Proponents of the view that Greek economic prospects would be better if the country abandoned the euro in favour of a devalued new drachma often cite the recent relative performance of Iceland and the Baltic states. Iceland depreciated the krona by more than 50% against the euro between mid-2007 and mid-2009. The Baltics, by contrast, adopted extreme austerity policies to defend euro exchange rate pegs, with Estonia joining the single currency in 2011.

A comparison for each country of the level of GDP in the fourth quarter of 2011 with its pre-recession peak provides surprisingly modest support for the devaluationist view. Iceland’s GDP shortfall was still 7.9% versus 7.6% for Lithuania and 9.2% for Estonia. Latvian GDP, however, was 15.9% lower.

This comparison, moreover, flatters Iceland because the prior economic boom was less extreme than in the Baltics, implying a smaller excess to unwind during the bust. An alternative benchmark is the level of GDP in the first quarter of 2005, when booms were arguably at an early stage. Iceland has grown 9.2% since then versus 13.2% in Estonia, 16.8% in Lithuania and 9.6% even in Latvia – see chart.

Greece may lack the political and social cohesion to undertake Baltic-style austerity and “internal” devaluation, implying that euro exit is inevitable. Claims, however, that this would represent a superior policy choice leading to better medium-term economic outcomes are suspect.

The forecasting approach employed here relies on the “monetarist” rules that:

1)    The real or inflation-adjusted money supply predicts economic activity about six months in advance.
2)    The nominal money supply influences prices / inflation with a longer and more variable lead-time of about two years.

These rules have worked better historically using a narrow money measure (i.e. a variant of M1, comprising currency in circulation and sight deposits), although broader aggregates should also be monitored for confirmation.

From this perspective, the current recession / deflation scare in markets stems from:

a)    Slower global real narrow money growth since late 2011 – now being reflected in a loss of economic momentum.
b)    Slower nominal money growth between the second half of 2009 and the second half of 2010 – reflected in a fall in inflation since autumn 2011.

As discussed in a post last week, the first rule suggests that the global economy will continue to slow at least through October, although real money has yet to signal a recession.

The second rule, more controversially, suggests that the current disinflationary trend will reverse in late 2012. A smoothed measure of G7 nominal money growth bottomed in September 2010 and rose strongly in 2011, consistent with G7 consumer price inflation troughing in autumn 2012 and picking up into 2013 – see chart.

The current recession / deflation scare is likely to result in additional central bank policy easing that may provide further fuel for an inflation upswing in 2013-14.

Such a scenario, needless to say, is at odds with the consensus and would be associated with a significant rebound in yields on Treasuries and other “safe-haven” government bonds later in 2012*. The gold price would probably rise sooner – confidence in the forecast would be strengthened by an extension of the recent rally.

*Speculators’ long position in US Treasury futures has risen further to a level exceeded on only six occasions over the last 10 years, all close to at least short-term lows in yields.

China’s “surprise” 25 basis point cut in the benchmark one-year lending and deposit rates today had been signalled by a plunge in market rates and suggests that May data to be released over coming days will show continued economic weakness and a further fall in inflation – see previous post. The latter trend is being driven by a sharp slowdown in the food component, with the post-New Year decline in food costs this year much larger than in 2011 – see chart.

The “MPC-ometer”* forecasts an easing of policy at this week’s Monetary Policy Committee meeting – its output is consistent with either a quarter-point cut in the Bank rate to 0.25% or a £75 billion expansion of gilt purchases.

The model, admittedly, predicted that the Committee would ease last month, when only David Miles voted for action. It is, however, sometimes early – for example, it forecast that QE2 would start in September rather than October last year. The MPC’s inaction last month seemed inconsistent with the May Inflation Report, showing a mean projection for CPI inflation in two years’ time of 1.8% based on unchanged policy.

Most of the model’s 12 inputs have shifted in favour of ease over the last month. GDP was revised lower, business and consumer surveys weakened, average earnings growth slowed further, CPI inflation moved lower, consumer inflation expectations eased, credit spreads widened and stock prices fell sharply.

The MPC-ometer was estimated on data since the Committee’s inception in 1997 so represents its historical “reaction function”. A failure to ease this month would suggest that either this reaction function has shifted (e.g. in response to the sustained inflation overshoot of recent years) or the MPC believes it is effectively “out of ammunition” at current super-low interest rates / gilt yields (although the latter view has yet to be voiced by any Committee member).

*The “MPC-ometer" is a statistical model designed to predict monthly Monetary Policy Committee decisions based on incoming economic and financial data. The model’s dependent variable is the weighted-average interest rate vote of the Committee’s members. For example, if five members want to raise official rates by 25 basis points (bp) while four prefer no change, the weighted-average vote is +14 bp (five-ninths of 25). If it is assumed that votes are either for no change or a move of 25 bp – reasonable under “normal” economic and financial conditions – then the model forecasts an actual rate change when the weighted-average prediction is greater than +12.5 or less than -12.5 bp. QE is incorporated by treating £100 billion of gilt purchases as equivalent to a 35 bp cut in Bank rate – this fits the data since QE started in March 2009. The MPC-ometer’s 12 inputs were selected on the basis of statistical analysis and can be grouped into indicators of economic activity, inflation and financial market conditions. The inflation sub-set is largest, comprising the latest headline annual increases in consumer prices and average earnings as well as several measures of expectations. Activity indicators include GDP growth and business / consumer confidence while credit spreads and movements in share prices and the exchange rate are used to gauge financial conditions. Importantly, the model also includes the prior month’s average interest rate vote to capture any revealed bias.