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.