Key Points: The "Debt Productivity" Problem

From mine of 30 June and 2 July:

Second, it is not the failure of debt to increase that hinders growth. It is the success of debt. The excessive cost of excessive debt is the problem. Salmon himself reports that the ratio of debt to GDP increased from 1.6 to 1 (in 1970) to 2.8 to 1 (in 2000) to 3.7 to 1 (by mid-2008). All of that happened before the crisis. All the while, Real GDP growth was in decline:

Using credit for growth works well when the accumulation of debt is not large. It works less and less well as the accumulation grows. Ultimately, the accumulation of debt grows so large that the economy can no longer function normally. That's when people start noticing there is a problem.

By that point, of course, we're not just using credit for growth. We're using credit for everything.

Gunnar and Smith

At Gang8, Gunnar writes:

What is the source of profit in a market economy?

The question arises in the following context:
1. Producers pay 1 million for inputs for production.
2. The payment creates employment income of 1 million.
3. Employment income = purchasing power of 1 million.
4. How can sale proceeds of output sold exceed 1 million?

This is more than just a theoretical question on the origin of profit: In the context the same applies to INTEREST on loan capital used in production. By which is meant interest in excess of administrative costs of credit institutions.

In the foundational text of mainstream economics, Paul Samuelson finessed the question:
“It is quite clear that in the real world net revenue [les: profit] is not zero for all firms, nor is it tending towards zero. […] It is clear that this residuum must be “due” to [here comes a sophism that has made a mess of mainstream economics for half a century] something, and it may be labeled by any name we please…” Foundations, p. 87.

At the outset of my work on a Ph.D. thesis at Harvard Economics Department in my younger days, I was curious to ascertain what that “something” might be?

I discovered the answer – but it did not sit well with the Department Head, but that is another story.

The answer is so crystal clear that it takes that special blinkered vision which is the hallmark of economists of the Samuelson school not to see it:

Something which in the nature of things cannot originate in employment income (EI) must originate outside the production sector.

The question concerns purchasing power in excess of employment income and there is but one answer: Purchasing power in excess of employment income (= Profit and interest on loan production capital) must originate as newly created purchasing power within the financial system.

I formatted it a bit, and dropped Gunnar's intro about the Icelandic university student who asked a good question, but I don't think I missed anything relevant in Gunnar's answer. I wanted to shorten it more!

Here's the thing: Gunnar sees producers' profit as outside and apart from the component parts of the price of commodities. Adam Smith saw producers' profit as inside and part of the component parts of price.

If you define producers' profit as outside and apart, then the million that Gunnar's producers pay for inputs for production does not include what they pay themselves. If you define it as inside and part of, then the million does include what producers pay themselves.

So first you decide the answer you want to get, and then you define producers' profit accordingly.

Unfortunately, no matter which way you define it, producers profit *IS* a component part of the price we pay for commodities. So you might as well just define it Adam Smith's way and be done with it.

Gunnar, this means you.


Further reading -- Book I, Chapter VI: "Of the Component Parts of the Price of Commodities" from The Wealth of Nations:

 • At the Library of Economics and Liberty (nice, with numbered paragraphs!)
 • At Bartleby's (3½-page printout)
 • My 1½-page extract

You were saying about a bubble?

If you look at the path of RGDP since 1983 it is easy to imagine a straight-line trend for the last 30 years, with a "bubble" arising in the late 1990s and popping in 2008:

Graph #1: Inflation-Adjusted ("Real") GDP for the last 30 years

It's a good story that makes us feel better about that sharp drop there in 2008. Like it's not really a sharp drop, just a return to normal.

We used to talk about the trend since 2009 as "the new normal". Now it's just "normal".


I don't mean to rain on your parade, but Graph #1 is not a log graph. It's just a normal graph. A straight-line trend on a normal graph shows declining growth. Even if the blue line on Graph #1 was perfectly straight, it would show declining growth. You need a log graph. A straight-line on a log graph shows steady growth. Like this:

Graph #2: The Same Inflation-Adjusted GDP on a Log Scale

Looks like RGDP grew at about the rate shown by the red line from 1983 to 2000, but declined after the 2001 recession, declined even more in the 2008 recession, and has not recovered.

There's no bubble to be seen on Graph #2. And Graph #2 is the better look at growth.

So what this means is, the bubble story is bull. There was no bubble. And people are telling bubble stories to make themselves feel better because we cannot get growth back up to where it was between 1983 and 2000. Capiche?

Now, get out the big umbrella, because the rain is getting worse. We're only looking at RGDP since 1983. We ought to be looking at it since the 1950s and '60s, when the economy was good. That's what Jude Wanniski said, the economy was good in the 1950s and '60s.

Actually, what he said was "you have to have lived in the 1950s and 1960s to have experienced a good economy."

The trend line for growth in the 1950s and '60s would be higher than the red line on Graph #2, and going up faster. I don't have that on a log graph. But I have it on a normal graph, where a constant rate of growth looks like an upward-curving line. From mine of 28 November 2012:

Graph #3: Inflation-Adjusted GDP and Long Term Growth Trends

The red trend line is the actual RGDP trend, before 1980. The green trend line is the actual RGDP trend since 1980 (and before the financial crisis). RGDP (blue) hugs the trend lines.

Now, you were saying something about a bubble?

300 Years of Financial Crises

At Liberty Street Economics, James Narron and David Skeie of the New York Fed begin a series of posts with Crisis Chronicles: 300 Years of Financial Crises (1620–1920). In the first post they describe the Kipper und Wipperzeit (1619–23). Here's the setting for that crisis:

The period preceding and including the early 1600s was marked by a fundamental shift from feudalism to capitalism, from medieval to modern times, and from an economy driven by self-sufficiency to one driven by markets and money. It is within this social and economic context that various states in the Holy Roman Empire attempted to finance the Thirty Years’ War by creating new mints and debasing subsidiary coins, leaving large-denomination gold and silver coins substantially unaffected.

...debasing subsidiary coins, leaving large-denomination gold and silver coins substantially unaffected.

When last we visited Liberty Street Economics it was to consider the two economies in ancient Rome: Run-of-the-mill banking was regulated; aristocratic finance was not.

Centuries later, in the "Kipper" crisis, again we see two economies. This time, it's the run-of-the-mill coin that is being debased; the aristocratic, large-denomination coin is not.

The run-of-the-mill coin, by the way, is "medium of exchange". The aristocratic coin is "medium of account".

I'm tempted to say again, "Some things never change." But that's not quite right. Things do change. But things recur. The division of the economy into two economies comes and goes; it recurs. It is a limiting point, or an indication that a limiting point is near.

Toynbee wrote of "challenge and response". The recurring division into two economies is a challenge in the Toynbee sense of the word. The response determines whether the society survives and again prospers, or whether society dies by suicide.

Writing tips and banking crises

John Cochrane captures a great idea in the title of his post, Stopping Bank Crises Before They Start. It is not clear to me that he captures the same idea in the post itself.

On his sidebar, Cochrane links to Writing Tips for Ph.D. Students (PDF) where he says

A good joke or a mystery novel has a long windup to the final punchline. Don’t write papers like that — put the punchline right up front and then slowly explain the joke.

I suppose that's what he did in this Stopping Bank Crises post -- put the punchline up front where someone like me won't get it:

At its core, the recent financial crisis was a run. The run was concentrated in the "shadow banking system" of overnight repurchase agreements, asset-backed securities, broker-dealers and investment banks, but it was a classic run nonetheless.

But I'm not convinced. Oh, I'm interested, interested enough to chase down a few stray thoughts by way of my own "long windup" here. But I'm not at all convinced that the financial crisis was a run.

Google

Oh -- maybe it became a run, but that's not the same thing.

Wikipedia

Wikipedia

Wikipedia

Accompanying Wikipedia's Geithner note is the following graph:

Securitization markets were impaired during the crisis.

Okay, so it was a run. I see it now. I'm convinced. The peak was in 2006. The draw-down after 2006 on the graph is the run.

Now... Cochrane again:

At its core, the recent financial crisis was a run...

The run made the crisis...

This is a vital and liberating insight: To stop future crises, the financial system needs to be reformed so that it is not prone to runs.

Well... if the "run" is the big drop since 2006 on the graph... then I don't think that's the part we should stop. I think we should stop the run-up that we see from 2000 to 2006 on the same graph. If we never had that run-up, we couldn't have had the run.

But I don't know if that's what Cochrane is saying, or not.

Big Numbers

Cochrane writes:

By the time they failed in 2008, Lehman Brothers and Bear Stearns were funding portfolios of mortgage-backed securities with overnight debt leveraged 30 to 1. For each $1 of equity capital, the banks borrowed $30. Then, every single day, they had to borrow 30 new dollars to pay off the previous day's loans.

Yeah. If Lehman was funding portfolios leveraged at 4 or 5 to 1, Lehman would still be in business today. The excessive buildup is the problem. Like I said about the graph.

I think I agree with John Cochrane on this... I agree with what I think he's saying.

Salute the flag today

Salute your country today. And have a great weekend.

Creating malaise

Graph #1: Real GDP Growth Rate, and Trend Lines

Look at the range of dates often called the Great Inflation -- from the mid-1960s to the early 1980s. The red trend-line is low then, a flatland between 5% hills and 4% hills.

Growth in those years is often said to have been disappointing:

  • Chris Kissell:

In the 1970s, the American economy faced the dual problems of high unemployment and high inflation. The origins of this problem began in the late 1960s, and the economy was adversely impacted through the early 1980s. Overall, the American economy experienced malaise for almost 15 years.

  • U.S. History.org:

Nothing fuels a strong case of malaise like a sputtering economy.

  • Wikipedia:

The 1970s were perhaps the worst decade of most industrialized countries' economic performance since the Great Depression. Although there was no severe economic depression as witnessed in the 1930s, economic growth rates were considerably lower than previous decades.

"Economic growth rates were considerably lower" in the 1970s. You can see it on the graph, between the mid-1960s peak and the mid-1980s peak. But what else do you see?

I see the Federal Reserve fighting inflation by slowing growth, creating troughs in 1967 and 1970 and 1975 and 1980 and 1982. Those troughs did a remarkable job of creating "malaise" and making growth look bad.

The Last Catfish

On Sunday I wrote

Salmon's view is that for GDP to keep growing on the path established by Potential GDP, total debt has to keep rising like [it] was rising before the Great Recession. But that is only true if we insist on using credit for growth -- or, really, for everything. And that is a plan which cannot succeed.

We need a better plan.

Sometimes we start out using credit for growth, and end up using credit for everything. That's what happened between 1947 and 2007.

Using credit for everything costs too much. That's how we got in trouble.

All told, before the Great Recession we had about $3.50 of debt for every dollar's worth of GDP. In a good year we might get 5% GDP growth, five cents on the dollar. So we had $3.50 of debt for every 5 cents of economic growth.

$3.50 credit-in-use for every 5 cents of growth. Obviously we were not using credit only for growth. We were using credit for everything. That's how we got in trouble.


Using credit for growth works well when the accumulation of debt is not large. It works less and less well as the accumulation grows. Ultimately, the accumulation of debt grows so large that the economy can no longer function normally. That's when people start noticing there is a problem.

By that point, of course, we're not just using credit for growth. We're using credit for everything.

All we need is to pay off debt a little faster -- a little faster than we have in the past. This is accelerated repayment of debt, and it will reduce total debt, reduce the cost of that debt, and reduce the economy's inflationary urge besides.

The money created by taking on debt is destroyed when debt is repaid. Repayment of debt is deflationary. We could use it to fight inflation, if we need to. That's what we should have done in the 1970s.

If people are paying down debt faster, we might be creating a deflationary trend. We would want to adjust for that possibility, to keep prices stable. This is where the Fed comes in. The Fed can monetize some government debt, to put money enough into circulation to keep prices stable.

When the economy grows, we need more money. Not more credit. So we use credit for growth, and the economy grows, and we pay down our debt, and the Federal Reserve increases the quantity of money to compensate. That way, we don't have to use credit for everything.

It's not complicated. The confusion arises because people think printing money causes inflation. People think the Fed causes inflation. But private credit use is the culprit.

So here is the plan: We use credit for growth, just as always, but then we pay off our debt a little faster, and the Fed compensates for that by monetizing enough to keep the quantity of money growing in proportion to the economy.

The next year, the economy is N% bigger, the quantity of circulating money is N% bigger, and total debt is N% bigger or less.

In our case the debt number must be less, until balance is restored to our money.


So the plan is to use credit for growth, and then stop using that credit by paying off the debt. This will keep private debt small -- something we all seem to want for ourselves -- and it will keep private credit creation from interfering with Federal Reserve policy decisions regarding the appropriate quantity of money. The Fed will be better able to control inflation.

The use of credit does us a great service: It allows the real economy to expand. But once the economy has grown, the credit that drove it does us no good. It remains only as the cost of accumulating debt. The plan is to limit that accumulation so it does no harm.

To do it, we must pay down private debt. But paying down debt puts downward pressure on prices. So the Fed must step in to keep prices stable.

Later, when we've worked down the accumulation of debt to a low level, we might even think about restoring the value of the dollar by allowing some of that deflation to occur.


Accelerated repayment of debt is the key. But it won't happen by itself. We need incentives to make it happen. Tax incentives.

Right now we have the tax deduction for mortgage interest paid. People think of it as something that helps us afford to buy a home. And it is. But it also encourages the accumulation of debt.

Congress apparently keeps getting closer to eliminating the tax deduction for mortgage interest. They should have done that in the 1960s when the economy was still good. But no, they want to do it now, after the financial crisis, when the world has fallen apart.

It's bound to happen sooner or later. And we should give it up, you know, because it contributes to the accumulation of debt. But we shouldn't give it up easily. We should demand something in exchange.

We should expect Congress to replace the tax deduction for interest paid, replace it with a tax credit to help us make extra payments on our debts. We could get exactly the same dollar-value of benefit that we get from the mortgage interest tax deduction, or more. But the effect of the new policy would be to help us pay down our debt, instead of helping us accumulate more.

Catfish: "in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt."

As a follow-up to yesterday's post, I want to look at Felix Salmon's evaluation of debt and GDP growth:

From 1970 through the beginning of the crisis in 2008, GDP grew at a pretty steady pace. But the amount of debt required to generate that output just got bigger and bigger — the rate of growth of the credit market was much faster than the rate of growth of GDP. In 1970, GDP was $1 trillion while the credit market was $1.6 trillion: a ratio of 1.6 to 1. By 2000, when GDP reached $10 trillion, the credit market had grown to $28.1 trillion: a ratio of 2.8 to 1. And by mid-2008, when GDP was $14.4 trillion, the credit market was $53.6 trillion. That’s a ratio of 3.7 to 1.

In other words, in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt.

Yeah I know. But in fact, we did not "keep up a steady rate of GDP growth". Growth varied:

Graph #1: The Growth Rate of Real GDP

Annual growth rates were all over the place, as the blue line shows. The H-P trend is by no means steady, as the red line shows. And the straight-line ("linear") best-fit for the red line (black) starts out at over 4% annual growth and ends up at 2%. A steady rate of GDP growth? I don't think so.

We must look more carefully at debt growth and GDP growth -- separately, so as not to mistake changes in the one for changes in the other -- and in some detail.

For starters, the next graph shows the rate of growth of total (public and private) debt:

Graph #2: The Growth Rate of Total Debt

In the 1950s and '60s debt growth was relatively slow.

Now look at the red line on Graph #1. The 1950s and '60s show the highest two peaks in the GDP growth trend. It took some debt to get that growth, sure. But it was the best growth. And it was the smallest change in debt, except for debt since the crisis.

Still on Graph #1, look now at the 1980s and '90s. These decades show the two next-highest peaks in the red line, the GDP growth trend. The first of these reaches its high point in the mid-1980s, and the second in the late '90s.

Now on Graph #2 we see that the highest peak of debt growth is a mid-1980s peak. This debt is the debt that drove the red peak of GDP growth of the mid-1980s. Here we have GDP growth that's a percentage point worse than we had in the '50s and '60s. And it took the the largest percentage increase of debt to get that so-so growth.

After the mid-1980s the growth of debt slowed noticeably until about 1992. This respite eased financial costs somewhat, so that after 1992 a moderate growth of debt -- comparable to that of the 1950s and '60s -- was sufficient to drive the GDP growth shown as the red peak of the 1990s on Graph #1. The red peak of the '90s is as good or better than the '80s peak. And it was achieved at a much lower rate of debt growth.

There is lots of interesting stuff going on in these graphs. Felix Salmon offers an oversimplified picture. GDP growth was not "steady", certainly. Nor was there a continuous, regular increase in the ratio of debt to GDP.

Misread the graphs, and you misread the economy.