Incompleteness

On Friday I talked a little about the extent that spending is credit-financed. I was excited about that topic, because people most often ignore it.

That's how things become problems, isn't it. By being ignored for too long. So I picked up on that theme and tried to show our reliance on credit increasing over the years since the end of World War II.

Why does it matter? It matters because the greater our reliance on credit, the greater the factor cost of money. And increasing financial costs interfere more and more with the the cost of living and with profits to productive endeavor. So it is not only the rate of interest that matters, but also the number of times the interest rate is applied.

On Saturday I said the extent of credit use must certainly be related to the efficiency of credit use. And I suggested you might want to "think of the entire 1947-2007 period as one gigantic credit bubble".

But I got a little distracted in both posts, talking about credit efficiency and the productivity of debt.

Today I pull from an old one I came across while writing a new one:

I think they miss something...

Browsing the Billy Blog, a title catches my eye: The natural rate of interest is zero! But reading it, as often happens, I am distracted long before I get to Billy's main point.

Billy writes of the "rather insidious notion that mainstream economists continually refer to which is termed the 'neutral rate of interest'". Not being familiar with this technical term -- Oh, I've heard of it, but I don't remember the definition -- it catches my interest. Billy quotes from the Melbourne Age:

It’s generally considered that a cash rate around 5 per cent is now neutral for the Australian economy – that is, it neither stimulates the economy nor holds it back... A cash rate at 3 per cent then is highly stimulatory.

Right away I'm off on a tangent. Let's consider the idea: An interest rate of 5%, say, that neither stimulates nor holds back the economy.

What's missing from the picture? It's obvious to me. Consider two Australias, identical in every way but one. In the first, ten percent of all spending requires the use of credit at that 5% interest rate. In the second Australia, 90% of all spending requires the use of credit, at the same interest rate.

In the one Australia, the reliance on credit is low; in the other it is high.

In the one Australia, the total cost of interest is low, relative to total spending; in the other it is high.

In the one Australia, the total cost of interest is low, relative to wages and profits and rent; in the other it is high.

In the one Australia, the cost of interest does not significantly affect prices; in the other, it does.

In the one Australia, there is no monetary imbalance; in the other, there is.

Five percent may be the "neutral" rate of interest, but the effect on the economy of that or any other interest rate will depend heavily upon the level of the reliance on credit.

 
You can't just look at the level of interest rates. You have to look also at the reliance on credit. If interest rates fall by half but we use twice as much credit, the cost of finance is not any less. And if interest rates go up again, we're screwed.

Anyway I don't understand why people would want to have more debt if instead they could have more money. It's only a matter of policy. Instead of trying to get $40 of debt out of every new dollar of money, why don't we try to get only $20. And then we could have twice as much money in the economy without increasing the threat of inflation. To do this, we need change only policy.

When you put finance people in charge of policy, they cannot see debt as a problem.


But again, my focus here today is incompleteness of argument. Anybody who speaks of interest rates, but fails to consider the reliance on credit, presents an incomplete and largely incorrect argument.

DWB

The idea conveyed by the phrase "the productivity of debt" is false. Debt cannot be productive. Debt is only the record of outstanding loans. It is new credit-use that creates "extra" spending in the economy. It is new credit-use that can have a "productive" effect.

And I prefer to think of the efficiency rather than the "productivity" of the new uses of credit.

So when I saw a discussion of "the extent that spending is credit-financed" (see yesterday's post) I jumped right on that. Because the extent of credit use must certainly be related to the efficiency of credit use.

It's a point that bears investigation. But my intuition says a Laffer Limit applies. On a scale of zero to 100%, as the extent of credit-use increases I expect to see the efficiency of credit increase, peak, and decline. I see the peak as an optimum range, where credit use is most efficient, where it makes the maximum contribution to GDP.

I think too little credit use undermines growth by inhibiting implementation of good ideas, for example, and too much credit use undermines growth by increasing financial costs.

I also think this conflicting duality -- the benefits of additional credit use in combination with the loss to accumulating debt -- is a powerful source of cyclic behavior, generating or helping to generate business cycles, long waves, and maybe even cycles of civilization.

So I was interested in dwb's comment at Tim Duy's Fed Watch, and his related comment at Modeled Behavior.


At Fed Watch, DWB looks at the "gdp/debt" ratio, says "think of debt+equity as capital" and reads the long decline of the ratio to mean "the marginal product of capital has declined over time".

This is a fancy way to say the productivity of debt has fallen.

In the comment at Modeled Behavior, DWB reiterates: "the ratio of GDP/debt really is fundamentally the GDP/capital ratio more or less."

"[G]oing back to the 1950s, there is a consistent increase [in debt/GDP], (or more pertinently, drop in GDP/Debt). there is no correlation to interest rates or money velocity, its not a “credit binge” thing."

It is not a credit binge thing. I thought that was interesting. I take it to mean that our economic troubles today are *not* the result of asset bubbles. Rather, that the asset bubbles are death throes coming at the end of a long, initially golden increase in the accumulation of debt. I agree.

On the other hand, if you want to think of the entire 1947-2007 period as one gigantic credit bubble, that sums it up perfectly.


DWB also says this:

Now, if you think of the “debt” as capital and suppose you need a real rate of return of, say, 4% then 4%*totaldebt/gdp is about 15% of gdp or less. yawn, not really so unsustainable is it?

Yawn??

Put it in context.

Consider one example.

"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.

Private Debt 2012 (14): McConnell, Economics (1975), pp.280-81

Although the size and growth of public debt are looked upon with awe and alarm, private debt has grown much faster. Private and public debt were of about equal size in 1947. But private debt has grown much faster and is now over three times as large -- about $1,350 billion, compared with $470 billion -- as the public debt.

If you insist upon worrying about debt, you will do well to concern yourself with private rather than public indebtedness.

New Feature at the Times

The FDR Years

From Thomas Philippon:

Source: SSRN

And from Philippon's FinEff.pdf:

The sum of all profits and wages paid to financial intermediaries represents the cost of financial intermediation. I measure this cost from 1870 to 2010, as a share of GDP, and find large historical variations. The cost of intermediation grows from 2% to 6% from 1870 to 1930. It shrinks to less than 4% in 1950, grows slowly to 5% in 1980, and then increases rapidly to almost 9% in 2010.

It's hard to date the turning points exactly, and Philippon's own remarks don't help much. Looks to me like finance increased until the Great Depression, and then decreased until maybe the end of World War II.

The start- and end-dates on my Debt-per-Dollar graph are not the same as Philippon's. But the major turning-point dates are a good fit:

Everything goes up, except during the FDR years.

Scarecrow

This woke me up, to write. At Winterspeak:

winterspeak said...

The notion that reserves somehow enable lending is a terrible confusion of how the "monetary base" works, bank lending works, and reserve works.

Ramanan said...

It is true that the bank is attracting deposits and that it may have found itself with a lot of reserves before making the loan. However it doesn't "cause" the bank to make more loans because it doesn't make the borrower more creditworthy.

And at Asymptosis, Tom Hickey:

The argument is about causation. One claim is that reserves cause lending, and deposits lead to reserves, so deposits cause lending... The other claims is that demand causes lending...

Tom's complete comment is particularly good, I think, and useful to me. But that's beside the point just now.

Winterspeak and Ramanan and Tom Hickey all express the same thought: "The argument is about causation," as Tom says. The argument is about whether reserves cause lending.

But this is just the argument MMTeers are having amongst themselves. Nobody outside MMT says that reserves "cause" lending. MMT has adopted this as an argument they can shoot down, but it's nonsense because nobody is making that argument.

Reserves do not cause lending. Reserves limit lending. Whether they work or not is another matter; but the intent of the reserve requirement was from the beginning to give central bankers some control over other bankers in regard to money-creation. The intent was to put limits on the fractional-reserve process.

So Winterspeak's focus on reserves enabling lending, Ramanan's focus on reserves causing loans, Tom Hickey's focus on reserves causing lending, it is all just a red herring. A straw man.

Pretending that finance has no cost

At Heteconomist, links to the Keen / Krugman Dialogue on Minsky.

From Keen and the first post in the exchange, Steve Keen says "Krugman ... reassures his blog readers that there’s nothing to worry about when private debt levels rise or fall", and quotes Krugman as evidence:

People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.

"Does not involve a real transfer of resources."

But if you think of finance as a factor of production (like land, labor, and capital) then it is immediately obvious that an increase in debt is an increase in finance at the expense of the other factors! As Simon Johnson wrote,

It is surely not a good idea for finance to account for 40 percent of total corporate profits ... [S]uch performance, in an intermediate input sector, suggests someone else in the economy is being severely squeezed.

In other words, there *is* a real transfer of resources from the "nonfinancial" sector to the financial sector. And now, in Philippon's work we see an attempt to tally that cost. We see in Philippon the wages and profits accruing to finance -- part of GDP -- counted apart from the wages and profits of the nonfinancial sector.

Certainly, finance's share contributes to Gross Domestic Income and to the cost of production. But the role of finance is facilitation, not production. So the growth of finance offers no guarantee that output will increase along with the cost of output.

When finance grows beyond its Laffer Limit -- when it assumes an excessive share of the nation's profits or wages -- the result can be that costs increase faster than output. In a word: inflation.

In the Arthurian view, excessive finance was the root cause of inflation during the "Great Inflation". Finance has been excessive since the mid-1960s.

Arithmetic is not Economics

If you subtract a big number from a smaller number, the answer is less than zero. If you spend more money than you take in, you have a deficit.

That is the arithmetic of our problem, not the economics of it.

Here's the economics: If you use credit for money, you have a deficit. If our policies restrict the quantity of money and encourage credit use, it will be impossible for us to avoid using credit, impossible to avoid having deficits, and impossible to avoid accumulating debt.

And that is exactly what our policies do. They restrict the quantity of money, and they encourage credit use.