Thursday, January 17, 2013

An Alternative to Death by Credit

I think we need economic growth. I'm even willing to say we need credit for growth.

But I am unwilling to say that we need credit for everything, which is what policy says. Policy! How else do you suppose we ended up with debt that is three and a half times the size of our entire GDP?

A Definition of Credit and Debt

When you borrow a dollar, you take a dollar of available credit and put it to use. Spend it, and the dollar is gone -- but the credit is still in use. How do you know you have a dollar of credit in use? Because you still have a dollar of debt.

Every dollar you have borrowed and not yet paid back is a dollar of credit in use. Debt is the measure of credit in use.

A debt that is "three and a half times GDP" means that we have, in active use, credit in the amount of 3½ times our entire GDP. Yes, we need credit for growth. But we don't need to use that much credit. We don't need to be paying interest on that much credit.

The Need for Credit

How much credit do we need to use? Enough to get the growth we need, but no more.

If you have a stable economy -- I mean, not growing -- there should be enough money to support all the ordinary economic activity taking place in that economy. If credit is for growth, it's for growth. This concept suggests a policy path to debt reduction, and a way to minimize the cost of finance.

Sure, situations will always come up, where people need to use credit for emergencies or for large expenses, the house, the car, the water heater springs a leak. Of course. But when we depend more on money and less on borrowed money, we keep interest costs down. We keep the cost of living down. And we keep debt to a minimum. (This goal cannot be achieved in an economy where economic policy continues to encourage the concentration of wealth and income.)

Let's say we get 5% real economic growth every year -- an unrealistically high number, to be sure. What I'm saying is, we need credit enough to support that 5% growth. So... How much credit do we need to support 5% growth?

Graph #1: Change in Total Debt per dollar of Change in GDP
Click Graph for FRED Source Page
Graph #1 shows "change from year ago" of total debt, in billions, divided by "change from year ago" of GDP in billions. Starts in 1962 because there were some tall spikes before that, that made it difficult to see what we can see here.

1962-1982: It took about $2 of new debt to generate $1 of additional GDP.
1982-2002: It took $3 or $4 of new debt to generate $1 of additional GDP.
2002-2009: It tool $5 or more of new debt to generate $1 of additional GDP.

Just off the top of my head, Minsky (I think) and others...

No. Here. I don't know Minsky stuff. But at Into the Future, in the comments, Yegor Perelygin recently observed:

Minsky and his FIH ... split all borrowers into three categories. With the 1st category being the healthiest (can pay the servicing of the debt and the principle), and with the 2nd category being speculative, and 3rd being ponzi-oriented.

Just off the top of my head, maybe Graph #1 shows Minsky's three categories. Note the increasing instability: more after 1982 than before, and again more after 2002 than before.

The Arthurian argument (as distinct from the Minskyian) would be that as debt accumulates in the economy (debt relative to GDP, but more especially debt relative to circulating money) financial costs increase, so increasingly larger additions to debt are required to achieve a given amount of additional GDP.

Why does it show up in stages on this graph? Dunno. Policy changes maybe.

But anyway, let's take the worst case and say it takes $5 of new debt to generate one extra dollar of GDP. Should be half that, but say $5.

If we're thinking 5% growth, that's N dollars, so we should need at most 5N dollars of new debt to permit the 5% growth. We should need at most a new credit use equal to 25% of GDP.

Not 350%.


Yes, you are right: 25% of GDP one year, and 25% of GDP the next year and the next and the next, and in four years we're already in the neighborhood of 100% of GDP. Right you are. But we have not yet thought about paying it off.

If one year's debt amounts to 5% of GDP, that's a lot of money. A lot to pay off.

Suppose it takes 12 years to get each year's debt paid off. 12 times 25 is 300, so debt will stabilize at 300% of GDP. However, we're making payments every month, and balances due are going down. Our oldest balances approach zero. Split the difference between 300% and zero: Say debt accumulates to 150% of GDP and stabilizes there.

Less, really. Because after 12 years of 5% growth, GDP is well on its way to being twice as big. Call it a stable accumulated debt equal to 100% of GDP. That's a heck of a lot better than 350%.

But it all depends on debt being paid off. Pay off debt faster, and debt accumulation stabilizes at a lower level. Pay off debt too slowly, and the accumulation grows faster than GDP, forever. Or, anyway, until the crisis.

Debt repayment is the key.

The Good Fight

You are way ahead of me again, aren't you. When we pay down debt, the money comes out of circulation, hindering growth.

True. But you know what else? When the money comes out of circulation it hinders inflation, too. In my view, this is the right way to fight inflation: Reduce the quantity of money that is actually causing inflation -- the money that is already in circulation, that was put into circulation by the spending of borrowed money.

Don't think of paying down debt as something that hinders growth. Think of it as the right way to fight inflation. What we do now is not good policy: We raise interest rates until new borrowing is reduced. But new borrowing is the source of growth. The standard, universally accepted method of fighting inflation is to hinder economic growth and do nothing about the credit already in use that created the money and caused the inflation in the first place!

Existing policy does not discourage existing debt. It discourages the new borrowing that leads to growth. Meanwhile, the existing debt is left to accumulate.

The proper way to fight inflation, when the expansion of credit use causes inflation, is to slow the expansion of credit use by accelerating the repayment of debt. Not by raising interest rates on new borrowing.

It should be obvious.

An Arthurian Solution

I didn't address the objection: When we pay down debt, the money comes out of circulation, hindering growth.

Yes it does. But you know, we should be able to replace the money coming out of circulation, without adding to inflation. Of course, if credit use is at a level that is causing inflation, replacing all of that credit with money would keep the inflation going, yes, which we do not want.

But with less credit use, if the level of credit use is *not* causing inflation, then as the existing debt is paid down, we can print money and put it into circulation, enough to keep the quantity of money from falling. This would still not be inflationary.

That's my idea: Use credit for growth. Achieve growth. Make sure the debt created by that credit use is paid down. Print money to counterbalance the paydown of debt. Keep the quantity of money in a stable ratio with output, and keep making sure that private debt gets paid off fast enough to prevent inflation.


We need a certain level of money to support all the normal economic activity in a given economy. And we need credit for growth. But credit is temporary money that must eventually be paid back.

Suppose we have just the right amount of money for the economy. Then we use some credit for growth, and the economy grows. Then the debt is repaid. Now, even if there is exactly as much money as there was before, now there is no longer enough money to support the economy, because the economy is bigger.

Existing policy solves this problem by discouraging the repayment of debt. That keeps the credit circulating; and this creates a permanent financial cost, ultimately creating imbalances that lead to financial crisis.

Arthurian policy solves the problem by encouraging the repayment of debt, and by "printing" enough new money to keep "just the right amount" of money in the economy.

We can change policy without making any "systemic" or "institutional" changes. All that must change is the mindset that says we need credit for everything.

The new policy can be instituted by having the Fed engage in "monetization of debt" or purchasing Federal government debt, enough to keep circulating money growing in proportion to output.

In addition, policymakers -- Congress, mostly -- must begin to dismantle the complex system of policies they developed to encourage the expansion of finance.


Benjamin said...

I love this idea---monetizing the debt, while running a balanced budget (full confession: I like inflation in the 2-4 percent range, mostly to solve the sticky wage problem and to encourage real estate development).

I do have a question: The globe is building up huge pools of capital. Even in the USA, something like $4 trillion has been packed into just savings accounts since 2008.

When more and more nations cross into middle-class-ville, or have populations in the upper class (think India and China) the pool of global savings expands rapidly. I think we are there on the curve now, towards rapid expansion of the globe's capital pool, thanks to new savers globally. This may go on for generations.

Through history capital was scare; we had to eat our seedcorn to survive. Burn our fenceposts. Other clich├ęs.

Now, we have more seed corn than we can plant.

This is one reason sovereign yields have trended towards zero for the last 30 years. And now they are stuck there. (The other is central bank fixation on inflation).

Given huge pools of capital, what should macroeconomic policy be?

The Arthurian said...

Benjamin, I didn't answer your question. I think the huge pools of capital are largely a result of policies that encourage the supply and demand for credit. I would unwind those policies. An economy only works when money circulates.