Monday, September 23, 2013

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.


Anonymous said...

Hi Art,

The Economist credits Richard Werner. You might want to listen to what Werner actually says:

I prefer Minsky's take on the stability/instability of debt arrangements. Income and cost of debt is all borrowers and lenders really consider. During the 1948-2008 housing bubble people were building larger and larger houses with high costs in energy, maintenance, taxes etc. Often the location meant long commutes to work. Today people are building smaller and smaller houses with much lower costs close to where they work [similar to what they used to do before the boom].

The difference is the perception of income. Before 2008 the equity derived from the value of the house price increasing was being counted as part of income. Not so much any more.

The former obviously produces more GDP but is over time destabilizing while the latter is not, because actual income (rather than hoped for income) is what is considered.

The Arthurian said...

"The former obviously produces more GDP but is over time destabilizing while the latter is not, because actual income (rather than hoped for income) is what is considered."

Wow, are you telling me expectations don't work? :)

Thanks for the link. I watched it once. Werner talks a lot about using incentives (as opposed to a command economy) to get things done; that's my choice as well.

One question comes to mind. Early in the video Werner says banks (and borrowers, whom he leaves out) create 97% of our money.

I'm a little vague on the arithmetic that would lead to such a statement. (97% of existing money now? 97% of the new money created?) But I know that the quantity of M1 varies relative to the quantity of accumulated debt: varies slowly and methodically over periods longer than your 1948-2008 housing bubble. To me this suggests that the 97% number probably occurs late in the cycle, and that the number is much lower, early in the cycle.

jim said...

Art wrote:
"Wow, are you telling me expectations don't work? :)"

Rational expectations always work until
they don't.

I thinks Werner is counting coins and currency as issued by govt, the rest is from the banking system. I think he is talking specifically about the UK.

truthhive said...

Good read, if only it were so easy - like a perpetual motion machine.