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.

A post last week suggested that a €37.8 billion fall in Eurosystem lending to the banking system during September reflected a flow of capital back to the periphery in response to the ECB backstopping sovereign bond markets; such a flow eases funding pressures on peripheral banks, reducing their recourse to official support. This suggestion was supported by subsequent September balance sheet data from Banco de Espana and Banca d’Italia, showing declines in lending to banks of €29.5 billion and €3.9 billion respectively.

Eurozone-wide lending has continued to fall so far in October – the ECB’s weekly balance sheet shows a €17.4 billion reduction last week, while this week’s seven-day and one-month repo operations resulted in a net withdrawal of €14.3 billion. A reasonable hypothesis, therefore, is that 1) the Draghi plan has succeeded in attracting funds back to the periphery, 2) this will be reflected in an increase in the money supply in September / October and 3) such an increase will lay the foundation for a stabilisation and recovery in economic activity in early 2013.

Any break in this potentially virtuous circle should be signalled by a renewed rise in ECB lending.

The OECD’s composite leading indicators are useful for confirming signals about future economic activity from real money supply trends. The OECD, however, regularly misinterprets its own data.

A case in point is the release issued today to accompany August indicator results; this claims that “most major economies will continue to see weakening growth in the coming quarters”. Yet a forecasting indicator of global expansion calculated here by combining and transforming the OECD data rose for a second consecutive month – see first chart. Allowing for a typical three-month lead, this suggests that the six-month change in global industrial output will bottom in September and recover in October / November.

An experimental “leading indicator of the leading indicator”, moreover, rose for a fourth consecutive month in August, hinting at a further recovery in the indicator itself in September and October – second chart. (The “double-lead” indicator is explained in a previous post.) This, in turn, would imply that global firming will extend into early 2013.

These results confirm the positive signal from an earlier pick-up in global real narrow money expansion, first discussed here in July. This pick-up continued in August and will probably extend into September, so another peak in global growth is unlikely before next spring at the earliest – see post from last week.

The improving outlook signalled by monetary trends and leading indicator data has yet to be recognised by a consensus inclined towards bearishness because of ongoing Eurozone fiscal tightening and the risk of the US “going over the cliff”. The IMF faithfully follows the consensus and, according to press reports, will downgrade its global growth prediction this week – a further reason for optimism, given its forecasting record.