Monday, July 30, 2012

Cullen Roche: "the recent period of lax lending and unusual optimism"


From Pragmatic Capitalism: Failing to Connect the Boom to the Bust. Cullen Roche writes:
Since bank issued “inside money” is the primary form of money used in our fiat monetary system it’s totally normal and expected that a boom would result in credit expansions. As you can see in the chart below the rates of change in total liabilities tend to boom and bust with the business cycle. And this shouldn’t be at all surprising. When the economy booms people borrow more as they do more business, take more risk, etc. And when the boom slows and turns into a bust the credit cycle flips and the downturn ensues. Like food, we need credit expansions. But it’s when the credit cycle gets abused that we see the biggest booms and busts.


The bottom line to me is, you can’t even begin to understand the current economic machine without understanding this basic fact – we live in a fiat monetary system in which bank issued “inside money” is the primary form of money. Access to credit can exacerbate the boom as we just saw during the recent period of lax lending and unusual optimism. And the more credit the more potential for a boom (and a bust). So I wouldn’t say that rising debt levels always cause recessions, but rising debt levels certainly make it easier for economic agents to act irrationally and irresponsibly thereby substantially increasing the odds of a boom and a bust.

Number one, I like the graph. It reminds me of what I was highlighting here.

Number two, Cullen says: "bank issued 'inside money' is the primary form of money used in our fiat monetary system". Says it twice. The implication being that there is a "secondary" form of money that is "outside" money. Okay, so always keep in mind the ratio between inside money and outside money.

Here, let's think 1800s because it's easy to see gold. These days "outside" money comes from the government and it's made of nothing more substantial than paper, and it's hard to tell apart from "inside money". It's hard to tell apart. The difference is the cost of inside money, the interest cost. But that cost does not travel with the money. It stays with the borrower. So inside money looks like outside money, and debt looks like a separate problem.

But think back to a time when we didn't have the Federal Reserve, a time when we used gold for money. A time when gold prospectors performed the service that is now performed by the Fed: supplying the economy with outside money.

In cowboy movies, the prospector always walks into the saloon with his bag of gold. It's good for the movies. In real life, more likely the prospector walked into the mint and had his gold made into coins and he spent the coins, and that was how outside money came into the economy. Anyway, somebody had it coined.

Or people would leave their gold at the goldsmith's, or at the bank, and get receipts for it. And they would use the receipts to buy things. And the goldsmith, or the bank, might lend out the gold to a borrower. The bank might even put the gold in the borrower's "account" and give the borrower paperwork in stead of gold. And the borrower might spend that paper.

And if you stop and look at that, the paper that the depositor spends is inside money -- money created within the economy, not brought to it by a prospector -- and the paper that the borrower spends is inside money, and there is now more paper money than gold.

We don't use gold like that anymore. And that makes it hard to see the difference between inside money and outside money. But the main difference is the cost of it. The cost of it is the interest cost, plus the payback. And you can get a feel for that cost by looking at debt today.

And you can get a feel for outside money by looking at the money for which there is no such cost. Like the money that people have, which is the money in circulation, or M1 money.

And you can get a feel for the ratio between inside money and outside money, by looking at a picture of debt per dollar of circulating money. Or at debt per dollar of base money.


Number three, when Cullen Roche writes of "the recent period of lax lending and unusual optimism" I suppose he's referring to the years immediately before the crisis. Isn't it odd, now, to think of those years as a time of unusual optimism? It doesn't seem right, somehow.

Number four, Cullen again:

Since bank issued “inside money” is the primary form of money used in our fiat monetary system it’s totally normal and expected that a boom would result in credit expansions.

It is totally normal, yes, number one.

But, for some reason, it's easy to mistakenly imagine there is some correlation between growth and debt. Even though Cullen does refer specifically to credit expansions, not debt. Of course the "expansion of credit" adds something to debt. But if we were to stop credit expansion dead in its tracks, zero it out, existing debt would continue to exist. "Debt" and "expansion of credit" are not the same. The two are not the same. It's like the difference between the Federal debt and the Federal deficit. Exactly like that.

Number five, accumulation. "As you can see in the chart," Cullen writes, "the rates of change in total liabilities tend to boom and bust with the business cycle." Yes, indeed. But looking at the ups and downs there, and all Cullen's arrows on the graph, I can't help get the feeling that it's debt that is going up-and-down, too. But that's not right. It is credit expansion that is going up and down.

During the boom you get lots of credit expansion, so total debt goes up a lot. During the bust you get little credit expansion, and total debt goes up only a little. But total debt goes up, either way. (Until the crisis, of course. And that's why there eventually is a crisis.)

There ya go: When credit expansion declines, you have recession. When total debt declines, you have depression. There's a definition for you.

Don't worry, it's not set in stone. It's not fate. It's just stupidity. We *insist* on using credit for growth. We *insist* on using credit for everything. We *insist* on using bank-issued “inside money” as our primary form of money. Change that, and we change the world forever.

Always keep in mind the ratio between inside money and outside money.

Some people want to go back to gold. Some people want 100% reserve. I just want to reduce the debt-per-dollar ratio to a workable level, and keep it there. The same system we knew and loved for 60 years, only not so extreme.

"It’s when the credit cycle gets abused that we see the biggest booms and busts," Cullen says. Not sure what he means by "abused". Maybe he's talking about extremes.

1 comment:

Woj said...

Great post! It got me thinking about the difference between your two graphs on debt-per-dollar. I came up with a slightly different graph based on private sector debt-per-dollar of circulating money that I think is a better metric to reduce and stabilize (to some extent). The graph and my thought process are here http://bit.ly/NErA2b