Well look at that!

And they say nobody saw it coming.

"Unless we take action now, our nation may confront a situation similar to the Great Depression -- and maybe even worse."

(The opening statement of United We Stand by Ross Perot, 1992.)

Nineteen ninety-two.

Issue and Reissue

In days gone by when one spoke of money, "hard money" came to mind. "Precious" metal. "Specie" -- though that word is as obsolete today as money made of gold.

People kept their money at the goldsmith's. The goldsmith gave out receipts when he took in gold. People found it convenient to use the receipts for money, rather than trudging down to the goldsmith, exchanging receipts for gold, carrying the gold to market, and making their purchases. People found it convenient to use gold receipts for money, rather than the gold itself. Thus, paper money was born.

As gold receipts circulated more and more, goldsmiths found that they almost always had more gold on hand than they needed to cover incoming receipts. So they started lending out some of that excess gold. With gold on loan, goldsmiths had more receipts outstanding than they had gold in-house. Thus, fractional reserve banking was born.

Of course, the goldsmiths did not really have "excess" gold. They didn't have more than they needed to cover their outstanding receipts. They only had more than they needed at the moment.

And every once in a while there was a "panic" and a "run" on the bank, when everybody grabbed their gold receipts and went running down to the bank to get their gold, all at the same moment. That's when problems would arise with fractional reserve banking.

Not a Pretty Picture

The graph shows interest income in this country as a portion of GDP. Or, since economists say that income equals output, the graph shows interest income as a portion of total income.

Interest income rises rapidly from 8.8% (in 1960) to 31.6% of total income (in 1982), then remains high. The average for 1973-2008 is 25%. So 25% of our income in this country is for facilitation and 75% is for production. However, the selling price of the stuff we produce has to cover the full 100% of income. The excessive interest expense makes costs high, per unit of output. It reduces demand. And it reduces profit.

It also makes our stuff less competitive in global markets.

Why is interest such a large part of our economy? Because policy takes money out of circulation and encourages the use of credit. In 1960 that was a pretty good policy. By 1975? Not so much.


You can view the Google Docs spreadsheet for this graph.

Gimmie Some Slack

I like graphs. I like 'em because they make it easy to see trends. But I don't like to look at every little wiggle on a graph and point out significance. Wiggles are wiggles, trends are trends.

This time I go against my better instinct.

I was looking for something on productivity. At the Center for Economic and Policy Research (CEPR) I found The Real Economic Crisis by Dean Baker and John Schmitt, dated October 14, 2007.

The focus of the article is "the sharp deceleration in productivity growth since the middle of 2004." Scattered among the comments and insights in the paper is a little history of U.S. productivity. That's my focus here.

From the article:

Between 1947 and 1973, the golden age of postwar capitalism, productivity growth averaged about 2.8% per year in the United States.

From 1973 through 1995, however, productivity growth took a nosedive, with the average rate dropping to just 1.4%.

From the mid-1990s on, however, official productivity growth again accelerated rapidly, returning to a 2.9% rate reminiscent of the golden age. Quite suddenly, though, in the second half of 2004, productivity growth dropped sharply.

In summary:

1947-1973	1973-1995	1995-2004	2004-2007
GOOD	NO GOOD	GOOD	NO GOOD

What accounts for these changes? In particular, what causes the "no good" periods? Baker and Schmitt don't say. They say productivity decline "constitutes a serious long-term threat to US living standards." They say Europeans should "consider these data carefully" before adopting policies similar to those of the U.S. But they don't say what might account for productivity decline.

I'll tellya what accounts for it: DPD, that's what

My DPD ("Debt per Dollar") graph has an interesting fit to the productivity pattern. Debt-per-dollar moves consistently downward during the Roosevelt era, reaching a bottom in 1947. Just as it starts upward, Baker and Schmitt's "golden age" begins.

DPD increases and productivity is good until 1973, when debt reaches a Laffer limit. After that, continuing to increase our reliance on credit does more harm than good. Debt-per-dollar continues to rise exponentially. Productivity founders.

Then around 1990, debt-per-dollar turns briefly down again. Around 1994 DPD turns upward. According to Baker and Schmitt, productivity suddenly "accelerated rapidly."

Debt was beyond the Laffer limit in the 1990s. But a few short years of DPD downtrend relieved some pressure and gave us a decade of "golden age" productivity.

The graph shows a much steeper DPD climb after 1994 than before 1990. It shows our economy using up the slack created by the 1990-1994 downtrend. That slack was exactly what our economy needed in order to grow.

By 2004, the DPD slack was gone, and "productivity growth dropped sharply."

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

1947-1973	1973-1995	1995-2004	2004-2007
GOOD	NO GOOD	GOOD	NO GOOD

A Minor Point

That last bit from Andrew Haldane once again:

Debt operates rather like a tax. Debt servicing costs, like a tax, reduce the disposable income of the borrower. Too much debt means a higher debt “tax” and a greater drag on activity – lower lending by banks and spending by households and companies.

The cost of debt is like a tax, because it is a "factor" cost.

My favorite part of The Wealth of Nations is the part where Adam Smith identified the factors of production. Smith looked at the world around him. He saw the land-owning aristocracy, a rising business class, and the commonfolk.

Smith realized that each of these groups received income from economic activity. He knew that these incomes were the costs of production. Today we call those groups "factors" of production, and the costs "factor costs." The well-worn phrase land, labor, and capital identifies Smith's factors; rents, wages, and profits are the costs.

When I look at the world I see one more factor: money. And its factor cost: interest.

The "debt tax" that Andrew Haldane describes is interest, the cost of using other people's money. When you start to look at interest as a factor cost, you start to see the source of our economic problems.

The cost of using money to make a product is included in the price of the product, just as labor costs and resource costs and profits are included. The more the cost of using money embeds itself in prices -- the greater the factor cost of money -- the greater is its effect on life as we know it. And the more we rely on credit, in the economy as a whole, the greater the factor cost of money.

Debt? Debt is simply the evidence of our reliance on credit.

Gotta say it (Part 2)

Andrew Haldane (of the Bank of England) says: "What we face today may be called a debt overhang, but what it will feel like is a debt hangover. Like a hangover, it will slow activity in the period ahead."

So Mr. Haldane says excessive debt hurts economic growth. This is a very important point. But let's not call it "debt." For now, let's call it "credit use."

When we have little debt, credit use helps the economy grow. But then, credit use creates debt. And as you know, policy allows debt to accumulate. As debt accumulates, we get closer to the Laffer limit. We get closer to the point where continuing to do the same thing begins to have the opposite effect.

As we approach the limit, we start to lose the advantages of credit use. Economic growth becomes disappointing. Once we reach the Laffer limit, using credit to grow the economy begins to do more harm than good.

That's when we start talking about "debt" again.

Our leaders tweak the system: deregulating, creating incentives for savers, cutting taxes to stimulate growth. And we continue to rely on credit use. And credit use continues to create debt. And we continue to accumulate debt.

We are soon well beyond the Laffer limit. At that point not even magic can make the economy grow like it did in the good old days. Among the excerpts from Haldane on Agrawal's blog is this simple explanation of the effects of excessive debt:

Debt operates rather like a tax. Debt servicing costs, like a tax, reduce the disposable income of the borrower. Too much debt means a higher debt “tax” and a greater drag on activity – lower lending by banks and spending by households and companies.

Or as I said, just this morning:

New uses of credit help the economy grow. That's good. Old accumulations of debt create a cost that hinders economic growth. That's bad.

Not even magic can solve the problem. But the problem is not the new uses of credit. The problem is old accumulations of debt. And there's an easy fix for that.

Gotta say it

I want to thank again the blogger I couldn't find a second time, who put one and one together for me and got this series of posts started. I still can't find him. But I did find a post by Amol Agrawal from August 22 '08.

Agrawal also has a current post that fits the theme of my recent work. He presents a recent speech by Andrew Haldane, Executive Director for Financial Stability at the Bank of England. The BoE's financial stability man is concerned about debt.

Me, too.

The "accumulation of debt" is one of "the root causes of the crisis," Haldane says.

Yep.

"There is a debt Laffer curve," Haldane says.

Sound familiar? ...I said it better, I think.

"The lasting legacy of this crisis is too much debt held by too many sectors against too little capital."

Too much debt (everywhere) compared to (something). "Capital" is a little too vaguely defined for my taste. Haldane wants to "augment capital ratios" -- increase bank stock, basically, relative to bank assets. Haldane is looking at the problem like a banker.

I look at the problem like a citizen. I look at bank "assets" -- all those risky loans; all of the debt, in fact -- compared to the amount of money circulating in the economy. I compare debt to the amount of money we can use to pay off debt.

Haldane knows tons more than I do, I have no doubt. But you don't have to be a banker to know that debt's a problem. And you don't have to be a banker to know that cutting debt cuts the risk associated with debt. And you don't have to be a banker to know you cannot reduce debt by using more debt to pay off debt.

Cut wut?

Simon Johnson of The Baseline Scenario thinks we need to cut the size of our finance industry in half, from 8% of GDP down to 4%. I like Johnson's idea, because it matches up well with what I say in the 12 pages:

A reasonable goal would be to make it so that each dollar of money-money has to support about $20 of credit-money, rather than $35 or $40.

Cut debt by half. That's my plan.

Cut finance by half, that's Simon Johnson's scenario. He's the economist. I'm just a hobbyist. Let's go with his plan. All right then, the Johnson scenario: cut finance by half. Now... Financial products include investment, insurance, and lending.

What shall we cut?

There's nothing we can cut. We need investment. We need insurance. And we need to use credit. So how are we gonna cut our use of financial products in half?

I have a thought: We need the investment, the insurance, the new uses of credit. But we don't need the accumulation of old debt.

We need new debt. We need it for growth. Economic expansion depends on new uses of credit (and using credit creates new debt). But we don't need old debt. Old debt is a burden. It's a drag on the economy. And the more debt we're "managing," the bigger the drag on the economy.

Distinguishing between new uses of credit and old accumulations of debt makes the situation clear. New uses of credit help the economy grow. That's good. Old accumulations of debt create a cost that hinders economic growth. That's bad.

Cut debt by half; that's the plan. Cut old debt; that's the key.

"We are all Kosh"

The title of this post is from an episode of Babylon 5

From Economics by Campbell R. McConnell:

When a bank makes loans, it creates money.

McConnell expects his reader to find this "a startling fact." (I remember being startled by it, back in 1977.) And this:

It is through the extension of credit by commercial banks that the bulk of the money used in our economy is created.

He calls it "bank money." And this:

It seems logical to inquire whether money is destroyed when the loans are repaid. The answer is "Yes."

I have three thoughts:

1. On the internet

Most of the time when I see the "banks create money" idea on the internet, it is associated with the phrase "fractional reserve banking" and seems to be considered some sort of criminal activity.

I won't argue the point, except to say I don't see how it could be criminal, since it is common and public and built into the institutions and the fabric of society. And it's not some great secret kept hidden from everybody; all you have to do is take an economics class to learn about it.

Anyway, the problem is not that banks create money and debt. The problem is the excessive accumulation of bank-money or credit-money or debt, relative to the quantity of M1 (money in circulation).

2. What happens to a dollar

What happens to a dollar of bank money during its lifetime? It works just like real money (because it is money). Maybe it was your boss who took out the bank loan, to meet payroll. So, you get paid this week with "bank money." Maybe cash, maybe payroll check, maybe direct deposit, it's still bank money, created when your boss borrowed it.

Do you feel cheated? I don't see why. Would it be better if the boss gave you a hand-written IOU or a verbal promise to pay you in a week or two? I don't think so.

It doesn't matter that the money you receive may have been created that very day by a bank lending it to somebody. In fact, it has probably happened to you without your even knowing about it.

3. Like the Fed

Across the top of a dollar bill it says "Federal Reserve Note." The dollar is issued by the Federal Reserve. The Federal Reserve is called "the Fed."

Picture the Federal Reserve buying assets from the public. The sellers receive "new" money for the assets they sell. That money stays in the economy until the Fed starts to worry about inflation, and decides to sell some assets and take money out of the economy again.

Picture me borrowing money from the bank. It's new money we create, the bank and I, and when I receive that money and buy something, I'm putting new money into the economy. Exactly like the Fed does.

When I make a payment on that debt, I capture circulating money and take it out of the economy again. Exactly like the Fed does. If I choose to make only the minimum payments, the money I put into the economy stays in circulation for a long time. Only when I take a dollar and use it for debt repayment -- only then -- does my money come out of the economy. Just like at the Fed.

We are, each of us, a little version of the Federal Reserve.