Catfish makes me want to scream

Felix Salmon has a fantastic blog post on the subject of America’s GDP growth and the potential thereof. He's talking about this chart:

Salmon Graph #1: NGDP (blue) and Potential NGDP (green)

Salmon points to the bifurcation, where GDP falls away from Potential. He agrees with Greg Ip "that the green line might well overstated: that the economy can’t in fact grow, sustainably, at the kind of pace that the CBO is assuming it can." This view reminds me of Jim Bullard's earthquake story.

Salmon offers an explanation why the economy cannot grow at that higher rate. He shows a second graph:

Salmon Graph #2: Total Debt (red) added to Graph #1

He points out (in words) that total debt has grown far faster and far higher and far more than GDP. And he presents his explanation:

In other words, in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt.

Then, suddenly, the growth of the credit markets screeched to a halt, and we had a major recession. And since then, the size of the credit market has been roughly flat.

It makes sense that if we needed ever-increasing amounts of debt to keep up that long-term GDP growth rate, then when the growth of the debt market stops, our potential growth rate might fall significantly.

Now you might think I'd be happy to see Felix Salmon considering total debt as the problem underlying our economy's inability to find vigor. I am. But I want him to get it right. I think he has it wrong, and he makes me want to scream.

First of all, Salmon's view is that for GDP to keep growing on the path established by Potential GDP, total debt has to keep rising like the red line was rising before the Great Recession. But that is only true if we insist on using credit for growth -- or, really, for everything. And that is a plan which cannot succeed. We learned that the hard way.

The concept that underlies the design of policy -- the concept that credit use is good for growth -- is terribly, terribly flawed. It leads to unsustainable policy. As Salmon puts it, the bubble "had to burst at some point."

Second, it is not the failure of debt to increase that hinders growth. It is the success of debt. The excessive cost of excessive debt is the problem. Salmon himself reports that the ratio of debt to GDP increased from 1.6 to 1 (in 1970) to 2.8 to 1 (in 2000) to 3.7 to 1 (by mid-2008). All of that happened before the crisis. All the while, Real GDP growth was in decline:

Salmon says economic growth dropped below potential because debt growth tanked in the Great Recession. But in fact economic growth had been in decline (pulling Potential GDP down with it) for decades because rising financial costs undermined demand and eroded profits.


Salmon says the problem is five years old. I say it's more like five decades. Salmon explains the problem this way: "suddenly, the growth of the credit markets screeched to a halt". I explain it this way: "rising financial costs undermined demand and eroded profits."

Do you see how different his analysis is, from mine? For Felix Salmon the problem seems to come "suddenly" because he overlooks the long gestation.

Incorrect analysis leads to incorrect conclusions. Here are Salmon's conclusions:

I’m glad that we’ve finally put an end to the credit bubble, which had to burst at some point. But it’s naive to think that we can do so without any adverse effects on broad economic activity. So we might indeed have to resign ourselves to lower potential growth going fowards. If only because we’re taking ourselves off the artificial stimulant of ever-accelerating credit.

Like Bullard, Salmon is prepared to resign himself to lower potential growth going forward. Salmon thinks we can only get the growth if debt grows faster.

Salmon's reasoning is fundamentally tied to the notion that we need credit for growth. But that notion is fundamentally, horribly wrong.

//Related post: Felix Salmon: "we fervently hope" for more lending

//Link to Excel Spreadsheet with FRED data & my RGDP Growth graph

A remarkable coincidence of boost and drag

Modified from clker.com

...the new uses of credit provide economic boost, while the cost of existing debt is a drag on growth. This duality is what eventually makes credit-use ineffective, as ever-larger new uses of credit are required just to offset the drag created by the debt from prior credit use.

- mine of 6 April 2012

If you use credit to boost the economy, you must use enough to fully offset the drag created by existing debt -- and more besides, to realize a boost. But each new use of credit enlarges existing debt. So new uses of credit must always grow larger.


The total cost of interest is a measure of the drag created by existing debt. We looked at it the other day. Here's my estimate again of interest paid on all debt in the US:

Graph #1: Estimated Total Interest Paid, billions of dollars

Having an idea of the total cost of interest gives us a feel for the economic drag created by existing debt. I want to compare that drag to the economic boost we get from new uses of credit.

In Graph #3 of the 26th I showed "all the debt I know about". The change in debt from one year to the next is a measure of new credit use, recorded as an addition to existing debt. So we can use "change from year ago" of total debt as a measure of new credit use, and compare those values to the cost of debt as measured by interest paid:

Graph #2: The Cost of Debt (blue) and New Uses of Credit (red)

A remarkable coincidence: It's a horse race from the early 1950s to the late 1990s. Or maybe it's no coincidence at all.


When new uses of credit (red) are more than the cost of existing debt (blue) we can say credit use boosts the economy. Such moments are clearly visible before the 1974 recession, before the 1980 recession, after the 1982 recession, and since the late 1990s.

Before the 1990s it was generally true that when new use of credit ran above the cost of interest, the economy experienced growth; and when new use of credit dropped, coming close to the cost of interest, the economy experienced recession. This is exactly as I describe in the opening remarks of this post.

More recently, the economy seems not to behave according to this rule. Specifically, in the years sometimes described as a "macroeconomic miracle" -- the latter 1990s --new credit use (red) runs below the cost of interest. And then in the 2000s new credit use shows a massive spike, yet economic performance was pitiful. It seems that since the 1990s, some other complication has been inhibiting growth.

Economic forces, a sketch

Some people may say that when you make a payment on your debt, the guy who receives the money spends it; so that paying down debt is not really a drag on the economy.

But of course it is a drag on the economy. For paying down debt is the "equal and opposite" of taking out a loan. And taking out a loan typically helps boost the economy.

The opposite of taking out a loan is paying it down. And the opposite of boosting the economy is slowing it down. So of course paying down debt is a drag on the economy. It has to be.

How to get credit costs down

It was only an estimate, yesterday's post. I don't know the exact numbers. But you get the idea: The cost of credit is a big number. And when we are making payments on debt, we can't use that money to buy other things we want.

That's a drag, in more ways than one.

So maybe we want to get the cost of credit down, the cost of accumulated debt, get it down. I'm for that.

How could we do it?

Well, what does the cost of credit depend on? The cost of credit depends on how much debt there is, and the interest rate on all that debt.

To reduce the cost of credit, we can reduce how much debt there is or we can reduce interest rates. One or the other, or both of these things must be done if we want to reduce the cost of credit in our economy.

But you know, interest rates are already as low as they can go. Rates have been falling since 1981, and now they are at the zero lower bound. We can't really lower interest rates more. And that means we can't reduce the cost of credit by lowering interest rates.

So what's left? The only choice left is to reduce how much debt there is. It's simple, when you get right down to it.

Ballparking the cost of credit

...economic forecasts and statistics are often based on guesstimates.

- Wikipedia

I had reason recently to read again Steve Randy Waldman's Persnickety followups on inequality and demand. I should probably read the Cynamon/Fazzari paper he links. But I got distracted by a shiny object at the end of his post. This shiny object:

Setting aside everything that interests SRW and his readers, all I want to know at the moment is how the "effective Federal debt interest rate" is calculated. The answer is contained in the uppermost text on that graph:

(FYOINT/GFDEBTN)*100

"Federal Outlays: Interest" divided by "Federal Debt: Total Public Debt". Yeah. Divided by gross Federal debt. That's what I wanted to see. When I left off with this, I thought the gross debt number was the right one to use. It is good to see the thought confirmed on someone else's graph.

In addition to the effective interest rate on Federal debt, the above graph shows the comparable rate for household debt. I'm thinking the Federal rate is a low one, and the household rate a high one, relative to the average for all debt. Consumers on average probably pay a higher rate than businesses, the government a lower rate.

There's about five percentage points difference between the Federal rate and the household rate on Waldman's FRED graph. I'm thinking I want to split the difference and add 2½% to the Federal rate, to get a number I can use for the effective interest rate on all debt in the US.

It's just a guess, but it gives me something to work with.


FRED's FYOINT goes back to 1940. GFDEBTN goes back only to 1966. When you're old as me, 1966 is nothing. I'll use FYGFD instead, as it goes back to 1939. GFDEBTN is quarterly and FYGFD is annual, but I'm not losing anything by going with the annual values, as the interest number is annual anyway.

FYOINT and GFDEBTN are both in millions, while FYGFD is in billions, so I do have to convert for units. But in exchange I get a graph that goes back to 1940:

Graph #2: My guesstimate of the Effective Interest Rate on Total Debt in the US
Note: Using FYGFD (red) takes us back to 1940, GFDEBTN (blue) only to 1966

Oh yeah, that's definitely worth it.

Note that Graph #2 shows a peak at a 10% rate of interest, 2½ points higher than Waldman's green peak. (I've already added the two and a half.)


Now, about debt. FRED's TCMDO includes "credit market" debt. It excludes borrowing done outside of credit markets, as when the Federal government borrows Social Security funds. So I want to subtract from TCMDO the Federal portion of it (which is today about $12 trillion) and to what's left I want to add the gross Federal debt (which is now about $17 trillion). That will give me a number for all the debt I know about:

Graph #3: All the Debt I Know About
Total Credit Market Debt less Federal Debt Held by the Public plus Gross Federal Debt

See how the blue line just curves up and up, until the start of the recent recession? Things are different since that recession. The comments I will be making about the cost of this debt will refer to what was happening before the recent recession. My objective, as always, is to understand what led to the crisis.

Now, if Graph #3 shows the amount of debt, and Graph #2 shows the estimated effective interest rate on all that debt, I can just multiply the numbers together and get the total amount of interest paid in dollars... billions of dollars.

I'll have to not multiply by 100 in figuring the interest rate. Other than that, the top line of Graph #4 will show the line across the top of Graph #3 multiplied by the second line across the top of Graph #2.

Okay, Graph #4:

Graph #4: Estimated Total Interest Paid, billions of dollars

Do me a favor: Check my work. It's early yet, the calculation is complicated, and I've had only one cup of coffee so far this morning.

Visible on this graph in the last four recessions are disturbances to the general uptrend. A small flat spot in 1982. A longer flat spot around 1990. About as long, but down rather than flat around the year 2000. And down again, three or four times as far down, in the most recent recession.

Flat spots are probably visible in the earlier years as well, if you zoom in on the graph and look. But they seem to be getting worse.


Now I want to take Graph #4, showing the money paid as interest, and look at that number relative to GDP:

Graph #5: Estimated Total Interest Paid, relative to GDP

On this graph you can see interest costs rising from the 1950s to the early 1980s. During those years interest rates were going up, and debt was growing like crazy.

Since the early 1980s the graph shows a mild downhill trend. During these years interest rates were going down, and debt was growing like crazy.

Total interest costs in our economy, based on this estimate, range from a low of 6 cents per dollar of GDP (in the early 1950s) to ten cents (in 1970) to 15 cents (in 1980) to 20 cents (in 1990). Today, or at the end of 2012 I suppose, the total cost of interest in this country still amounts to 15 cents for every dollar of GDP.

That's a lot of interest cost, brother.


As you know, to fight inflation our policy restricts the quantity of money. When there is too much money in the economy, reducing the quantity of money (relative to GDP) will reduce inflation. (Before the crisis, I'm saying.) When there's not too much money in the economy, reducing the quantity of money doesn't help; but that's another story.

To fight inflation, policy restricts money. To stimulate growth, policy encourages spending. These policies are contradictory, and they lead to the situation where we have little money and we use a lot of credit.

How much credit do we use? Well, credit we're using is called "debt". Graph #3 shows how much credit we're using. Graph #4 shows what it costs. And Graph #5 compares that cost to the size of our economy.

But suppose our policies had been different for all these years. Suppose that back in the 1960s we realized that there was not too much money in the economy but, rather, too much use of credit. Suppose we had changed our policies then, so that they stopped excessively discouraging the use of money, and started encouraging payback of debt.

It could have been done easily, you know. It's not like we use gold for money. We have a flexible monetary system. The problem is not that we can't keep our monetary balances at optimum. The problem is that we don't know what the optimum is. We think using credit is good for growth. Perhaps you think it still today, even though we have $60 trillion of credit already in use, and everybody thinks it's a burden and a risk, and everybody wants to reduce their debt.

See, this debt problem didn't develop because everybody wants to reduce their debt. It developed because people think using credit is always good for growth, even when there's way too much credit in use already.


The problem isn't people, of course. The problem is policy. We set up policies... No, I refuse to take any blame for it. They set up policies designed to encourage the use of credit and let debt accumulate. And when the use of credit started causing inflation they blamed the money instead, and restricted the money, and still they encouraged the use of credit and the accumulation of debt. And that's how we ended up with $60 trillion of debt and $2.4 trillion of interest cost in a $16 trillion economy.

When there's too much money in the economy, the right way to fight inflation is to restrict the quantity of money. When there's too much credit in use, the right way to fight inflation is to accelerate the repayment of debt.

http://fredqa.stlouisfed.org/2011/10/06/the-market-vs-gdp-with-fred-graph/

"Whichever series we chose, we should chose the nominal rather than the real. The reasoning here is simple: Our market indexes are not inflation adjusted, so our base shouldn’t be either."

- FRED

I was looking for colors to match the default background blue of the FRED graphs. Went to FRED, searched for graph color values, didn't get lucky.

Clicked EVERYTHING and searched again. The third hit caught my eye:

The Market vs GDP. I risked a click.

I got a lesson in how to use FRED to make a graph.

Nothing on color values. That's so 1990s, I guess. But I did find -- Oh! They want to see "the stock market as a percentage of GDP or GNP". Okay, that might be interesting.

No. Not the graph, anyway.


Skimming past FRED instructions about things I already know, I come to this:

For this graph we could really choose either GDP or GNP. As GNP is a little more comprehensive, we’ll choose it (the nominal series) for our base.

Note: Whichever series we chose, we should chose the nominal rather than the real. The reasoning here is simple: Our market indexes are not inflation adjusted, so our base (GDP, GNP) shouldn’t be either.

GNP is "a little more comprehensive" than GDP. That's interesting, given that it's coming from people who work at FRED. I wonder what it means.

But I'm not focused today on which data to use or how to get it. Today, I'm focused on what they think at FRED about dividing nominal values by inflation-adjusted values. As a rule, they don't like it.

Let me repeat that: They don't like it.

I don't like it, either.

I don't like it when it is used to fake evidence that printing money causes inflation.
I don't like it when it is used to fake evidence that rising labor costs cause inflation.

Millions of millions

FRED's default for Federal Debt: Total Public Debt (GFDEBTN):

So I'm looking at the graph this morning, noticing that the Federal debt is up around 17, not down around 14 like an older graph I was looking at.

17 million.

Huh? How come the Federal debt is so low?? The highest value on the vertical axis is 18 million... All the values are millions... Yes, the axis label says millions of dollars...

No, dummy. The highest value is 18 million million dollars. 18 trillion.

Didn't have my coffee yet.

A simple question

At Interfluidity, Mark A. Sadowski summarizes Mason and Jayadev (2012):

They find that whereas the household sector borrowed heavily in the 1946-64 period, and more often borrowed than not in the 1965-80 period, the household sector ran a primary surplus throughout the 1981-99 period with the sole exception of 1985. Only more recently, during 2000-2006 did the household sector borrow heavily again. Nevertheless, household sector debt as a percent of disposable personal income rose substantially during 1981-99 due to high real effective interest rates and low rates of growth in nominal income.

> the household sector ran a primary surplus throughout the 1981-99 period

> household sector debt as a percent of disposable personal income rose substantially during 1981-99

Don't these facts suggest that household sector debt was already too high by 1981?

Krugman: "I believe in the debt overhang story enough to be worried"

Paul Krugman:

Canadian household debt has kept rising even as the US level has declined:

So if the new, non-bank-centered view is right, Canada ought to be quite vulnerable to a big deleveraging shock despite its boring banks. Of course, people have been saying this for several years, and it hasn’t happened yet — but remember, the US housing bubble took a long time to pop, too.

I’m not exactly making a prediction here; but I guess I believe in the debt overhang story enough to be worried, and Canada is certainly an important test case.

Okay... And then from the Conference Board of Canada, there's this

and this

Think of the world in terms of cost.

The growth of debt is a cost. If that cost goes high enough, it breaks the economy.

Income inequality is a cost that drains spending power from the 99%. If income inequality is a little higher in the US than Canada, the cost is higher, too.

Combine the higher cost of debt in the US with the higher cost of inequality in the US, and you can see why the US economy broke and the Canadian economy didn't.

Can we put it all into a formula and predict the day Canada's economy breaks? I wouldn't even try. But I'll tell you this: The object is not to get just as close as we possibly can to the breaking point.

Our economy was good in the 1960s. That's the target. We ought to shoot for a level of debt like we had in the 1960s, and a level of inequality like we had in the 1960s. That's the target.

It's a start.

Being fair and balanced

Following up on yesterday's post where the uptrend-to-crisis pattern of debt dominated all three graphs:

Graph 1: Year-to-year change in TCMDO debt, in billions.
Graph 2: Revision to the first graph to allow for rising prices.
Graph 3: Revision to the second graph to allow for real growth.

The two considerations, price increases and real growth, had almost no effect on the pattern of increase in debt. Debt was the dominant factor.

But you know, it was only three graphs. So today I want to look at variations on the relations we looked at yesterday. Maybe it was just a fluke that made debt seem to dominate the other factors.

Yeah, right.


All these graphs from yesterday and today are based on three FRED data sets:

TCMDO debt
GDPDEF (the GDP Deflator) as a measure of prices
GDPC1 as a measure of real (inflation adjusted) GDP

Yesterday we looked first at the year-to-year difference in debt. For the second graph I divided the year-to-year number by the price series. And I divided that result by real GDP for the third graph. Not much science in that sequence of events; it's just where my mind thoughts took us.

Today I want to start with the year-to-year difference for prices, and for real GDP, as we did yesterday for debt.

Graph #1: the GDP Deflator as a measure of prices. Usually a graph of prices shows the percent change. This graph only shows the difference in the Deflator value from one year to the next.

At about 4.5, the high point on Graph #1 is lower than what we usually see. And the later values are higher than usual, near half the peak. But that high point is part of the Great Inflation, to be sure.

Graph #2: Change from prior year value of inflation-adjusted GDP, in billions of 2005 dollars.

There is a general uptrend throughout the period. But as with the previous graph, this graph shows a simple difference, not percent increase.

Okay. Next I want to take the other data series and divide by it. That's what I did yesterday when I started with debt. Today I save debt for last.

Graph #3 shows the Graph 1 values divided by Real GDP.You can still see the Great Inflation, that high spot that should go from the mid-1960s to the early 1980s. A  little hard to read the dates.

Graph #4 divides the Graph #2 series by the price level. Where Graph 2 went up, Graph 4 goes down.

I want to say Graph 4 goes down because prices went up. Writing this in the wee hours here, I don't have much to say about these graphs other than "here they are'. But I think it is important to look at different relations of the same data we looked at yesterday. Maybe something will turn up that suggests yesterday's impression of things was simply coincidence, or was not.

Okay. Now we've looked at the change in prices, relative to real output, and the change in real output relative to prices. All that's left is to divide Graph 3 and Graph 4 by debt.

Graph 5 shows what happens when you take the numbers from Graph 3 and divide by TCMDO debt. You can still see the Great Inflation there, but much reduced. And the numbers are very low, and drop off to zero because debt is so big and so dominant.

Graph 6 shows what happens when you take the numbers from Graph 4 and divide by TCMDO debt. The line still goes downhill, quickly now. The numbers are very low, and drop off to zero because debt is so big and so dominant compared to everything else.

Debt is the dominant factor.


// Preview or download the Excel file. (Contains macros.)

...the same nightmare, over and over...

Preview & download the Excel file. (Contains macros for formatting graphs, Compound Annual Growth Rate calc and Kurt Annen's Visual BASIC code for calculating Hodrick Prescott values.)

What's up

At 3:42 this [17 June] morning I wrote myself a note:

When you type CMDEBT in the search box at FRED, what comes up on the screen is a series called TCMILBSHNO.

Yeah, that'll be easy to remember.

By 6:47AM that distressing situation had passed, and searching for CMDEBT turned up a series named CMDEBT. And what a relief that was!

Anyway, I want to show you a graph of CMDEBT. Two lines on the graph. Don't compare the lines to each other. They're on two different scales. Just compare each line to itself, and visualize its trend.

What's up? CMDEBT thru 1975 (red, right scale) and thru 2012 (blue, left scale)

The red line goes up (till the end). The blue line goes up (till the end).

The red line is the same as the blue line, but the red one stops at 1975. To show it, I put a second copy of the blue line on the graph (FRED made it red), stopped the display of it at 1975, and put its values on the right-side scale. FRED did the rest.

The two lines show the same data. But the red one shows a close-up of the early years of the blue line. Because, on the blue line, the early years are squished down near zero. Hard to see what's going on there.

See that highest peak of the red line? If you look straight down from that peak to the blue line you can see the same peak there in blue, barely visible.

The red line shows an upward trend that's hard to see in the blue line. But it's there.

Conclusion:

CMDEBT was always going up, even in the early years when the blue line looks flat.


What's that you say?

You were expecting a more substantial conclusion?

Pfff... That's not how it works. We look at little facts about the economy because they're fascinating, and because we know deep in our heart just how important they are. We spend time with them because we love to do that.

Substantial conclusions arise in their own time. You can't squeeze them out like ...

Never mind.

What does it matter anyway?

When I started out writing yesterday's post, I was thinking I had a petty objection to a detail in an Interfluidity post. I thought my objection was not relevant to Steve Randy Waldman's analysis, and I was prepared to present it as an objection in principle, an objection that might apply in other situations, but not to his analysis.

Writing the post made me work through a few things, and in the end I concluded that Waldman's analysis is incorrect.

Waldman took a casual look at a graph of consumer debt, and thought he saw a significant jump in the pace of borrowing. He failed to realize that the spike in the debt/GDP ratio resulted from the large drop in nominal GDP growth caused by a sharp fall of inflation.

Waldman's mistake is a common one, and obvious once you notice it. The jump in the debt/GDP ratio was the result of a big undershoot of GDP, not a sudden increase in borrowing.

There was no sudden increase in borrowing that we can point to and say it was this increase in borrowing that compensated for growing income inequality. There is a hole in Waldman's argument.

Interestingly, in remarks on yesterday's post Steve Waldman said:

It would be perfectly possible, for example, for the broad story to be true -- poorer households must increasingly borrow to maintain aggregate consumption -- and yet for aggregate borrowings to decline over the period.

Yes it would; and I make points like that occasionally, myself. But here Waldman is saying is that his evidence -- his graph showing that "beginning in the early 1980s, household borrowing began a secular rise" -- is irrelevant because it doesn't treat "distributional questions".

Maybe. But now the discussion is getting over my head. What I know for sure is, his graph does *not* show any secular rise of borrowing that begins in the early 1980s. And if it seems to show that, it's an illusion.

I've treated this issue before, in the "red herring" post. In that case it was Scott Sumner misreading a debt/GDP graph -- as it happens, the same misreading of the same debt/GDP ratio that we see in Waldman's post.

Sumner identified "three big debt surges" and analyzed the economy on the basis of those surges. As I reported in the "herring" post:

The inflation is the reason for what appears to be a flat spot on the graph. The inflation "eroded" debt.

The growth of debt continued apace.

My StepRate function, applied to annual CMDEBT numbers from FRED, shows that the compound annual debt growth rates during Sumner's three periods were:

• 1952-1964: 10.7%
• 1984-1991: 10.25%
• 2000-2008: 9.33%

During the famous flat spot of 1965-1983, the comparable rate of debt growth was 9.36%. That's near 90% of the growth rate for the 1952-1964 "debt surge" and it is higher than the growth rate for the third debt surge Sumner identifies.

There was no remission. Debt did not stop growing. It barely slowed.

What does it matter?

If you misread the graphs, you misread the economy. That's all.


Links:

• The Sumner post
• The Interfluidity post
• My Measuring the Erosion of Debt PDF
• My Debt and Inflation posts.

Inequality and [something else]

At Interfluidity an older post, from January of this year: Inequality and demand. Steve Randy Waldman quotes from Paul Krugman's Inequality and Recovery and opens the "haranguing" with these thoughts:

Let’s start with the obvious. The claim that income inequality unconditionally leads to underconsumption is untrue. In the US we’ve seen inequality accelerate since the 1980s, and until 2007 we had robust demand, decent growth, and as Krugman points out, no evidence of oversaving in aggregate. Au contraire, even.

Waldman contradicts Krugman, provides links showing "evidence of oversaving in aggregate", and asks

how do we reconcile the high savings rates of the rich with the US experience of both rising inequality and strong demand over the “Great Moderation”?

Debt is how we reconcile those things, he says. Those at the less fortunate end of the inequality scale made up for their shortfall of income by borrowing more. Waldman presents a graph in evidence of this.

Then his post takes an interesting turn. He writes:

Rather than arguing over the (clearly false) claim that income inequality is always inconsistent with adequate demand, let’s consider the conditions under which inequality is compatible with adequate demand. Are those conditions sustainable? Are they desirable?

Long story short, he points out the conflict between the economy's need for more lending and the "microeconomic evaluations of solvency" that might limit the lending, limit the demand, and limit the growth. His conclusion includes this thought:

If we had any sense at all, we’d relieve our harried bankers (the poor dears!) of contradictory imperatives to both support overall demand and extend credit wisely.

All well and good. I liked the post. I liked the graphs. I liked the perspective. I liked all of it. I have just one problem. It's a small problem. I don't think it affects Waldman's argument. It's just a detail. So, why do I bring it up? What does it matter anyway? I'll get to that.

Waldman writes:

I would pair Krugman’s chart with the following graph, which shows household borrowing as a fraction of GDP:

Includes both consumer and mortgage debt, see “credit market instruments”
in Table L.100 of the Fed’s Flow of Funds release

Household borrowing represents, in a very direct sense, a redistribution of purchasing power from savers to borrowers. So if we worry that oversaving by the rich may lead to an insufficiency of purchases, household borrowing is a natural place to look for a remedy. Sure enough, we find that beginning in the early 1980s, household borrowing began a secular rise that continued until the financial crisis.

My problem is that Waldman shows a graph of debt and says it shows borrowing. Debt and borrowing are not the same thing. Debt is a stock; borrowing is a flow. Debt is the accumulation of borrowings. Reminds me of what STF succinctly noted at Winterspeak some time back:

Saving = flow
Savings = stock

Here's the thing: Waldman glances at the graph and says, "beginning in the early 1980s, household borrowing began a secular rise that continued until the financial crisis."

Easy to see it on the graph, isn't it? But it is an illusion.

The graph shows debt, not borrowing. And ending in the early 1980s was a Great Inflation that whittled debt down by whittling down the dollar, boosting income and inflating GDP. Waldman's graph shows an increase in debt that begins after the early 1980s when inflation was suppressed, because inflation was suppressed, because the denominator of Waldman's CMDEBT/GDP ratio stopped increasing at such a highly inflated rate.

Look at the change in debt -- annual additions to the accumulation -- and you'll see a different picture than Waldman shows:

Graph #2: Quarterly Change in Debt (same debt as Waldman shows) in Billions

The annual additions to consumer debt were quite high in the 1980s. But after a big jump early, the trend is flat through the 1980s. It even falls some, in the 1990s.

Moreover, the secular increase in borrowing does not begin in the 1980s. It begins in the late 1970s... or the early 1970s... or the late 1960s... or the early 1960s, maybe. The secular increase goes back as far as the eye can see. The increase is much more "secular" than Waldman indicates. Much longer-lasting that since the '80s implies.

Another look:

Graph #3: Percent Change from Year Ago (same debt as Waldman shows)

High spikes early. Then the peaks drop off to the latter 1960s. A series of rising peaks follows, terminating in the 1980s -- just when Waldman says a secular increase begins.

Oh, sure: You can attribute those rising peaks of the 1970s to inflation. People had to borrow more because prices were going up, sure. But also, prices going up (or, more precisely, incomes going up) made all the previously existing debt easier to bear. And that happened year after year after year while the Great Inflation persisted.

Inflation made the debt easier to bear. Inflation reduced the size of existing debt relative to GDP. Because of inflation, the GDP number went up about as fast as the debt number went up. It was this increase in GDP due to inflation that made accumulated debt run flat on Waldman's graph. But only until the end of the Great Inflation. Only until the early 1980s. Beginning in the mid 1980s, falling inflation created what looks like of a sudden surge in the growth of debt on his graph. It was not a surge of debt.

On Graph #3 you can see a pretty substantial increase of debt in the 1980s, an increase comparable to that of the latter 1970s. Only the 1980s increase is visible on Waldman's graph. But clearly, the two spikes are near the same size. Clearly, borrowing rose about as fast in the latter 1970s as in the 1980s. Clearly, the secular increase in household borrowing began before the 1980s.

One more graph: Graph #4 shows the same debt as Waldman's graph, but with a different denominator, a different measure of income.

Graph #4: New borrowing always occurs in dollars of the current moment. But once you take out a loan, you have a debt that is stated in the dollars of that fleeting moment. After that moment, any and all inflation reduces the burden of the existing debt.

The blue line shows debt relative to income. It is comparable to Waldman's graph. The red line shows debt relative to income, in dollars of constant purchasing power. The blue line shows the actual burden of accumulated debt. The red line shows the actual pattern of "borrowing".

Waldman's graph shows the burden of accumulated debt reduced by inflation, like the blue line on Graph #4. The red line on Graph #4 shows the same accumulation, adjusted to eliminate the effects of inflation.

On Waldman's, the trend is flat in the 1970s, because existing debt was eroded by inflation. On mine, the trend of the red line is steeply upward in the 1970s, because new borrowing increased at a rapid pace.

When Steve Randy Waldman shows you a graph of debt and identifies it as a graph of "borrowing" he is in error. And when he says a secular increase in borrowing began in the early 1980s, he is seriously mistaken.


I said at the top that I like Waldman's argument and that, in the context of the Interfluidity post, the errors are minor. Now, having worked through things, I'm not so sure the argument is good. Waldman says two things:

• "In the US we’ve seen inequality accelerate since the 1980s..."
• "beginning in the early 1980s, household borrowing began a secular rise..."

Put the two together, and it sounds like they're related. Actually, that is the argument Waldman makes in the post: those of us at the short end of the income inequality scale made up for a shortfall of income by increasing our borrowing. Despite my objections to the post, Waldman's argument makes sense to me. Still makes sense to me.

But there must be something else going on. For it is not true that household borrowing began a secular rise in the early 1980s. That increase began much earlier. So there was no sudden offset to compensate for the changing inequality. Something else must have made up the difference.

Perhaps it is as simple as a slowdown of GDP growth. Growth has been slower since the early 1980s, and slower yet in the new millennium. Growing inequality, insufficiently offset by increases in new borrowing, might have caused this slower growth.

Thus we may enhance Waldman's argument. It feels right to me. Certainly, I was uncomfortable with Waldman's set-the-stage claims that "until 2007 we had robust demand [and] decent growth" and again, that "demand remained strong" in those years.


// Tomorrow: What does it matter anyway?
// For more on Graph #4 see this post.

Rules for the Direction of the Mind

From René Descartes:

Truly we shall learn how to employ our mental intuition from comparing it with the way in which we employ our eyes. For he who attempts to view a multitude of objects with one and the same glance, sees none of them distinctly; and similarly the man who is wont to attend to many things at the same time by means of a single act of thought is confused in mind. But just as workmen, who are employed in very fine and delicate operations and are accustomed to direct their eyesight attentively to separate points, by practice have acquired a capacity for distinguishing objects of extreme minuteness and subtlety; so likewise people who do not allow their thought to be distracted by various objects at the same time, but always concentrate it in attending to the simplest and easiest particulars, are clear-headed.

But it is a common failing of mortals to deem the more difficult the fairer; and they often think that they have learned nothing when they see a very clear and simple cause for a fact, while at the same time they are lost in admiration of certain sublime and profound philosophical explanations, even though these for the most part are based upon foundations which no one has adequately surveyed -- a mental disorder which prizes the darkness higher than the light. But it is notable that those who have real knowledge discern the truth with equal facility whether they evolve it from matter that is simple or that is obscure; they grasp each fact by an act of thought that is similar, single, and distinct, after they have once arrived at the point in question...

Everyone ought therefore to accustom himself to grasp in his thought at the same time facts that are at once so few and so simple, that he shall never believe that he has knowledge of anything which he does not mentally behold with a distinctness equal to that of the objects which he knows most distinctly of all. It is true that some men are born with a much greater aptitude for such discernment than others, but the mind can be made much more expert at such work by art and exercise. But there is one fact which I should here emphasize above all others; and that is that everyone should firmly persuade himself that none of the sciences, however abstruse, is to be deduced from lofty and obscure matters, but that they all proceed only from what is easy and more readily understood.

If I have this wrong, tell me. If I have it right, tell the other guy.

Sometimes things are simple, and we misunderstand because we expect things to be complicated.

Where does money come from? No, I mean currency, where does currency come from? You can go to the bank and cash a check and the bank will give you greenbacks. Currency. Base money.

Yeh, you could cash a check at the local Mom-n-Pop. But the currency you get from them was already in the economy before you wrote the check. So, cashing a check at the Mom-n-Pop doesn't increase the amount of currency in the economy.

Cashing a check at the bank does increase the currency in the economy. That's the only legal way I can think of, to increase the currency.

When you do that, when you cash a check at the bank, the bank takes money out of the "vault" to pay you. Vault cash is "reserves". So when you cash a check at the bank, currency comes out of reserves and goes into your pocket. Goes into the economy.

When you cash a check at the bank, the amount of money called "reserves" decreases and the amount of currency increases.

On Graph #1, the blue line is currency. The red line is vault cash and other reserves:

For a very long time, until 2008, currency was larger than reserves, and growing faster than reserves. So how is it that Steve Roth can say

Reserves can’t leave the system, whether in a flood or a trickle.

The blue line going up is reserves leaving the system. The blue line shows how much was taken out of reserves, over the years. A lot, actually.

All of the increase in cash in the economy, represented by the blue line, had to come out of vault cash, had to come out of reserves. If we just got it from Mom-n-Pop, the blue line would have stayed flat. The cash came out of banks. It came out of reserves.

Obviously, the Fed compensated for all that check-cashing by creating new reserves, so the red line never went to zero.

Steve Roth writes:

The banking system can’t remove reserves from the system by transferring them to the nonbank sector in exchange for bonds, drill presses, or toothpaste futures.

Maybe not. But anyone cashing a check at a bank removes reserves from the system.

Circulating currency increased from about 2½ times reserves (1960) to about 17½ times reserves (2008). This difference is not trivial.

Simpler

My economics is simple. For me, money breaks down to what's circulating and what isn't. (Money that's in savings isn't circulating.) Pretty simple definition. Some might say simplistic. It's not.

Anyway, much discussion these days involves base money and reserves and other forms of narrow money, narrower than circulating money. So I scratch my head a lot, and keep quiet sometimes, maybe not enough. And I look at the Wikipedia table when I need to, and I try to remember details about money.

So.

With recent activity still fresh in my mind, I want to take another look at Steve Roth's The Fed is not “Printing Money.” It’s Retiring Bonds and Issuing Reserves.


My recent post started out as a look at the definition of base money:

As the MB column [in the Wikipedia table] indicates, base money is made up of three parts: Notes and coins in circulation, Vault Cash, and Reserves not physically present in banks.

If you walk into the bank with a dollar in your pocket, that dollar counts as "Notes and coins in circulation". If you deposit the dollar, it changes to "Vault Cash". It is still part of base money, but now it counts as Reserves...

If that dollar then for some reason gets sent to the Fed it is still base money and it is still reserves, but now it is "not physically present in banks".

That's the relation between the three components of base money.

Pretty simple. Based on standard definitions. My goal is to understand this aspect of the economy as it is commonly understood. By contrast, Steve Roth's goal seems to be to change the definitions. It's right there in the title of his post! He writes:

I’m going to go even farther than Dow and say: the Fed is not printing money... The Fed is issuing new reserves and exchanging them for bonds.

Reserves are not “money” in any useful sense.

Yes, that's how the Fed issues new reserves: It exchanges them for stuff. For a hundred years before Roth wrote those words, the Fed would buy stuff -- bonds, say -- with newly created money, and that new money was considered reserves, and the reserves were part of a narrow base upon which a broader supply of money was built.

Now, for some reason, issuing reserves is not to be considered "printing money"???

Hey, the economy changes. Sometimes definitions need to be updated. And sometimes people get things wrong and definitions have to be corrected. I can live with all of that.

But it's important to begin by understanding things as they are commonly understood, and to understand them simply, and to see if it all still makes sense when simplified.

For if you do not begin by understanding things that way, you cannot know if those things are right or wrong.


Our economy *has* changed. One of the things that changed is we now pay interest on reserves. I mean, the Fed now pays interest on reserves.

That makes sense in a way, because reserves are like money in a savings account, and we get interest on our savings.

Does that change make it true that reserves are not money?

No. It makes reserves more like money in a savings account. And that makes sense too, because people who know better than me say that reserves are money that is not being spent. Or I don't know, maybe they just say that reserves are not spent, omitting the fact that reserves are money.

But are reserves money?

No, reserves are shoes. The dollar in your pocket is money, the circulating part of base money. When you deposit that dollar in the bank it is still money, the vault cash part of base money. But when your bank deposits that dollar in its bank, in the Fed, it is the reserves part of base money but it magically stops being money and starts being shoes.

Of course reserves are money.


The economy is complex in the sense that everything is part of it and everything comes into play one way or another. People who fail to simplify things sufficiently are liable to confuse themselves because of this complexity.

Steve Roth has confused his thoughts on reserves with other things. He finds it convenient to say that reserves are *not* money because he has in mind to use that thought to support his views on inflation and monetizing debt. Roth writes:

It doesn’t make sense to say that the Fed is “monetizing” the debt (because reserves aren’t money).

But peoples fears of inflation, right or wrong, have no bearing on the definition of reserves. If reserves are money, then reserves are money regardless of your view of inflation.

These are two separate issues, what reserves are, and whether the recent massive expansion of reserves will lead to inflation. Two separate issues. Steve Roth wants to argue that the massive expansion won't cause inflation because it isn't monetizing debt. So he finds it convenient to change the definition that says reserves are money.

The argument is awful. The logic is worse.

The Components of Base Money

From a recent post we know that circulating currency, together with total reserves, make up what we call "base money". Graph #1 compares base money (red) to the sum of reserves and circulating currency (blue):

Graph #1: Total of Components Equals the Monetary Base

The sum matches up well to base money as long as the numbers are available.

So we know that the two components added together do indeed equal Base Money. But don't you want to know which component makes up the bigger part of base money? I do. Graph #2 shows each component as a percent of Base Money:

Graph #2: Components as Portions of the Total

Currency (notes and coins) in circulation for the last several decades has made up the better part of base money.

Just before the problems of 2008, total reserves (red) had fallen to about 5% of base.