Wednesday, October 5, 2016

What's wrong with the new Richard Vague article

Not much is wrong with it. Vague's The Private Debt Crisis is very good. But I do have a few remarks. Richard Vague writes:

Both private debt and government debt matter, and both will be discussed here, but of these two, it is private debt that has the larger and more direct impact on economic outcomes, and addressing the issues associated with private debt is the more productive path to economic revival.


I get complaints from tards sometimes when I look at Federal debt. Yet as Richard Vague says: "Both private debt and government debt matter". He adds: "it is private debt that has the larger and more direct impact". Yup.

When too high, private debt becomes a drag on economic growth.

Yup. He explains it well, too. Except he says

... consumers are in fact carrying 13 percent more debt as a percent of GDP than they were in 2000, the moment before the ill-fated private debt boom that led to the 2008 crisis ...

I'm a little uncomfortable with this sentence because it suggests that the increase of debt-to-GDP is a problem, period. Me, I don't know that it's a problem if the increase is gradual. I think it is, but I can't prove it to my own satisfaction.

I've looked at this before:

Graph #1: Private Debt as a Percent of GDP
I draw a trend line. Richard Vague draws a horizontal at the current level. I'm not sure my trend line has merit, but I'm sure his horizontal has none.

In that vein, his Chart 3 shows private debt to GDP for the six nations that "have accounted for roughly 50 percent or more of global GDP since the Industrial Revolution." The chart goes back to 1740.

The lines go up. As Vague puts it, "the general trend is toward higher levels of debt." He presents the chart as evidence of "the path from low leverage to overleverage". And that's what I think it is, too. But I can't accept the argument Richard Vague makes, that it's a problem. For as he points out,

The benefit of increasing leverage from low levels has played a central role in the miraculous gains in incomes over the 200-plus years since the Industrial Revolution.

What looks to us like "low levels" of leverage looked like high levels to people at the time. See the problem?

Something else: "Overcapacity".

As mentioned, short bursts of runaway growth in private debt have often led to crisis—the United States in 2008 and Japan in 1991 to name just two. That is because so much lending occurs that it results in overcapacity: Far too much of something is built or produced—housing and office buildings are two examples—and too many bad loans are made.

I'm not at all comfortable with that statement.

The goal is not just to tell a story that makes sense. The goal is to understand the economy. It is too easy in economic studies to come up with a story that sounds good, and build on it. Decades later, the story that was assumed to be correct turns out to be wrong -- but it has become part of the foundation supporting forty years' work, and no one is willing to dismantle enough of that work to remove the few bad bits.

Even if people were willing, and even if the mistake did get fixed, we're dealing with the mindset of a generation here. More than a generation. All those people would have to change their minds, and that's never going to happen. Science advances one funeral at a time.

That's where econ is today, by the way. I want no part in repeating such an error.

Anyway, 60 to 70 percent of assets are financial assets, as opposed to productive assets. Two thirds of our assets produce nothing but income. They don't contribute to "capacity". They contribute only to the cost of the output produced by non-financial assets.

Richard Vague says we end up in crisis "because so much lending occurs that it results in overcapacity ... and too many bad loans are made." It's a great story. But the problem is not that the lending creates overcapacity. The problem is that the lending creates debt.

When you get "too many loans" (too much debt, really) you get too much financial cost for the non-financial sector to bear. That's how "bad loans" arise. The non-financial sector starts defaulting, and the financial sector starts to worry. And when the financial sector starts to worry, the economy is in trouble.

Overcapacity? The borrowed money had to go somewhere! Besides, if finance wasn't worried today, they'd still be lending and we'd still be adding to capacity (so to speak) and we wouldn't be calling it "overcapacity".

I think Vague's argument here is just wrong.

Richard Vague repeats his "overcapacity" story in regard to China:

In its rush to grow, China has simply built far too many buildings—witness the many ghost towns—and produced far too much steel, iron, and other commodities—and made far too many bad loans in the process. Its overcapacity is so pronounced that it will take years for true demand to catch up with this oversupply.

No. If less income was taken by the financial sector, the productive sector could afford to put those buildings to use, and to put the steel and iron and other commodities to use, and the loans would not have gone bad.

Loans go bad because finance is drawing too much profit from the productive sector. The productive sector withers for decades, until the feedback effect makes the financial sector start to go sour. Then everything fails at once.

That's my story, and I'm sticking to it.


The Arthurian said...

I said: "What looks to us like "low levels" of leverage looked like high levels to people at the time."

Adam Smith said: "When paper is substituted in the room of gold and silver money, the quantity of the materials, tools, and maintenance, which the whole circulating capital can supply, may be increased by the whole value of gold and silver which used to be employed in purchasing them."

Smith was talking about a quantity of bank money equal to the stock of gold and silver money. That's a 1:1 ratio. That's low leverage. But we find Smith having to argue in favor of it. So at the time, most people probably thought of a 1:1 ratio as high leverage.

Alexander Hamilton said: "It is a well established fact, that banks in good credit, can circulate a far greater sum than the actual quantum of their capital in gold and silver. The extent of the possible excess seems indeterminate; though it has been conjecturally stated at the proportions of two and three to one."

Hamilton was talking about a quantity of bank money two to three times the stock of gold and silver money. That's a 2:1 or 3:1 ratio. That's low leverage. But we find Hamilton having to argue in favor of it. So at the time, most people probably thought of a 2:1 or 3:1 ratio as high leverage.

Positive Money says: "Banks create new money whenever they make loans. 97% of the money in the economy today is created by banks, whilst just 3% is created by the government."

Positive Money is talking about a quantity of bank money that is more than 32 times the size of the stock of government money. That's high leverage today. Too high, says Positive Money. Too high, says Richard Vague. Too high, I agree.

But the ratio will probably be even higher 50 years from now, unless we do something about it. And if the ratio is higher 50 years from now, 32:1 will look like a low ratio.

The ratio is an indicator of how fragile the economy is. 32:1 is very fragile.

The Arthurian said...

See, that's not right, what I said. I said "32:1 is very fragile." But that's not true.

This is true: 32:1 is very fragile today.

50 years from now we'll be okay with 32:1. It'll be at some higher number that fragility lurks. 32:1 now and 32:1 fifty years from now, that's a horizontal line, that's now how it works.

What's been going on for the past 8 years and continues yet is a restructuring of the financial system so it is not fragile at 32:1. Because financiers don't want to be stuck at 32:1. They can't increase their holdings fast enough unless the ratio goes up. That's where the sloping line comes from, on the graph that I showed. And that's why the lines go up on Richard Vague's chart that goes back to 1740.

When the ratio goes up, the financial sector takes a bigger share of the pie. The productive sector is left with a smaller share. It's the euthanasia of labor. It's the wrong plan.

The Arthurian said...


32:1 now and 32:1 fifty years from now, that's a horizontal line, that's NOT how it works.