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.