the structural deficit of advanced economies. If the fiscal multiplier were really 1.7, this would imply “fiscal drag” of 1.7% of GDP – probably sufficient to neutralise or outweigh stimulus from faster real money expansion. On closer inspection, however, the analysis generating the 1.7 estimate turns out to be suspect, relying heavily on results for two small countries. A defensible reworking of the numbers suggests that the prior hypothesis of a multiplier of “only” 0.5 cannot be rejected by standard statistical tests.

The 1.7 estimate is based on a comparison of deviations of GDP growth from forecasts over 2010-11 with projected changes in structural budget balances. Using the IMF’s own numbers, the best-fit line drawn through the associated scatter chart has a slope of -1.2, implying that fiscal tightening of 1% of GDP was reflected in a growth undershoot of 1.2% relative to forecast, on average. This 1.2 estimate must be added to the sensitivity of about 0.5 incorporated in the growth projections, implying a “true” multiplier of 1.7.

One oddity of the IMF’s analysis is that, while claiming to investigate the impact of fiscal consolidation, it includes eight countries whose structural budget balances actually worsened in 2010-11. Restricting the sample to only those countries that tightened fiscal policy, in fact, has no impact on the estimated “true” multiplier; the slope of the relationship is unchanged at -1.2 – see the red line in the chart below.

The chart, however, makes clear the dependence of this result on two “extreme” observations towards the bottom, for Romania (middle) and Greece (right). When these two countries are omitted, the estimated slope falls to -0.3 and is not statistically significant – green line. The claim, in other words, that the true multiplier is greater than 0.5 rests entirely on developments in Greece and Romania in 2010-11.

Significant fiscal tightening has clearly contributed to a deep Greek recession but it is impossible to disentangle this from the impact of a slump in the money supply caused by capital flight and lack of monetary policy autonomy – Greek narrow and broad money fell by 22% and 24% respectively in the two-years to end-2011. There has been no such money supply contraction in Romania but nor has the economy been notably weak – GDP expanded by 0.2% in 2010-11 combined. The undershoot relative to forecasts may simply reflect unwarranted IMF growth optimism in 2010.

Summing up, the IMF’s bold claim about the fiscal multiplier has provided a publicity coup for Keynesians but rests on flimsy statistical foundations. Fiscal tightening will exert a modest drag on global GDP growth in 2013 but real money supply developments should continue to drive the economic cycle, with recent trends warranting optimism.

Based on available information, six-month expansion in global real narrow money – the best longer-term leading indicator of economic growth – probably rose further in September, reaching its highest level since January. Allowing for the typical half-year lead, this suggests that an incipient upswing in global economic momentum will be sustained at least through March 2013 – see first chart.

September monetary data have been issued for the US, Japan, Brazil, China and India, together accounting for 60% of the G7 plus emerging E7 aggregate used here to proxy the global money supply. Faster US and Chinese real money expansion drove the suggested increase in the global measure last month – second chart. Eurozone numbers due on Thursday will be important for the final outcome but are very unlikely to show sufficient weakness to offset the US / Chinese increases.

The positive signal from real narrow money has received confirmation from a recent upturn in a shorter-term global leading indicator employed here – see previous post. A further recovery in new orders components of October manufacturing purchasing managers’ surveys would provide additional support for the suggested economic scenario; “flash” readings for China, Euroland and the US are released on Wednesday. Based on equity analysts’ earnings revisions, a rise in the G7 new orders measure above the breakeven 50 level looks possible – third chart.

The broad money supply comprises monetary instruments of varying liquidity, ranging from physical cash and current accounts to time deposits and bank bonds with a term of several years. A “Divisia” monetary aggregate attempts to measure the “transactions services” provided by the broad money stock by applying weights to the various components, with these weights inversely related to interest earned (on the assumption that a higher interest rate is offered to compensate for illiquidity).

The Bank of England’s UK Divisia indices are ignored by both private and official economists but are monitored here for confirmation of signals from the preferred M1 and M4ex aggregates. Real (i.e. CPI-adjusted) Divisia money has foreshadowed swings in the economy in recent years and has accelerated strongly in 2012, with six-month growth in the less-volatile non-financial measure at its highest since 2007, before the recession – see chart. The message is clear – consensus gloom about UK economic prospects is wildly exaggerated and data should continue to surprise positively in late 2012 and early 2013, to an extent that even media perma-bears will be hard-pressed to deny.

Chinese monetary trends signal a recovery in the economy in late 2012 and early 2013 but growth may remain below-par by recent standards.

Chinese analysts, like those elsewhere, tend to focus on credit rather than money, while preferring the broader M2 measure to narrow money M1. Real (i.e. CPI-adjusted) M1, however, continues to outperform as a leading indicator, as it has in a wide range of countries. A contraction in real M1 in early 2012 signalled recent economic weakness, even as bank loans and M2 were growing respectably – see chart.

Real M1 has revived since mid-year but six-month growth in September was moderate rather than strong – 4.2% (not annualised) versus an average of 6.1% since 2005. Pending further improvement, China may lag the global economic upswing expected here on the basis of monetary trends and recent leading indicator data – in contrast to 2009, when a Chinese boom drove a V-shaped recovery in world industrial output.

UK consumer price inflation remains likely to rise above 3% in early 2013, triggering a final exculpatory letter from the Bank’s Governor before his departure next June.

A post in August suggested that CPI inflation would bottom at 2.1% in September before rising to 3.1% in January, with the increase due to a combination of energy and food price rises, higher undergraduate tuition fees and sticky “core” inflation. The Office for National Statistics yesterday reported September inflation at 2.2% (or 2.15% comparing index levels last month and September 2011) and recent news has warranted only marginal adjustments to the assumptions underlying the earlier projection. An updated profile is shown in the chart – CPI inflation is forecast to average 3.1% during the first half of 2013.

The view here remains that the government should exclude the tuition fee boost to the CPI when uprating index-linked benefits – recipients of such benefits are not affected by the fee increase so do not require compensation. A post in April 2011 argued that as much as 40% of the money raised from higher fees could be absorbed by increased inflation-linked spending, representing an unintended and unwarranted transfer from students to pensioners and other benefit recipients.

The first “monetarist” forecasting rule is that the real money supply leads the economy by about six months. Using the narrow M1 measure, this rule has worked well in the Eurozone in recent years. Real money weakness predicted the current recession but a pick-up since the spring suggests that the economy will recover from late 2012. A shorter-term composite leading indicator appears to be bottoming, consistent with this scenario.

An alternative “Keynesian” view is that the recession has been caused by fiscal policy tightening, which is scheduled to continue in 2013. On this view, no recovery is in prospect before 2014 at the earliest – unless policies change. The money supply pick-up, in other words, will be offset by a fall in the velocity of circulation.

The Keynesian view assumes that there is a significant empirical relationship between changes in the budget balance, adjusted for the impact of the economic cycle, and GDP growth. At the aggregate Eurozone level the relationship has been insignificant and wrongly-signed in annual data since 1999, when EMU was born. (The result is similar when the change in the budget balance is lagged by one year.)

There has, by contrast, been a significant positive relationship between GDP and real money growth over the same period, after allowing for the lag implied by the first monetarist forecasting rule. (The lag undermines the argument of some Keynesians that the money supply simply reflects the impact of fiscal policy changes, so is not an “independent variable”.)

There has also been a significant positive relationship between GDP and real money growth at the country level over the past two years. The monetarist rule, in other words, works well both for the Eurozone as a whole and in individual countries.

The correlation between GDP growth and changes in budget balances across countries over the past two years, unlike the aggregate relationship since 1999, is of the “correct” sign. It is, however, weaker than for real money expansion. When both are included in a regression, the coefficient on the change in the budget balance becomes statistically insignificant.

To summarise,

• The Eurozone real money supply predicted the recent recession and is now signalling a recovery in economic activity from late 2012.

• Real money growth has worked well as a forecasting indicator for the Eurozone in aggregate since EMU’s inception since 1999, and for individual countries over the past two years.

• There has, by contrast, been no statistically significant relationship between GDP growth and changes in the cycle-adjusted budget balance, either in aggregate or at the country level after controlling for real money expansion.

• A solid, sustainable economic recovery in 2013 requires real money expansion to maintain its recent faster pace into next spring.