Sunday, April 8, 2012

Incompleteness


On Friday I talked a little about the extent that spending is credit-financed. I was excited about that topic, because people most often ignore it.

That's how things become problems, isn't it. By being ignored for too long. So I picked up on that theme and tried to show our reliance on credit increasing over the years since the end of World War II.

Why does it matter? It matters because the greater our reliance on credit, the greater the factor cost of money. And increasing financial costs interfere more and more with the the cost of living and with profits to productive endeavor. So it is not only the rate of interest that matters, but also the number of times the interest rate is applied.

On Saturday I said the extent of credit use must certainly be related to the efficiency of credit use. And I suggested you might want to "think of the entire 1947-2007 period as one gigantic credit bubble".

But I got a little distracted in both posts, talking about credit efficiency and the productivity of debt.

Today I pull from an old one I came across while writing a new one:

I think they miss something...


Browsing the Billy Blog, a title catches my eye: The natural rate of interest is zero! But reading it, as often happens, I am distracted long before I get to Billy's main point.

Billy writes of the "rather insidious notion that mainstream economists continually refer to which is termed the 'neutral rate of interest'". Not being familiar with this technical term -- Oh, I've heard of it, but I don't remember the definition -- it catches my interest. Billy quotes from the Melbourne Age:

It’s generally considered that a cash rate around 5 per cent is now neutral for the Australian economy – that is, it neither stimulates the economy nor holds it back... A cash rate at 3 per cent then is highly stimulatory.

Right away I'm off on a tangent. Let's consider the idea: An interest rate of 5%, say, that neither stimulates nor holds back the economy.

What's missing from the picture? It's obvious to me. Consider two Australias, identical in every way but one. In the first, ten percent of all spending requires the use of credit at that 5% interest rate. In the second Australia, 90% of all spending requires the use of credit, at the same interest rate.

In the one Australia, the reliance on credit is low; in the other it is high.

In the one Australia, the total cost of interest is low, relative to total spending; in the other it is high.

In the one Australia, the total cost of interest is low, relative to wages and profits and rent; in the other it is high.

In the one Australia, the cost of interest does not significantly affect prices; in the other, it does.

In the one Australia, there is no monetary imbalance; in the other, there is.

Five percent may be the "neutral" rate of interest, but the effect on the economy of that or any other interest rate will depend heavily upon the level of the reliance on credit.
 
You can't just look at the level of interest rates. You have to look also at the reliance on credit. If interest rates fall by half but we use twice as much credit, the cost of finance is not any less. And if interest rates go up again, we're screwed.

Anyway I don't understand why people would want to have more debt if instead they could have more money. It's only a matter of policy. Instead of trying to get $40 of debt out of every new dollar of money, why don't we try to get only $20. And then we could have twice as much money in the economy without increasing the threat of inflation. To do this, we need change only policy.

When you put finance people in charge of policy, they cannot see debt as a problem.


But again, my focus here today is incompleteness of argument. Anybody who speaks of interest rates, but fails to consider the reliance on credit, presents an incomplete and largely incorrect argument.

1 comment:

paul said...

This notion needs to be hammered on relentlessly until everyone internalizes it. Credit can be and has become a cancer, creating instability and destruction.

Most of us would be better off not using credit excepting short-term credit for transaction efficiency.

Our leaders created a monster that will be very hard to get rid of when they encouraged everyone to buy-now-pay-later.

It seems everything that our economic policies promote defy th elaws of arithmetic.

Our (and the world's) leadership is adept at one thing…can-kicking.