Tuesday, February 23, 2010

Asking the Wrong Question

This from Private Sector Development [PSD], an "informal" arm of the World Bank:

Credit and growth: Which drives which?


This is a question that is stalking financial policymakers: Does credit growth drive economic growth, or does growth in the real sector drive credit growth? If the latter, then policymakers in emerging markets might do well to repress the financial system - the likelihood of crises will probably be reduced, while growth will not be harmed. But a new paper provides a bit of evidence that points in the opposite direction. From Does Access to External Finance Improve Productivity:

This paper examines the effect of access to finance on productivity. We exploit an exogenous shift in demand for U.S. corn to expose county-level productivity responses in the presence of varying levels of access to finance. The exogenous shift in demand for corn is due to a boom in ethanol production, which is a result of a number of complementary forces (rising crude oil prices, the Energy Policy Act of 2005, and new federal tax incentives). We find that counties in the midwestern United States with the lowest levels of bank deposits have been unable to increase their corn yields as much as other counties. This result demonstrates the positive impact of access to finance on productivity.
Now, if we could just replicate this kind of study in an emerging market to see whether the results hold...

Posted by Ryan Hahn on March 3, 2009


The PSD post turned up when I googled "growth of credit" (no quotes). Also this --

This column presents new research suggesting that a “creditless recovery” is possible, but it would likely be slow and shallow.

-- from Amol Agrawal's Mostly Economics. And this --

We are probably two thirds of the way through the decline of the current crisis, and starting to think about the recovery. Following Reinhart and Rogoff’s methodology, I explore the prospects for credit growth to sustain the recovery. If history is any guide, worldwide credit will not recover anytime soon.

-- from Michael Pomerleano at the Financial Times Economists' Forum.

From the two latter sources we may surmise that without credit, recovery will be slow and shallow; and that credit will not improve for a long while. This is not good news. I don't think it's news at all.

To the matter at hand: Ryan Hahn asks, "Does credit growth drive economic growth, or does growth in the real sector drive credit growth?" Answer: Credit growth never drives economic growth; all it can ever do is facilitate growth. This would be mere semantics were it not that Hahn asked the question.

Perhaps better phrasing of the question would help: Is credit growth necessary for economic growth, or not? This question has already been answered: Without credit, recovery will be slow and shallow. Of course credit is necessary. (Remember, it was the World Bank that asked the original question. So of course the answer is 'of course, credit is necessary'.)

Here's a better question: How can we have the credit we need for growth, without ending up with still more debt and yet another financial crisis?

Tough question? But the answer is so simple! New and old, ladies and gentlemen. New and old.

We need credit for growth. That's new credit, new uses of credit. But when we stop thinking of it as credit-use, and start thinking of it as debt, it is already old.

All we have to do is pay off the old stuff. This reduces debt. It reduces the risk of financial instability. It makes credit available again. It makes banks hungry -- and that's good for growth. Oh, and by the way, paying off the old stuff is a way to fight inflation.

So you're thinking: All well and good. But paying off debt takes money out of the spending stream, depressing demand. Depressing the economy.

Two things. First, the credit is newly available again, and the banks are hungry. Second, we counterbalance our reduced use of credit by an increased used of non-credit money. You know: quantitative easing, QE, which central bankers finally realized was necessary, after the crisis hit.

We correct the imbalance between money and credit-use by decreasing credit-use and increasing the quantity of money in circulation. The factor cost of using money is less thereby, reducing inflation on the cost-push side. And how do we reduce inflation on the demand-pull side? Accelerated repayment of debt.

It's just a matter of asking the right question.

4 comments:

Secret Economist said...

We don't need credit for growth; this is a myth. Credit is a reallocation of assets from somebody who has excess to somebody who is surfiet of funds. In principal, every person/firm could spend their own funds and demand would be the same.

But at times somebody with a good idea is in the surfiet category. If credit does not flow to her, the idea is wasted, gone; growth is slower.

But the stock of exisiting debt does not keep credit from flowing to new ideas. Profitable ideas will always find a funding source.

Looking to the corn article. Counties with the lowest bank deposits also have the lowest output per acre -- that is why they have low deposits; they are poor. Financing flowed only slowly to these areas because profits were, at least in expectation, low.

Jerry said...

> But the stock of exisiting debt
> does not keep credit from flowing
> to new ideas. Profitable ideas
> will always find a funding source.

I think the idea is - there are shades of gray, but the more you are paying out in interest (which is proportional to the stock of existing debt), the less you have to do anything else with.

Certainly, if everyone (or even: most people) were paying 100% of their income to interest costs, then that WOULD prevent the your entrepreneur from finding any investment capital, right?

I think the federal government currently would need to pay about 10% of its income to interest costs, just to sort of tread water on existing debt. At a guess, I probably am doing the same thing. And I know a lot of other people who are worse off than that. And it can get worse in a hurry - things that grow exponentially can get away from you if you're not careful. (e.g. - this is maybe a little naive, but you get the idea: http://perotcharts.com/category/challenges-charts/page/31/ ).

So, anyway, at 100% there would obviously be a serious problem. At 0% there is no problem. So, somewhere in between, there becomes a problem. What is the critical number, exactly? 5%? 10%? 25%? We don't know.

But the point is that our number has been going up, and up, and up (since...the 60s?), and it can't keep going up forever. Eventually we will hit the critical point and it will all go to hell. And maybe the stuff we see going on now is a result of having hit that point.

Jerry said...

And sure, the interest paid is income for somebody. Who can presumably re-lend it to your entrepreneur. But, I don't know... we don't have any "control" over what that guy does with the money. Maybe he will just sort of sit on it. Or, more likely, maybe he will invest it somewhere out of the country, with less expensive (i.e. worker-favorable) labor laws (China?), or it will move its corporate headquarters to Dubai, or something like that. Bad for this country, yet, the result of economic policy in this country.

The Arthurian said...

Hello, SE. When I read your first paragraph I immediately got a new appreciation for Say's Law. "In principal, every person/firm could spend their own funds and demand would be the same." In principle, supply creates its own demand. I don't know if you'd say I have the right idea there, but it made sense to me. Thanks.

Also your description of credit -- "Credit is a reallocation of assets from somebody who has excess to somebody who is surfiet of funds" -- struck me immediately as clear and correct. Only later I started wondering how fractional reserve banking and credit as the creation of new money fits into your description. I'm still up in the air on this one.

"They are poor" -- Now that is clarity. A lot of power in those three words. Nice touch.

And hello, Jerry. You write: "So, anyway, at 100% there would obviously be a serious problem. At 0% there is no problem. So, somewhere in between, there becomes a problem. What is the critical number, exactly?"

That critical number is the Laffer Limit.

Like pornography, I don't know the exact number that puts us over the Laffer limit. But I know we're over the limit when I see it.