"To the extent that spending is credit-financed..."

In The myth of the “Phoenix Miracle” at VOX, Michael Biggs, Thomas Mayer, and Andreas Pick write:

To the extent that spending is credit-financed, demand in a particular period should be a function of the new borrowing that takes place in that period. Demand (and consequently GDP) is therefore a function of the flow of credit, and growth of GDP should be related to growth in the flow of credit rather than growth in the credit stock.

First off, I was glad to discover an actual example of how stock-flow consistency can make a difference. The article is quite specific about this, referring to "inappropriate comparison between the flow of GDP and the stock of credit." Their Figure 1 offers a very clear picture of the difference it can make.

I was also glad to see the emphasis on growth and new uses of credit. For the new uses of credit provide economic boost, while the cost of existing debt is a drag on growth. This duality is what eventually makes credit-use ineffective, as ever-larger new uses of credit are required just to offset the drag created by the debt from prior credit use.

The article also provides an optimistic conclusion:

If the pace of de-leveraging slows gradually from current levels, the increase in the credit impulse would support private sector demand growth even as debt levels fall.

But it seems a very narrow row to hoe. A little too much drop in debt levels would undermine growth; a little too little, and there is no de-leveraging at all.

There is another option. Note the introductory phrase in the first excerpt: "To the extent that spending is credit-financed...."

To the extent that spending is credit-financed, demand is a function of new credit use. To the extent that spending is *not* credit-financed, demand is independent of credit use. So, let's look at the extents.

The graph shows dollars of GDP per dollar of new credit use each year:

Graph #1: GDP relative to the Change in Total Debt

This graph, actually, is what I was trying to look at when I ended up comparing changes in both datasets, in I got this one by accident.

The spikes on Graph #1 are high until 1960. Several rise to between $100 and $200 of GDP per dollar of new credit use. Then the spikes are much lower -- under $100, say -- until maybe 1972. After 1972, there are basically *no* spikes at all.

GDP was largely independent of credit use in the years before 1960. It was somewhat independent of credit use until the early 1970s. Since that time, GDP has been tightly bound to credit use.

So I want to say that "the extent that spending is credit-financed" has changed significantly, from very little in the early years to very much in recent decades. The "extent that spending is credit-financed" varies, and has increased over time.

But that's not all. Look at the bottoms of the spikes -- leaving out the two really big lows. Consider the trend suggested by the path of the ordinary lows. The path is relatively high until after 1970, then lower and downtrending with a bottom at 1985. Then it rises through the 1991 recession, remains high until the macroeconomic miracle is under way, and declines again.

The trend of these minimums shows that there was substantially more output per dollar of new credit use in the 1950s and 1960s than in later years. Either credit use was more "efficient" in the early years, or "the extent that spending is credit-financed" was much less. Or the smaller extent made the use of credit more efficient.

Or the smaller extent of credit use made the use of credit appear more efficient, and left people talking about the productivity of debt, certainly a flawed concept.

Graph #2: Minimums from Graph #1 (with 1954Q1 and 2009Q4 removed)

Graph #2 is from this Google Docs spreadsheet.

h/t Marko #57 at Asymptosis.

Why

From my four o'clock:

Anyway, Robins. He says, "Getting less and less economic benefit from each dollar of new debt is becoming an enormous and onerous problem for the US." That's the debt productivity thing. Robins quotes Grandfather Hodges:

“In 1957 there was $1.86 in debt for each dollar of net national income, but in 2006 there was $4.60 of debt for each dollar of national income – up 147%. It also means this extra $2.74 of debt per dollar of national income produced zilch extra national income. In 2006 alone it took $6.32 of new debt to produce one dollar of national income.”

Why is debt less productive?

Because debt is NOT productive and it never was. Credit-use is productive.

When you go to the bank for a loan, it's because you want to spend some extra money on something. The extra spending you do will help the economy grow. Productive.

When the bank gives you a loan, you and the bank (together) put credit to use. I assume that if you borrow a dollar, you're gonna spend it. So, a dollar of credit put to use is a dollar of boost for the economy. Productive.

When you pay back your loan, you do it by taking money out of circulation and giving it back to the bank. Because the money comes out of circulation, it creates a drag on the economy. Counter-productive.

There is no magic in this. The dollar of "boost" and the dollar of "drag" have to balance out.

//

The use of credit is a boost for the economy. Debt is a record of how much boosting we have done. This record of boosting is not "productive."

Or if you prefer: Debt is the obligation to pay back what is borrowed.

Well, sure. Why else bother to keep track of it??

But in any case, debt is a DRAG on the economy, that counterbalances the BOOST that comes from using credit. Credit-use is productive; debt is not.

//

Nobody goes to the bank to accumulate debt. People use borrowed money -- credit -- because it suits their needs. But nobody says, "Gee, I think I'll borrow some money because I want to add to my debt today." Nobody says that. Debt is not the driving force. Debt is just a record of the borrowing. Debt can never be "productive."

Why is credit-use less productive than formerly?

Because there is so much to be paid back, so much drag. Because our debt is so vast. That's why.

Credit Efficiency

In a post titled Debt And Transfiguration, Paul Krugman argued against the view that a high level of debt causes problems in the economy. Inadequate growth, he said, makes debt appear excessive. He thinks the people who worry about the debt have cause and consequence reversed.

Then (ha ha) he added: "I’m not denying that high debt can be a problem."

Specifically, Krugman was arguing against the view that "bad things happen when debt goes above 90 percent of GDP." As evidence he said that in both Japan and Europe, debt increased after growth slowed. And in the U.S. he said, "the only period when debt was over 90 percent of GDP was in the early postwar years, when real GDP was falling."

Now I don't know whether Krugman was referring simply to the denominator problem -- that the value of the debt/GDP ratio can rise because of lagging GDP -- or whether he has a meatier argument. But to the people who already don't agree with Krugman, that couldn't possibly make the least bit of difference.

People who already disagree with Krugman -- those, let's say, who worry what will happen when debt goes above 90% of GDP -- will be scratching their heads, wondering why he is talking about World War II debt. The problem is not some old debt from 65 years ago that everybody knows wasn't a problem. The problem is the current high level of debt, and current projections of even higher debt to come. After all, not even Krugman denies that high debt can be a problem.

Still, he has a point: Debt was over 90% of U.S. GDP once, and it turned out not to be a problem, that time.

For the 90-percenters, Krugman creates a dilemma: Why was the World War II debt not a problem? They say debt is a problem now. They know they are right. I know they are right. I think even Krugman knows they are right. But he raises a question they cannot answer. As things stand now, the only solution is for 90-percenters to reject Krugman more completely. Dilemma and all.

Krugman suffers the same dilemma. He knows that high debt can be a problem. And yes, he knows that it turned out once, at least, not to be a problem. But he doesn't know why. He doesn't know why high debt was not a problem after World War II. If he knew, surely he would tell us.

The dispute between Krugman and the 90-percenters is fought on a particular playing field. That playing field is the graph "debt relative to GDP." When the trendline reaches 90% it is a huge problem. Or it is no problem at all.

To settle that dispute, answer one simple question: What does the graph show?

Consider first what the graph does not show: It does not show that debt is high. It only shows that debt is high relative to GDP: Gee, this mountain looks big compared to that mole-hill. Yes, we have a mountain of debt. But the graph does not show that. It shows a thing we already knew: The graph shows that GDP growth has been laggard. But that was our original complaint. We don't have the growth of output, the growth of jobs, the growth of living standards, the growth of profit that we need, that we expect, that we want, that we demand. GDP is a mole hill.

What does the graph show?

The graph shows the efficiency of credit use. If an increase in debt is efficient, it produces a lot of growth. So GDP increases more than the debt, and the trendline goes down. But if an increase in debt is not efficient, it produces little growth. So then GDP increases less than the debt, and the trendline goes up. The trendline rises or falls depending on the efficiency of credit-use as measured by improved growth.

There are discussions you can find on the internet, regarding the size of the "multiplier" -- the size of the effect we get per dollar of economic stimulus spending. Formerly, the multiplier was thought to be quite large. Now it is often said to be quite small. If you come across such a discussion, it may be presented as an argument: someone is right; someone is wrong.

Here's what I think: In the days when credit-efficiency was high, the multiplier was high. In the days when credit-efficiency is low, the multiplier is low. It is not a matter of someone is right and someone is wrong. It is a matter of credit efficiency.

What does the graph show?

It shows a steep decline from the 1946 peak to about 1952. We got a lot of growth for every dollar of credit use. Credit efficiency was extremely high.

It shows a less steep decline from 1952 to 1966, the year I graduated high school. Credit efficiency was somewhat less.

It shows a mild decline from 1966 to 1974. We gained only a little growth for every dollar of credit use. Credit efficiency was quite low.

It shows flat from 1974 to 1981. At this point there was no gain from credit use. (The multiplier was about 1.) We had reached a Laffer limit.

And it shows a sharp increase after 1981. There was a loss from credit use. If growth was better in the 1980s than in the '70s, this trendline shows why: It took a lot of debt to boost economic growth. Credit use was inefficient.

After the mid-1990s the trendline loses its "bowl" shape. We'll look into that later. Meanwhile I should point out that the trendline, which disappears behind the graph border in 2009, approaches 90% in that year: last year. I know this sharp spike in the trend is part of a policy designed to boost economic growth. But low credit efficiency makes that policy ineffective.