Saturday, September 13, 2014

He's kidding, right?

Benoît Cœuré of the ECB asks:

"Why is the effect of finance on growth non-linear?"

He's kidding, right?

You have to take the verb "finance" and consider what it means. It means to borrow money. Borrowing money is good for economic growth. A dollar borrowed is a dollar spent. The numbers go up. You might even want to conclude there is a one-for-one relation between borrowing and spending, or between borrowing and growth. But it's a bit early yet for conclusions.

Borrowing money is good for economic growth. But when you borrow a dollar, you create a dollar of debt. (Think of debt as the record of money borrowed.) Debt has to be repaid. And just as borrowing puts money in to the economy, repayment of debt takes money out. You know this. Even Benoît Cœuré knows this.

So, borrowing money is good for growth. But paying down debt is bad for growth. It's yin and yang. It's shadow and light. It's the two sides of the coin.

The effect of finance on growth goes something like this: The change in growth is equal to the amount of new borrowing, less principal repaid, less interest paid, plus interest withdrawn and spent into the economy.

And then you have to factor in the fact that spending recycles income, and the fact that not all spending contributes to growth, and the fact that debt accumulates.

It becomes too complicated for me to put a number on it. But you can easily see it's not a simple linear relation.

I think you already knew this. But maybe Benoît Cœuré didn't know.

The linear, one-for-one relation between borrowing and economic growth is made complex by the cost of debt. Therefore, the relation becomes non-linear.

I think that answers Benoît Cœuré's question.

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