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