Real vs Money Incomes – the one thing we need to understand during deflationary times (with an illustration from Greece and Cyprus)

deflation.jpgIn inflationary times, real income growth is always good news. However, in deflationary times, real income growth may well reflect a deepening recession (or even a depression). This is important to know lest deepening recession is presented as… economic recovery (as has been the EU’s wont in recent times).

How can real income growth reflect a deepening recession?

Real National Income (or Real Gross Domestic Product) is the ratio of (i) Money National Income (or Nominal Gross Domestic Product) and (ii) an index of Average Prices.

In short, R = N/P (where R = real income, N = money income and P = an index of average prices)

Clearly, real income is a metric created so that, if all prices (P) and all money incomes (N) change by the same proportion, real income (R) does not change, thus reflecting the real of constant purchasing power. By construction, therefore, R only rises (falls) when money income grows faster (more slowly) than average prices.

It is easy to show that an economy’s real income growth rate is equal to the growth rate of money income minus the proportional rate of change in average prices (i.e. of the inflation rate) – See this Appendix for the proof.

In short, g = m – p where

  • g is the proportional rate of growth of R
  • m is the proportional rate of growth of N, and
  • p is the inflation rate, i.e. the rate of increase in P).

In plain words, when money income grows faster than inflation (i.e. m>p) real incomes grow.

There are two conclusions to draw from the above, depending on whether we live in inflationary or deflationary times:

Conclusion 1: In inflationary times, for real income to grow money income must be growing even faster

Proof: Since g = m – p, if p is positive (reflecting rising average prices P), then real income (R) rises (i.e. g>0) if and only if m>p>0

Conclusion 2: In deflationary times, it is possible for real income to grow while money income is shrinking

Proof: Since g = m – p, if both m and p are negative numbers (reflecting falling money income N and falling average prices P), R grows (g appears positive) as long as prices are falling faster than money income is rising (i.e. 0>m>p).

Moral of the story

When a depression gets deep enough, real income can appear to be rising!

What does this mean? It means that deflation has become so bad that money income continues to fall but not as fast as average prices.

But is a shrinking money income a problem when real income rises? Yes, falling money income is always terrible news if households, government and companies labour under significant debt. Private sector debt never falls of its own accord since indebted companies and households are never offered a negative interest rate by their creditors. This means that, when money income shrinks in an economy where firms, families and government are seriously indebted, the economy is pushed into wholesale insolvency. (The fact that prices are falling faster than incomes may make goods and services more affordable but does not help individuals and the government who are sinking deeper and deeper into debt, their debt-to-money income ratio rising inexorably.)

In summary, in a deflationary economy comprising indebted households, firms and government, real income growth is utterly consistent with a Great Depression and a steady path toward wholesale insolvency (of the indebted parties).[1] Only when real growth (g) exceeds the rate of deflation (d) do money incomes recover during deflationary times.

Illustration: The cases of Greece and Cyprus


The conventional ‘wisdom’ that the financial press, the troika and the EU institutions have been peddling is that: (1) Greece was recovering during 2014 and (ii) our Syriza government’s election in January 2015 led to a ‘return to recession’.

The truth begs to differ. Let us begin with the data from 2014. Yes, real income growth returned to Greece for the first time since 2008. The annual value of g came in at 0.8%, the first positive number in several years. However, 2014 remained a deeply deflationary year, with p=-2.6% (as measured by the nation’s official GDP deflator). Given the formula in (1), i.e. g = m – p, it turns out that money incomes shrunk during 2014 at a rate of m = g + p = 0.8 – 2.6 = -1.8%

Turning to what happened after our election on 25th January 2015, and during the second quarter of 2015 (which coincided with my tenure at the Ministry of Finance – March to June 2015), the data tells us that g = 0.3% and p = -1.28%. From (1), we derive m = g + p = 0.3 – 1.28 = -0.98%.

In other words, the reality (and at odds with the troika’s propaganda) is that Greece was not recovering in 2014. Instead, throughout 2014 Greece continued to languish in its Great Depression (its money income falling by 1.8%). Moreover, during our combative negotiations with the troika in the spring of 2015 (the purpose of which was to re-negotiate the cause of our Depression, i.e. the recessionary fiscal consolidation program that the troika had imposed upon Greece), money incomes continued to fall but at a reduced rate. The recession of course accelerated again when, on 30th June 2015, the troika, in its bid to asphyxiate our government, closed down Greece’s banks!


In recent weeks, Brussels and media that take their cue from the EU’s institutions have been singing the praises of Cyprus’ emergence from recession. Yet again, the truth insists of differing. According to the official statistical service of the Republic of Cyprus, real growth was g = 0.4% in the last quarter of 2015 (October to December). However, during the same quarter, the rate of deflation was d = 0.75%. From equation (1), it is clear that the Cypriots’ total money (or euro) income fell by 0.35% (m = g-d = -0.35). For a small nation languishing under a total debt that is three times the level of its money income[2] (and with more than 60% of all bank loans being non-performing), any celebration of Cyrpus’ recovery is seriously premature.

[1] Deflation is terrible for another reason too: Once people expect prices to keep falling, they have an incentive to postpone purchases of durables (choosing to wait until their price falls further). But this is catastrophic for the producers of these durables who now postpone investment, pushing aggregate demand lower and therefore accelerating the rate of deflation. Combined with the increasing debt-to-income ratios, this development locks the economy into a debt-deflationary doom loop.

[2] Government debt equals 108% of GDP and household debt an astounding 202% of GDP.