The Economist: Wrong and wronger

I want to take another look at the excerpt we saw yesterday, from The Economist:

When a bank makes a loan, it credits the money to the borrower’s deposit account. In so doing the loan adds to the money supply. If that money is spent on a new car, factory or other freshly produced good, it contributes to demand, helping the economy to make fuller use of its productive capacity. If the economy is already near full capacity, it will probably just raise prices instead.

The phrase "freshly produced" is a little creepy, I'd say, but it's easy enough to see the meaning. And as for the meaning, it makes sense to me. At least, the part of the excerpt repeated above makes sense. I think the rest of it is nonsense:

But either way, the bank lending will add both to debt and to nominal GDP, the money value of economic output, leaving the ratio of debt to GDP largely unchanged.

However, loans can also be spent differently. They can be used to buy existing assets, such as homes, office-blocks or rival firms. Since the asset already exists, its purchase does not add directly to GDP, which measures only the production of new goods and services. As a consequence, debt increases, but GDP does not.

There are two topics there in the nonsense part, in the two separate paragraphs:
1. The consequence of buying "freshly produced" stuff.
2. The consequence of buying "existing assets".

I want to treat these separately. But I had to leave 'em together, uninterrupted in the excerpt, so you could see that the first thought dies with the words "leaving the ratio of debt to GDP largely unchanged." There's nothing else there. There is no follow-up thought that you're not seeing because of some editing I did. It's not there, in the original article. It's just not there.


Regarding the first topic: The article says as long as we use our borrowed money to buy new stuff, the ratio of debt to GDP remains "largely unchanged".

Don't depend on it. I know a lot of people agree with the view expressed in the excerpt. I'm just saying, don't think the issue is settled.

Debt is a stock, and GDP is a flow. Next year, we still count the debt we created this year, or what's not yet repaid of it, but this year's GDP doesn't count at all. Next year, we start counting GDP at zero, but debt starts from a high number. Debt accumulates; GDP does not. It's that simple, really.

Why does debt grow faster bigger than GDP? Because debt is a stock and GDP is a flow.

On top of that, money tends to disappear. Some of it goes to trading partners. A lot is saved. And some slips down between couch cushions. All these things make money disappear from circulation, reducing the spending that is counted as GDP. (It reduces spending in general, including the spending that counts as GDP.) The disappearance of money undermines the expansion of GDP. The bigger the trade deficit, and the greater the saving, the more is GDP growth undermined.

Debt does not disappear like that. Therefore, contrary to what the article says, the ratio of debt to GDP does not tend to remain unchanged. In the U.S. experience, it takes a great inflation to stabilize that ratio.