It's not that complicated

The Real Effects of Debt, PDF, 34 pages, by Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, 2011. They evaluate government debt and non-financial corporate debt and household debt. The opening sentences of the Abstract:

At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. When does debt go from good to bad?

Dammit, no. Debt is not a flashing light that sometimes flashes red and other times green. Debt is always bad, period. Debt is the cost that is associated with credit use. Credit use is always good, and debt is always bad.

You may want to finesse that a bit, and say credit use is sometimes good and sometimes bad, and I won't argue with you. But please understand: I'm saying it my way to emphasize a point. Credit-use is demand. Credit-use is spending, and spending is demand. But credit-use doesn't cost anything, while it's still just credit-use. It's like getting stuff for free. That's why it's good. That's why it boosts the economy.

But then, a month or so after you use the credit, you get the bill. Now it's not credit-use anymore. Now it is debt. And now it's like paying for something, without getting anything. That's why debt is always bad.

Don't argue with me, dammit, I'm trying to make an idea simple.

In the PDF they say moderate levels of debt improve growth. But that's wrong. It's the credit-use that improves growth, because credit-use is demand. It's debt that harms growth, because the payment is disconnected from demand, and with debt there is payment but no demand.

Moderate levels of debt improve growth? Not really. Moderate levels of debt harm the economy less than high levels of debt. Moderate debt is easier to bear, because moderate credit-use can balance against it. When you have high levels of debt, it takes high levels of credit-use to offset the drag from the debt.

To understand debt, keep three principles in mind: Debt always hurts the economy. Credit-use always helps the economy. And credit-use always creates debt.

Credit use is good for growth but accumulated debt is not, so the effect is non-linear

VOX: Financial development and output growth in developing Asia and Latin America: A comparative sectoral analysis by Joshua Aizenman, Yothin Jinjarak, & Donghyun Park:

The Global Crisis put to the fore the possibility that the relationship between financial depth and output growth may be non-linear – the development of the financial sector may benefit the real sector, but only up to a point.¹ Beyond that point, further financial development may have no effect or even a negative effect on growth.

The evidence suggests that the level of service flow of financial sector is good only up to a point, after which it becomes a drag on sectoral growth in the sample countries.

Overall, our evidence is consistent with the hypotheses we set forth at the outset, in particular the non-linear effect of financial development on growth and its uneven effect across sectors. In addition, we find that financial depth has a negative effect on manufacturing in East Asia and a positive effect on finance, insurance, and real estate sector in Latin America. Financial efficiency, as measured by lending-deposit interest spread, is positively associated with the growth of finance, insurance, and real estate sector... We also find some evidence of a financial Dutch disease – the faster the growth of financial services and the larger the lending-deposit interest spread, the slower the growth of the manufacturing sector.

Footnotes

1 Boyd and Smith (1992) show that the quality of financial intermediation has first-order effects on capital flows and economic growth, providing a nice interpretation to the Lucas paradox (1992) of capital flowing uphill, a topic that gained even more attention in the context of the global imbalances in the 2000s (see Laura et al. 2003, Ju and Wei 2011 and the references therein). Cecchetti and Kharroubi (2012) study how financial development affects growth at both the country and industry level. They find the level of financial development is good only up to a point, after which it becomes a drag on growth. These results are in line with Rousseau and Wachtel (2011)’s ‘vanishing effect’ – i.e. credit has no statistically significant impact on GDP growth over the 1965-2004 period. Looking at the more recent data, Philippon and Reshef (2013) concluded that at the very high end of financial development, rapidly diminishing social returns may have set in. Aizenman et al. (2013) found that periods of accelerated growth of the financial sector are more likely to be followed by abrupt financial contractions than are periods of slower financial sector growth. Though these studies do not identify the mechanisms associated with the ‘vanishing effect’ of finance, they are consistent with Minsky (1974)’s hypothesis over time that financial deepening may eventually divert financial resources from financing real activities into speculative and ultimately destabilising risky and bubbly yield-seeking financial investments.

Nonlinear? Sure.

The part I like best? Rousseau and Wachtel in the footnote: credit has no statistically significant impact on GDP growth over the 1965-2004 period.

Yeah. Accumulated debt has been excessive since 1965? Yeah.

From the list of references: Rousseau, P, and P Wachtel (2011), “What is Happening to The Impact of Financial Deepening on Economic Growth?” Economic Inquiry, 49, 276-288.

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.

Growth Modeling: The nonlinear thing

At Yahoo Answers, Simplicitus said

Total factor productivity is the otherwise unexplained productivity left over after all the individual factors (labor, capital, etc.) are taken out.

See? That's why I say TFP seems like an error term, a correction value, an adjustment to make the answer come out right. I never forget, my chemistry teacher in college joked one time that we can "multiply by zero and add the right answer." That's not exactly what TFP is, but it is pretty much how I used it for yesterday's graph.


In Total Factor Productivity (PDF, 5 pages) Diego Comin writes:

Total Factor Productivity (TFP) is the portion of output not explained by the amount of inputs used in production. As such, its level is determined by how efficiently and intensely the inputs are utilized in production.

TFP growth is usually measured by the Solow residual. Let g_Y denote the growth rate of aggregate output, g_K the growth rate of aggregate capital, g_L the growth rate of aggregate labor and alpha the capital share. The Solow residual is then defined as g_Y − α∗g_K − (1−α)∗g_L.

This is starting to get familiar. The growth of output minus weighted values of the growth of capital and the growth of labor leaves a "residual" because the growth of labor and capital do not fully account for the growth of output. The difference, the discrepancy, is said to be due to changes in the efficiency of labor and capital, and it is called TFP, Total Factor Productivity.

So if I get labor and capital and TFP from FRED, and use an appropriate alpha, I should be able to plot a line very similar to Real GDP. Did it yesterday, in fact.

That's why I dwell on the Solow Growth Model. I think I can use it to create a simulation of the economy in a spreadsheet. That's one of those things I try to do every once in a while, create a spreadsheet where each row represents a year, and the numbers for one year are used to generate the numbers for the next year. Doesn't sound difficult, but I've never got a satisfactory result. Maybe the Solow model will help.


One of the basic ideas I try to convey on this blog is the idea that there is a particular level (or a limited range of levels) of finance that is best for economic growth. Too little finance, and money for economic expansion is unavailable. Too much finance, and the cost of accumulated debt undermines growth. When you hear people talking about the "nonlinear" effects of debt, this is exactly the phenomenon they mean. (You heard it here first.)

But I can't really show what I think happens unless I can simulate a growing economy. I think I can take the Solow growth model and add something to simulate a financial sector and a growing accumulation of debt. So then we can see if accumulating debt has the effects I describe.

And my financial sector will be built on the stable, predictable economy of the Solow model, so that changes arising from the addition of a financial sector will be quite obvious. But don't expect to see it tomorrow.

Meanwhile...

Glasner on finance

In Falling Real Interest Rates, Winner-Take-All Markets, and Lance Armstrong, David Glasner writes:

... insofar as reduced marginal tax rates contributed to an expansion of the financial sector of the economy, reduced marginal tax rates may have retarded, rather than spurred, growth. The problem with the financial sector is that the resources employed in that sector, especially resources devoted to trading, are socially wasted, the profits accruing to trading reflecting not net additions to output, but losses incurred by other traders.

I wouldn't say "socially wasted", but that's just me. Glasner's important point is that an expansion of the financial sector may have retarded growth. Now, that's not something you see economists say every day!

In Of the Component Parts of the Price of Commodities Adam Smith identified three things needed to create something of value: material to work on, the working, and tools to work with -- land, labor, and capital.

He called these "the three original sources of revenue". The sources of all income.

Creating things of value was central to Smith's analysis, because the creation of things of value is the source of the wealth of nations. Work is the connection between the world of things and the world of value. If someone will pay you to do something, it is because they value whatever it is that they want done. When you do it for them, income is created. And if you add up all the income created in a year, you get GDP. (And you know how important GDP is.)

Smith pointed out that not all activities create value directly:

The interest of money is always a derivative revenue... All taxes, and all the revenue which is founded upon them, all salaries, pensions, and annuities of every kind, are ultimately derived from some one or other of those three original sources of revenue

All income arises from the three factors of production.

All income is cost. The cost is worthwhile because of the production derived from it; this is the meaning of the word "value".

But not all costs arise from the three factors of production. I recently referred to the interest of money as the factor of facilitation.

The problem with the financial sector is that the resources employed in that sector generate cost but not production. Granted, finance facilitates production. But there is no linear, one-for-one increase of output per dollar of financial cost.

Finance brings non-linearity into the picture. This is how it happens that questions of debt productivity and credit efficiency arise.

Comparable questions arise regarding the size of government, and for exactly the same reason. But everyone looks at the size of government, and no one looks at the size of finance, and therein lies the problem.

To paraphrase David Glasner, the income that accrues to finance is losses incurred by productive factors.