Tuesday, January 10, 2012

The Debt Problem: Speculation or Excess?


In recent comments, Jim distinguishes between productive and unproductive debt, and associates unproductive debt with speculation:

Unproductive debt is when you are borrowing against the hope that some asset will increase in price, but the only reason the asset will increase in price is because you and other people are borrowing to put money in.

Jim is in good company: Steve Keen has expressed similar views:

At some stage, the growth of unproductive debt had to falter, and when it did a serious financial crisis would ensue as aggregate demand collapsed.

Keen has also done Non-mainstream modeling of the GFC and reports that

Without speculative borrowing—defined as borrowing that finances speculation on asset prices but does not finance the construction of new assets—the model generates a cyclical system which generally does not break down; with speculative borrowing, the model almost inevitably approaches a crisis caused by the accumulation of debt

Despite all that, I claim that the problem is not speculation. The problem is excess. But I don't want to seem to say that speculation is harmless. In the white box I present a complete list of new arguments explaining the problems with speculation:

 
 
 
 
 
 
New arguments, meaning the things I have to add to that discussion.


The DPD graph shows continuous increase in debt since 1947. The economy passed through several different stages during that increase:

1. The golden age (1947-1973) (Dean Baker and John Schmitt)
2. The great inflation (1965 to 1984) (Meltzer PDF)
3. The Age of Speculation (since the mid-1980s1)
4. The Macroeconomic Miracle (1995-2000) (Robert J. Gordon)
5. Sluggishness and Crisis (2001-present).

Stage One -- golden growth -- occurred because the DPD was low. Or I should say, because DPD was low, DPD did not inhibit growth.

Stage Two -- inflation -- occurred because the growing financial costs associated with growing debt were eating into profits. The inflation of the period was cost-push, though that is not widely observed.

Stage Three -- speculation -- developed as policymakers suppressed growth in order to suppress inflation, and then tried to find alternative ways to encourage growth. They removed the prohibitions against excessive speculation.

Stage Four -- the miracle of 1995-2000 -- occurred because the DPD had fallen, making the debt level relatively low again, briefly.

Stage Five -- sluggishness and crisis -- occurred as soon as the slack in debt had been used up.


Despite the various responses of the economy to the increase in DPD, (and with a brief exception before the 1995-2000 miracle) debt expansion was continuous since 1947.

People variously view the onset of problems with the onset of inflation, or the end of golden growth, or the advent of Reaganomics, or of the sluggishness, or of the crisis. But these all are problems that people have with the economy. They are none of them the economy's problem.

The economy does not care that we don't like inflation. It does not care that we don't like unemployment. It does not care that we don't like crisis. It does not care. These things we see as problems are simply the economy's way of dealing with disturbances or imbalances that we the people create.

For the economy, they are not problems. For the economy, they are solutions.


The economic problem began in 1947 when the DPD started to climb.

The problem began in 1947 with the growth of debt. This does not mean that the solution would have been to keep debt at its 1947 level. But we do have to find the best level, the best range for the DPD, the range that gives us the best tradeoff between the benefits of credit-use and the harm of accumulating debt. We have to find that range, and we have to keep the DPD there.

I hold that the best range is what we had some time before the end of the golden age: the early 1960s, when inflation was at its lowest and growth was spectacular. So I would like to say that the problem began in the latter 1960s. However, as long as people refuse to look at the trend of debt, I am forced to argue that the problem is not speculation, but excess, and that the problem began in 1947.


I do have something to say about speculation after all. Back when the economy was going gangbusters, people could make money by investing in the productive economy. But as debt and financial costs grew, profits fell in the productive sector and made such investments less appealing.

As productive investment became less appealing, speculative investment became more appealing. Thus the growth of speculation is itself a result of the growth of debt.

In summary then:

1. The problem of excess arose before2 the problem of speculation, and
2. The problem of excess leads to the problem of speculation.

The problem is not speculation. The problem is excess.


NOTES
1. The conclusion of the Keen post referenced above observes that "the superficially good economic performance during “The Great Moderation” was driven by a debt-financed speculative bubble". I therefore think it safe to apply the dates of the Great Moderation to the Age of Speculation.

2. The problem of excess debt was evident already in the late 1960s when financial costs were pushing prices up. By the early 1970s the problem was obvious as it led to the end of the golden-age growth.

6 comments:

Greg said...

Its not an either or problem I dont think. Its both.

The reason speculation starts to emerge after debt gets too high is that all true productive activities are being financed so those people looking for some way to earn a return just turn to speculative activity with borrowed money. And in boom times there are two rules 1) every bet looks like a good bet 2) if you can bet with borrowed money all the better.

The Arthurian said...

U:"Its not an either or problem I dont think. Its both."

I:"As long as people refuse to look at the trend of debt, I am forced to argue that the problem is not speculation, but excess, and that the problem began in 1947."

//

U:"And in boom times there are two rules 1) every bet looks like a good bet 2) if you can bet with borrowed money all the better."

#1 is true;
#2 is the result of policy; a different policy would change this rule.

jim said...

debt that works towards augmenting income won't grow faster than income by definition.

Debt that doesn't grow income must be based on speculation of increase in price of assets or a willingness to lose wealth.

Prior to the housing bubble bursting, households kept their debt pretty much in balance with the value of their real estate. People mistook increasing asset values for income. Now they know better and are adverse to taking on risk based on the hope of increasing asset prices.

http://tinyurl.com/7zqsj2w

_

The Arthurian said...

jim: "debt that works towards augmenting income won't grow faster than income by definition."

Maybe you could expand on that a bit? It is not obvious to me.

It looks to me like you see a fence separating productive from nonproductive debt, and that as long as we stay on the "productive" side of the fence, everything will be fine.

But all the while productive debt is increasing, interest income is increasing as a portion of total income. And interest income is not a payment to productive factors. Interest is a cost to productive factors. The interest income shows up on the nonproductive side of the fence.

It is true that some or much of interest income comes back to the productive side when people withdraw the money and spend it. But not all of it comes back. The goal of saving is to KEEP the money in saving. So the income on the nonproductive side is likely to grow, at the expense of income on the productive side.

But not only does the cost of interest make the productive side less profitable and less appealing... At the same time, it makes the nonproductive side more profitable and more appealing. Until very near the end.

But perhaps I am confusing "nonproductive" with "financial" and with "speculative" ?

jim said...

Hi Art

You describe unproductive debt in great detail and then act as if your exposition proves productive debt doesn't exist.

If a loan is made based on the assumption that there will be a net gain in the monthly flow of money to the debtor, that is productive.

Prior to 2008 very few loans fit that desciption. After 2008 very few don't. That explains why in the last 3 years income has grown faster than debt.

The Arthurian said...

jim: "You describe unproductive debt in great detail and then act as if your exposition proves productive debt doesn't exist."

Really? Where??

When debt is so excessive that the economy cannot function, it hardly matters whether the debt is productive or not. And when debt is so excessive that the economy cannot function, it is most difficult to find ways to be productive with debt.

Anyway, it isn't the DEBT that is productive, it is the original use of credit (which creates the debt) that is (or is not) productive. That original use of credit is soon complete, and the productive burst soon ended. But the debt lingers. So, come to think of it, yes: Debt is never productive. Debt is only an amount of money owed.

jim: "If a loan is made based on the assumption that there will be a net gain in the monthly flow of money to the debtor, that is productive."

Yeah... Or speculative.