This Borg we call Finance

At Worthwhile Canadian, The trade cycle: debt is trade, by Nick Rowe.

Nick's first few paragraphs are very, very good. Classic. All they are, really, is the clear expression of a simple definition of GDP. Nick puts it in his own words in a way that leaves no doubt he understands this one all the way to the core. And then he uses that definition to come up with "something peculiar". Peculiar, and fascinating. And Nick is just coasting. Everything emerges from the one well-understood definition.

Here are the first 3½ paragraphs in all their pristine glory:

The trade cycle: debt is trade

GDP is high in booms and low in recessions (relative to trend). That is (roughly) how we currently define "booms" and "recessions".

GDP (roughly) measures the volume of trade in newly-produced final goods. But that is a narrow measure of trade. A lot of goods get traded that are not newly-produced. People buy and sell old houses, for example, where by "old" I mean "not produced this year". And those trades are not counted as part of GDP.

There is nothing wrong with excluding sales of old houses from GDP. Because GDP is supposed to measure the volume of production and not the volume of trade. But there is something peculiar in defining booms and recessions and the business cycle in terms of the volume of production, rather than the volume of trade. We produce goods and trade the goods we have produced, presumably because it makes buyer and seller better off, which is why production matters. But trade in old goods, like old houses, presumably makes buyer and seller better off too, so trade in old goods matters too.

In a monetary exchange economy, all goods, both newly-produced and old goods, get bought and sold for money. If something goes wrong with money, we should expect to see trade in all goods, both new and old, get disrupted. Some mutually advantageous trades in newly-produced goods don't get made; some mutually advantageous trades in old goods don't get made either. The decline in production we observe in a recession is just one symptom, albeit an important symptom, of a general decline in trade of both newly-produced and old goods.

Just to be clear, I'm not exaggerating my praise for those paragraphs. I really like the excerpt because Nick pulls so much from a simple definition.


Before long we get to the important part of Nick's post. Less simple, less classic, less definitional, but more to the point Nick wants to make. Thus it begins:

What do we trade? We trade newly-produced goods. We also trade old goods. We also trade IOUs. When I sell an IOU, we call it "borrowing". When I buy an IOU, we call it "lending". Borrowing and lending are trade, and those trades happen for the same reason all trades happen -- because the buyer and seller are presumably better off as a result of the trade. Of course there are exceptions, but then there are exceptions to all trades. Everyone has regretted buying or selling something, whether or not it was an IOU.

Notice how Nick slipped IOUs into the discussion? Before, it was new goods and old goods. Now, it is new goods and old goods and IOUs -- a list of interchangeable parts. But you can't eat old sushi, and IOUs are not goods.

He continues:

If you look at business cycles this way, as a trade cycle, in which the volume of trade rises in booms and falls in recessions, it is totally unsurprising that the volume of borrowing and lending should also rise in booms and fall in recessions. Because borrowing and lending is just another type of trade...

Wow. If I was writing this post, this is where I would want to start: "The volume of borrowing and lending rises in booms and fall in recessions." No explanation needed. But the next little bit -- "borrowing and lending is just another type of trade" -- I'm not comfortable with that. It's not "just" another type of trade. It is the monkey wrench.

The rest of that paragraph is good:

The same monetary problem that disrupts trade in newly-produced goods, and disrupts trade in old goods, also disrupts trade in IOUs. Because, in a monetary exchange economy, all those goods -- newly-produced goods, old goods, and IOUs -- are traded for money.

That's exactly right. But Nick leaves out the most important part: IOUs are used as money. Sure, he gets to it later, as an afterthought, after he gets to his conclusion. It's too late, then. You need to read the story this way:

The same monetary problem that disrupts trade in newly-produced goods, and disrupts trade in old goods, also disrupts trade in IOUs. Because, in a monetary exchange economy, all those goods -- newly-produced goods, old goods, and IOUs -- are traded for money. But IOUs are used as money.

IOUs are the monetary problem that disrupts trade. When "something goes wrong with money" the thing that's wrong is that there is an excess of IOUs relative to the quantity of money. It's not some unidentifiable "something". It's the excessive reliance on credit.

Nick doesn't say that. He relies instead on the sorry notion that "lending is just another type of trade". Nick touches on the truth when he identifies the problem that disrupts trade as a "monetary problem". But he seems unaware that this thought invalidates the other -- invalidates it because lending creates money. Lending is not "just another type of trade", because lending creates money.


I am happy to see Nick focus on the "monetary problem" as the problem that disrupts trade. But borrowing and lending are not "just another type of trade".

Labor is productive. Capital is productive. Finance is not productive. Finance only facilitates production. It's not the same thing. Production is power to the ground. Facilitation is a slipping clutch. Nick Rowe's "trade" treats them as equals.

Credit-use imposes a cost on production. Credit-use increases the cost of production. When there is little debt, the imposed cost is low. When there is a lot of debt, the imposed cost is high. The cost of excessive credit-use reduces profit and reduces disposable income and raises prices and makes our products less competitive internationally.

Labor is often blamed for the high cost of U.S. products. But all costs are costs. Even financial costs are costs. Why then do we always and everywhere blame labor for our cost problems?

Source: Mine of 23 June 2010

Debt is not just another type of trade. Interest income is not the same as wage income. Interest income tends to stay tucked away in the financial sector -- the non-productive sector -- where it can draw additional interest. Wage income is spent. Wage income is mostly recycled back to the productive sector where it can be used again as income.

Not every penny of wage income is recycled, of course. Some of it gets saved, finding its way to the financial sector where it, too, can draw in more of what remains of the money that has not yet been assimilated by this Borg we call Finance.


Let's wrap it up. I'm numbering the rest of Nick's paragraphs...

(1)	What would be surprising and in need of explanation would be if trade in IOUs did not follow the same cyclical pattern as trade in other goods.
(2)	Neil Irwin tells me that trade in IOUs is increasing in the US. (HT Mark Thoma). He's right that it's good news. I'm just re-framing what he is saying.
(3a)	Yes, some IOUs are used as money. Which means that some trades in IOUs create money.
(3b)	And this, depending on the monetary policy followed by the central bank, may create a positive feedback loop. But the job of a good central bank is to replace that positive feedback loop with a negative feedback loop, just like a good thermostat. (I'm talking about "banks", in case you missed it.)
(4)	[After this afternoon, I will be taking a couple of weeks away from the blog.]

... and match-marking my responses:

(1)	Nick is right. We should expect trade in IOUs to rise and fall with the economy. We should expect pattern similarity. However, as time goes by, the rise and fall of trade leaves the total volume of IOUs at an increasingly higher level, relative to the total volume of goods. So after a time, the economy is not the same as it was at the start. The trade in IOUs has become a larger part of the total, the trade in goods a smaller part. After a time, a larger part of the total income arises from and accrues to finance. A smaller part arises from and accrues to the productive sector. The effects of this imbalance are called, vaguely and carelessly, a "monetary problem".
(2)	Nick is happy to hear that "trade in IOUs is increasing in the US". Happy, because to him it means that trade in goods is increasing also. He foresees recovery. But Nick seems to overlook the fact that finance has grown large relative to the productive side. He overlooks the fact that a decent increase in the trade in IOUs may be accompanied by a pitiful increase in the trade that boosts income and employment and GDP. If past performance is any indicator, if the marginal productivity of debt is any indicator, then we cannot possibly afford the increase in debt that would be required to get a halfway decent bit of GDP growth. Nick is overly optimistic.
(3a)	Some trades in IOUs create money, Nick says. Okay. So the other trades in IOUs don't create money. They still create additional financial cost.
(3b)	And when the positive feedback loop gets started, it builds on what has happened already. It is the increase in aggregate demand that has already happened that gives rise to the spreading view that demand is on the rise. And it is the increase in borrowing that has already happened, that pushes things to further motion. And it is the spending that has already happened that gives prices an upward spin. And what does the central bank do in response? It jacks up interest rates. It increases the cost of future financial activity to curtail additional expansion. In other words the spending that has not yet happened, and cannot possibly have contributed to inflation, is suppressed. Growth is suppressed. But no effort is made to accelerate the repayment of the recently created debt that stands as evidence of the "extra" spending which is what created the upward pressures on prices in the first place. What is necessary is to keep interest rates low to encourage growth, always, and to set up tax incentives that accelerate the repayment of lingering debt. We cannot leave it up to the central bank to replace the self-reinforcing, inflationary, positive feedback loop with a self-attenuating, price-stabilizing, negative feedback loop. We can't leave that up to the central bank and yet leave intact the massive and complex construction Congress has created to foster credit use and the accumulation of debt. No central bank could succeed in such an environment.
(4)	Nick, have a good vacation. When you get back maybe we can talk.