Asking the Wrong Question

This from Private Sector Development [PSD], an "informal" arm of the World Bank:

Credit and growth: Which drives which?

This is a question that is stalking financial policymakers: Does credit growth drive economic growth, or does growth in the real sector drive credit growth? If the latter, then policymakers in emerging markets might do well to repress the financial system - the likelihood of crises will probably be reduced, while growth will not be harmed. But a new paper provides a bit of evidence that points in the opposite direction. From Does Access to External Finance Improve Productivity:

This paper examines the effect of access to finance on productivity. We exploit an exogenous shift in demand for U.S. corn to expose county-level productivity responses in the presence of varying levels of access to finance. The exogenous shift in demand for corn is due to a boom in ethanol production, which is a result of a number of complementary forces (rising crude oil prices, the Energy Policy Act of 2005, and new federal tax incentives). We find that counties in the midwestern United States with the lowest levels of bank deposits have been unable to increase their corn yields as much as other counties. This result demonstrates the positive impact of access to finance on productivity.

Now, if we could just replicate this kind of study in an emerging market to see whether the results hold...

Posted by Ryan Hahn on March 3, 2009


The PSD post turned up when I googled "growth of credit" (no quotes). Also this --

This column presents new research suggesting that a “creditless recovery” is possible, but it would likely be slow and shallow.

-- from Amol Agrawal's Mostly Economics. And this --

We are probably two thirds of the way through the decline of the current crisis, and starting to think about the recovery. Following Reinhart and Rogoff’s methodology, I explore the prospects for credit growth to sustain the recovery. If history is any guide, worldwide credit will not recover anytime soon.

-- from Michael Pomerleano at the Financial Times Economists' Forum.

From the two latter sources we may surmise that without credit, recovery will be slow and shallow; and that credit will not improve for a long while. This is not good news. I don't think it's news at all.

To the matter at hand: Ryan Hahn asks, "Does credit growth drive economic growth, or does growth in the real sector drive credit growth?" Answer: Credit growth never drives economic growth; all it can ever do is facilitate growth. This would be mere semantics were it not that Hahn asked the question.

Perhaps better phrasing of the question would help: Is credit growth necessary for economic growth, or not? This question has already been answered: Without credit, recovery will be slow and shallow. Of course credit is necessary. (Remember, it was the World Bank that asked the original question. So of course the answer is 'of course, credit is necessary'.)

Here's a better question: How can we have the credit we need for growth, without ending up with still more debt and yet another financial crisis?

Tough question? But the answer is so simple! New and old, ladies and gentlemen. New and old.

We need credit for growth. That's new credit, new uses of credit. But when we stop thinking of it as credit-use, and start thinking of it as debt, it is already old.

All we have to do is pay off the old stuff. This reduces debt. It reduces the risk of financial instability. It makes credit available again. It makes banks hungry -- and that's good for growth. Oh, and by the way, paying off the old stuff is a way to fight inflation.

So you're thinking: All well and good. But paying off debt takes money out of the spending stream, depressing demand. Depressing the economy.

Two things. First, the credit is newly available again, and the banks are hungry. Second, we counterbalance our reduced use of credit by an increased used of non-credit money. You know: quantitative easing, QE, which central bankers finally realized was necessary, after the crisis hit.

We correct the imbalance between money and credit-use by decreasing credit-use and increasing the quantity of money in circulation. The factor cost of using money is less thereby, reducing inflation on the cost-push side. And how do we reduce inflation on the demand-pull side? Accelerated repayment of debt.

It's just a matter of asking the right question.

1973, QE, Debt, Wages, Waste, and To Boldly Go

"Interesting article," JBMoore writes. "States that the US has a structural economic crisis." JB provides a link to a post by Izabella Kaminska of the Financial Times. Text within the URL is urgent but confusing. I click... I read:

“The US is not a viable concern anymore” – Duncan

...I bristle at the title. Recently broken, hastily repaired, our economy is extremely fragile right now. It must not be battered carelessly. It could break again.

The post turns out to be a review of the economic ideas of one Richard Duncan, partner at an asset management firm, as expressed in his book The Dollar Crisis.

The careless title is Kaminska's, not Duncan's. In the first paragraph, Kaminska writes:

while he is pretty pessimistic on the US, Duncan says there is a way out if policymakers make bold decisions.

Kaminska is willing to break the US economy if it gets attention for her writing. I decide I don't like her much. Now, as for Duncan, Kaminska writes:

In the Dollar Crisis, published in 2003, Duncan explained how the collapse of the Bretton Woods system in 1973 was always going to lead to a global financial crisis due to the trade imbalances it encouraged....

Simply put, according to Duncan, the breakdown of the gold standard allowed too much paper-money to be created in the US.

In Duncan’s words, the collapse of Bretton Woods represented the moment “capitalism became corrupted by government debt”. From that point on “US policymakers abandoned the core principles of economic orthodoxy: balanced government budgets and sound money”.

So far, so good. But then Duncan's argument -- or possibly Kaminska's reporting -- seems to fall apart. Kaminska quotes Duncan, who fits together recession, massive deficits, and quantitative easing "to prevent economic collapse." Then Duncan says, "This policy response is supporting the global economy but it has not even targeted the structural flaws responsible for the crisis."

The structural flaws responsible for the crisis? As Duncan has it:

wages in the US are up to 40 times higher than those in developing countries like China. Therefore, the United States makes very little that the rest of the world cannot buy somewhere else much more cheaply.

As Kaminska has already explained, the 1973 collapse of Bretton Woods and the consequent excessive creation of paper money allowed government debt to ruin capitalism. Now it turns out the underlying problem is that U.S. workers are overpaid.

Where did that come from?

Duncan is pointing at any problem he sees, calling it the underlying problem. Going off gold allowed us to print too much money. Okay, I get it. But then somehow this money becomes government debt, so we have too much money and too much debt. The magic of too-much-money becoming too-much-government-debt eludes me; but I let that go, because Duncan is focused on monetary problems and that's the right place to focus.

Then, suddenly, the structural flaw responsible for the crisis is pay differential, not Bretton Woods. And when Kaminska presents Duncan's "bold" solution, it only makes matters worse:

And so, like any troubled company, the US too must restructure itself if it is to remain operational, says Duncan. How it goes about it, though, will be crucial to its success. The best policy according to the author would be heavy government investment in so-called ‘future’ industries — everything from solar, biotech, nano-technology and so on. Trouble is, a move like that would take more government spending not less.

Apart from the cotton-candy word restructure, Duncan's plan is to further increase government debt and deficits on the development of new high-tech products, which China can then make for us for a fraction of the cost.

the lesson the US must learn from Japan is not to waste that money building bridges to nowhere, but instead to use the money wisely to restructure the economy to restore its viability.

The key this time for Duncan? Waste not.

If you don't mind, I'll just dismiss most of Duncan's argument outright. Just prune them suckers. Leave the strongest shoot. Duncan's strongest argument is that the collapse of Bretton Woods was the key event in a long process of decline and disaster.

Kaminska provides a fuzzy graph, noting "One chart reflecting the situation well according to the author is this one:"

"In Duncan’s eyes," Kaminska writes, "it clearly shows the breaking of the global financial system’s imbalanced back."

From her comments, I don't think Kaminska sees what Duncan sees in that graph. I sure don't see much in it. It's just another graph showing increase. But let's try to evaluate it.

The key for Duncan is the 1973 Bretton Woods collapse. We can look for a trend-change in his graph somewhere around 1973. But look for yourself: His graph starts at 1980, and shows a gradual uptrend beginning perhaps in 1985. No way this graph shows any connection to the Bretton Woods collapse. And this is Duncan's strongest shoot.

Or maybe Duncan wants us to see the uptrend suddenly die in 2007-2008. Okay, I can see that. And no doubt that death is the result of something. The result of something. But what? The 1973 Bretton Woods collapse? The Chinese wage-rate? The excessive printing of money that somehow becomes excessive debt? Waste?

Perspective is important. For perspective I compare Duncan's views to my own: Duncan wants "bold decisions." I want decisions based on a correct analysis of the problem. And as for analysis: Duncan's is a potpourri of everything handy. My analysis is that economic policy has created a monetary imbalance, resulting in the excessive reliance on credit. And my graphs show something.

There ya go, JB. Waddaya think?

Red Shift

Printing money causes inflation. Everybody knows it. And prices keep going up. So I guess they've been printing too much money. Everybody knows. Everybody but me.

Here is what I know to be true:
The quantity of money reached a peak in 1946 and has been falling since. The volume of debt pyramided on money hit bottom in 1947 and has been rising since.

If they've been printing money, it wasn't enough to cause the inflation we had. If money causes inflation, inflation in our time has been caused by borrowed money.

Money is green. Debt is red. The one graph shows money falling -- less green -- since 1946. The other shows debt rising -- more red -- since 1947. Less green and more red, for six decades. Our money is the wrong color.

What is the real cause of excessive credit use? The cause is economic policy.

It is policy to withdraw spending-money from the economy. It is policy to encourage spending. It is policy to encourage the use of credit. It is policy to encourage the accumulation of debt.

Why do we have all this debt? Because we use all that credit. It is policy.

We use credit for money

I say debt is caused not by excessive spending, but by the use of credit. You think that's just silly. You think excessive spending causes the use of credit.

I agree: Sure it does. Sometimes.

You: All the time.

(I do not point out that if the Prodigal Son wastes his whole inheritance but not a penny more, he has spent excessively without using credit.)

Me: No. Excessive spending is one cause of credit-use. There are other causes.

You: That cannot be. Excessive spending -- spending in excess of income -- always results in the use of credit. There can be no other cause.

(I do not point out that if one saves 75% of one's income, and spends a frugal 30% of income by borrowing 5%, this also results in the use of credit.)

Me: Okay. But what you are telling me is: IF A > B THEN (B-A) < 0. That is a mathematical definition, and it is certainly true. But it is not a cause. The mathematical definition is true always -- even when we do not have a deficit. Why do we have deficits?

You: Well, the reason is corruption... the special interests... greed... liberal thinking... forgetting conservative principles. The reason is whatever causes spending to be more than government brings in.

Me: Oh, you are right about that: The reason is whatever causes spending to be more than government brings in. Yes, indeed. It may be that spending is excessive. Or it may be that spending is not excessive but still greater than 'B', if you know what I mean. We will never solve these budget imbalances until we discover the real cause of excessive credit use, and fix that specific problem.

And what is the real cause of excessive credit use? The cause is economic policy:

  •  It is policy to withdraw spending-money from the economy.

  •  It is policy to encourage spending.

  •  It is policy to encourage the use of credit.

  •  It is policy to encourage the accumulation of debt.


Why do we have all this debt? Because we use all that credit. It's policy.

Announcements

Debt is not caused by excessive spending.

Debt is caused by the use of credit.

Excessive Reliance on Credit

Between 1960 and 2008, government's share of the total annual interest costs in our economy fell from more than 20% to less than 10%. In other words, total interest costs grew more than twice as fast as government interest costs.

Another look: The government share fell from almost 21% to a little more than 7% of total interest costs. In other words, total interest costs grew something less than three times as fast as government interest costs.

People already know that government interest costs are high. And total interest costs in our economy grew between two and three times faster.

That's excessive reliance on credit.

Another Look

Take another look at Wednesday's graph:

The graph shows a general downward trend. Government interest payments as a portion of total interest payments has been trending down since 1960. Also, the government share is quite relatively small: 20% in 1960, falling to 10%, rising to something over 15%, and dropping to 7 or 8% in 2007.

To repeat the obvious: Government interest expense is not "small." But private-sector interest expense is so much larger, and is growing so much faster, that government interest by comparison looks small and is declining.

Now, to the fine points. The graph shows a general decline punctuated by updrafts. Based on the timing, I'd say the updrafts are associated with recessions. The graph shows decline from 1960 to about 1974 where the first updraft begins. Other updrafts begin at or around 1981, 1990, 2001, and 2008.

Yep. Recession dates from the National Bureau of Economic Research

NATIONAL BUREAU OF ECONOMIC RESEARCH

US Business Cycle Expansions and Contractions

Contractions (recessions) start at the peak of a business cycle
and end at the trough.

BUSINESS CYCLE REFERENCE DATES
Peak	Trough
Quarterly dates are in parentheses
April 1960(II) December 1969(IV) November 1973(IV) January 1980 (I) July 1981 (III) July 1990 (III) March 2001 (I) December 2007 (IV)	February 1961 (I) November 1970 (IV) March 1975 (I) July 1980 (III) November 1982 (IV) March 1991 (I) November 2001 (IV)

Source: NBER

Link: NBERNote: Earlier recessions have been omitted from the list.

match up well with updraft dates. It is in times of recession -- times of private-sector decline -- that the government portion shows increase.

So what does this tell us? As long as the economy's growing, it's growing on credit. While it is growing, interest costs in total are growing so fast they make government interest costs look small. While the economy is growing, the use of credit grows faster than our government grows. That's what the graph says.

The Debt Thing

There was a lot of puttering involved in yesterday's post. Much of it was double-checking my data (probably not too interesting) so I hid it as "additional notes" in that post. But this graph must not be hidden.

Federal debt since 1990 is fairly stable at 60% of GDP until 2008, when it shoots up to 100% of GDP. A big change, and sudden.

Remember Perot?

In 1992 Perot wrote:

Today we have a $4-trillion debt. By 2000 we could well have an $8-trillion debt. Today all the income taxes collected from the states west of the Mississippi go to pay the interest on that debt. By 2000 we will have to add to that all the income tax revenues from Ohio, Pennsylvania, Virginia, North Carolina, New York, and six other states just to pay the interest on the $8-trillion.

If you live in one of those states, take a look at the IRS payroll deduction that reduces your next week's take-home pay. Your money is going just to pay interest on this debt, which in 1993 will amount to $214 billion. During the first 152 years of our nation's existence, we spent less than $214 billion to operate the entire government of the United States!

Remember how Perot said government interest costs were gonna go thru the roof? Perot was right. But take a look at this graph:

The graph shows government interest payments as a portion of total interest payments in the U.S.A. It shows interest paid by government (federal, state, and local together) as a portion of total interest paid. It shows government interest going down!

I'm not saying the cost of government interest is small. I'm pointing out that the total interest cost in our economy is so big it makes the government portion look small.

ADDITIONAL NOTES

Interest costs of the federal government as a portion of total (federal, state, and local) government interest costs have been fairly constant at around 80% of total.

Another view of federal interest costs as a portion of federal plus state plus local: The table at left verifies Perot's observation of the $4 trillion federal debt in 1992. But the debt didn't reach $8 trillion in 2000. Didn't even reach $8 trillion by 2005. But we are beyond it now.

Federal Debt and the GDP  Year  U.S. GDP Federal Debt 1990 5803.1 3233.31 1991 5995.9 3665.30 1992 6337.7 4064.62 1993 6667.4 4411.49 1994 7085.2 4692.75 1995 7397.7 4973.98 1996 7816.9 5224.81 1997 8304.3 5413.15 1998 8679.66 5526.19 1999 9353.5 5656.27 2000 9951.5 5674.18 2001 10286.2 5807.46 2002 10642.3 6228.24 2003 10886.2 6783.23 2004 11867.8 7379.05 2005 12339 7932.71 2006 13398.9 8506.97 2007 14077.6 9007.65 2008 14441.4 9986.08 2009 14237.2 11875.90 2010 14623.9 13786.60 2011 15299 15144.00 2012 16203.3 16335.70 2013 17182.2 17453.50 2014 18192.6 18532.30

This graph shows the federal debt in red, and for comparison the GDP (in blue). It's not really a long-term graph, but since 1990 the two lines run parallel -- until the Paulson crisis of 2008, and the Obama response.

It is worth noting that the last few years of this chart are projections. Predictions. Not realities. Not yet.

It also may be of interest to some, that the federal debt is expected to reach the level of GDP and climb above it in the year 2012. (Maybe that's what the Mayans were worried about.)