There is one thing...

Reading Credit, Financial Conditions, and Monetary Policy Transmission, the "preview" PDF from the AEA...

It's really good:

[We] study the influence of private nonfinancial credit in the dynamic relationship between financial conditions and monetary policy and macroeconomic performance in the U.S. from 1975 to 2014. Specifically, we examine the role of private nonfinancial credit in conditioning the response of the U.S. economy to impulses to financial conditions and monetary policy.

They want to see if high debt creates problems. Nothing is more important at this stage of the game. Nothing.

We use a broad measure of credit to households and nonfinancial businesses provided by banks, other lenders, and market investors. We follow conventional practice to measure high credit by when the credit gap (credit-to-GDP ratio minus its estimated long-run trend) is above zero...

That's what we looked at yesterday, how they figure the credit gap. I'm okay with it now. Sort of.

In addition to credit growth and the credit gap, they use a "financial conditions index":

Financial conditions indexes are summary measures of the ease with which borrowers can access credit.

A brief description:

To incorporate financial conditions, we construct a financial conditions index (FCI) combining information from asset prices and non-price terms, such as lending standards, for business and household credit, following Aikman et al (2017). In studies of monetary policy transmission, FCIs represent the ease of credit access, which will affect economic behavior and thus the future state of the economy.

Also:

Periods when the FCI is low (indicating financial conditions are tighter than average) are associated with worse overall economic performance: the unemployment rate is higher and rising, and real GDP growth is significantly lower...

And:

a positive impulse to financial conditions stimulates economic activity, but also leads over time to a build-up in credit and, ultimately, subpar growth.

You get the picture. So what did they learn from their study?

We find the following results. First, credit is an important channel by which impulses to financial conditions affect the real economy. We find that positive shocks to financial conditions are expansionary and lead to increases in real GDP, decreases in unemployment, and increases in the credit-to-GDP gap...

They find that policy works. But not always:

However, when the credit-to-GDP gap is high, initial expansionary effects dissipate but lead to further increases in credit, which, in turn, lead to a deterioration in performance in later quarters... When credit growth is sustained and the credit gap builds following looser financial conditions, the economy becomes more prone to a recession...

In a high credit environment, instead of getting more economic growth you get more credit growth and more recession. But it is not only pro-growth policy that is undermined by high levels of debt; restraint is undermined as well:

When the credit gap is low, impulses to monetary policy lead, as expected, to an increase in unemployment, a contraction in GDP, and a decline in credit. However, when the credit gap is high, a tightening in monetary policy does not lead to tighter financial conditions, as expected, and has no effect on output, unemployment, and credit...

In other words, a high level of debt makes policy less effective.

We test whether the transmission of monetary policy to forward Treasury rates differs significantly between high and low credit gap periods, and find there is less impact in high credit-gap states...

In other words, a high level of debt makes monetary policy less effective.

In addition, we evaluate whether the nonlinearities in economic performance may reflect factors other than credit, such as whether financial conditions are tight or loose, but find that the nonlinear effects are related to loose financial conditions only when credit is high, reinforcing our findings that credit has an independent role in explaining performance.

These findings are simply astonishing! Remember, it's not just some clown in the corner making graphs for his blog who is coming up with these things. It is people from the Bank of England and the Federal Reserve: central bank economists, saying things I would be happy to say. Things I am happy to repeat.

But then, they also say:

These empirical results can be useful for structural models that could link credit to financial conditions or monetary policy, and allow for nonlinear effects of shocks to economic performance based on credit.

Useful for making models? I was hoping for so much more: They want to see if high debt creates problems. Nothing is more important...

They point out that their result, their

empirical result ... supports the literature on the role of credit ... starting with Bernanke and Gertler (1989).

Since 1989. This is 2018. It's 29, almost 30 years they've known that a high level of debt (or credit, as the bankers call it) creates problems for the economy. Isn't it time to use these findings for something other than making models? How long do we have to wait for that to happen?

And there is one thing that I cannot get past. The last sentence in the last paragraph:

Taken together, our results suggest that theory and policy should address the role of credit in the transmission of monetary policy and financial conditions. In particular, economic dynamics of particular relevance to policymakers appear significantly different when credit-to-GDP has grown significantly faster than average for some time. This dynamic bears on the costs and benefits of using monetary policy to lean against the wind and prevent the buildup of credit (Svensson (2016), Gourio, Kashyap, and Sim (2016)). Moreover, it points to the benefit from additional research evaluating the potential for macroprudential policies to reduce the vulnerabilities associated with excess credit.

It's all good, right up to that last sentence, where the cat escapes the bag. They think it would be good to come up with "policies to reduce the vulnerabilities associated with excess credit."

Not policies to prevent credit from rising to the level of "excess credit". No no. Policies to reduce the vulnerabilities, so that we can have excess credit and not be so exposed to the troubles that it creates. They want to be able to expand credit further.

Dammit. They still think like bankers.

Are you high?

Sometimes it is important to distinguish between the trend and the "trend" of data.

Yesterday's post looked at the trend of debt relative to GDP. Looked at how to look at the trend. If the debt-to-GDP ratio is pushed up by a bubble, I'm not comfortable with the idea that the trend goes up. I think the trend is where it would have been without the bubble, and the bubble is an anomaly.

Likewise, if the debt-to-GDP ratio is pushed down by unacceptably high inflation, I'm not comfortable saying that the trend goes down. The trend is where it would have been without the inflation, and the inflation is an anomaly.

Of course, these thoughts depend on a "where it would have been" version of the trend, which is as fanciful a measure as Potential GDP or the natural rate of unemployment.

But I'm not comfortable with the idea of taking "debt in a normal economy", adding in "debt from bubbles", figuring something like a moving average of the two, and calling that average the trend. It's just not right. The trend is the trend, and the bubble is the bubble. You don't average them together and call that the trend.

Still, there may sometimes be reasons to ignore the "where it would have been" line.


I've been reading Credit, Financial Conditions, and Monetary Policy Transmission (the "preview" PDF, 39 pages, from the AEA) by David Aikman of the Bank of England, and Andreas Lehnert, Nellie Liang, and Michelle Modugno of the Federal Reserve Board. It is strikingly good.

I interrupted my reading of the AEA PDF to write yesterday's post when I saw how they decide whether the credit-to-GDP ratio is high or low. They figure the trend (bubbles and all) and compare the ratio to the trend.

They use a "slow-moving" trend, meaning it varies more slowly than the ratio itself. Much more slowly: They use a "smoothing factor" of 400,000 when the standard value is only 1600. So their trend line is nearly straight:

Graph #1: Private Non-Financial Credit relative to GDP, with Trend
This graph is from the "PowerPoint" download at the AEA page.

The graph shows their trend line in red. Above-trend is "high". Below-trend is "low". Their methodology allows them to describe debt as "high" or "low" even in a high-debt environment. This allows them to say, for example, that debt was low in 1997 and low again in 2012.

If you happen think debt went high around 1980, then you see everything after 1985 on the graph as high. You may not be comfortable saying that debt in 2012 was "low".

You are not alone. In the PDF they note that

Even after falling significantly from its peak in 2009, the level remains elevated relative to previous decades.

In other words, debt is high. Their statement is a strong objection to the methodology that they use. I like the honesty. I take their statement as evidence that the authors of the PDF are not completely comfortable saying that debt was low in 2012. This is big. To me it means they are on the right track: They agree with me!

They do justify the methodology by saying everybody does it that way:

We follow the literature in defining the credit-to-GDP gap as the difference between the ratio of nonfinancial private sector debt to nominal GDP and an estimate of its trend...

That doesn't make it right, of course. But wait for it: They do make it right.


Why do I object so strongly to their trend calculation? Because comparing the debt ratio to a rising trend makes the ratio seem lower than it really is.

They understate the level of debt by circular logic: They figure how high debt is by comparing it to the trend when, all the while, high debt has been driving the trend up! It's madness.

But it turns out there is method in their madness. They say:

A concern with using measures based on credit-to-GDP is the upward trend in the ratio. As an empirical matter, this is dealt with by focusing on the gap with respect to an estimate of the trend designed to be slow moving.

They worry that critics might question the validity of their work because of the upward trend of the ratio. In order to circumvent that criticism, they measure how high the debt-to-GDP ratio is by comparing it to its trend. If the ratio is above the trend, they call it high. This way, when they say debt is high, no one can contradict them.

Okay. For me, their methodology weakens their argument. But if it strengthens their argument in the eyes of someone who doesn't see debt as a problem, it's worth it.

Good job, guys. But don't forget: After you convince the critics that you're onto something, you'll have to open their minds further and get them to move away from comparing debt to trend to determine whether debt is high.

Just tell 'em their logic is circular.

Seeing past the aberrations in Debt-to-GDP

Total debt, relative to GDP:

Graph #1: Total Debt relative to GDP

I've seen a lot of people point out the low, flat area between 1965 and 1984. Debt was low then, they say, and the economy was good.

Maybe. But the low, flat part is low and flat because of the inflation of that era. People seem to think debt stopped growing for a while. In fact, we were adding to debt more rapidly during the flat years than before. From 1952 thru 1964 the average annual debt growth was 6.6%. From 1965 thru 1980, it was 9.9%. Debt growth was 50% more during the flat. It looks flat because inflation made NGDP increase as fast as debt.

It wasn't magic that kept debt low in those years. It was the raging inflation. Inflation changed the path of the debt-to-GDP ratio and created the low spot.

Inflation was an aberration. The low debt ratio was a result of it.

If you look at it the way I do, you can almost see the path that debt-to-GDP would have taken if we never had that crazy inflation. You could draw a straight line connecting 1960 to the late 1980s, bypass the low spot, and see what the path of debt might have looked like without that inflation.

Something like this:

Graph #2: As Above (but Annual Data) with a Trend Line Added

The years from 1987 thru 1997 occur shortly after the Great Inflation. They look on-trend to me. I show them in red. I had Excel create a straight-line trend based on that period.

In the early years, before the Great Inflation, the trend line (black) is a perfect fit for the years from 1956 to 1960. And it's a very good fit from 1952 to 1963. Those early years show the same trend as the years shown in red after the Great Inflation. The blue line, low and flat during the inflation, is an aberration.

I didn't have to try a dozen times to make the graph show what it shows. I looked at the years between the Great Inflation and the Great Recession, and picked dates where the blue line appeared to be on-trend rather than returning to or departing from it. Then I put a linear trend line on those years, and it came out just as you see above.


I did fiddle with it some, after that. I changed the trend line to exponential. Then I added a few years to the end of the red zone and watched the trend line change as I added them. I was exploring. This is what I found:

Graph #3: As Above (Annual Data) with an Exponential Trend

The trend line fits the red zone just about as well as it did before. It fits the years 1952-1963 even better than it did before. And, at the end of the graph, in 2016, the blue line meets the trend line! The two lines appear to show that debt-to-GDP has returned to trend after a decade-long recovery from the tech and housing bubbles.

Perhaps you can imagine the graph ten years out, with the exponential curve continuing and the debt-to-GDP data clinging to it. It could make you think debt finally got back to normal in 2016. And that could make the next ten years very good indeed.

Come to think of it, this is my "vigor" story again, from a different perspective.

Where we stand

The FRED Blog has a post dated 11 January which shows this graph:

The Green Line (quarterly data) ends at Q3 2017. The others appear to show Q4 preliminary

It's a mess. The lines are all over the place. However, since the start of 2017, the lines converge toward a 3% growth rate, then move upward together. It's a little early to draw conclusions of vigor from this graph, sure. But remember, in March it will be two years that I have been predicting vigor to begin in 2018.

"We are at the bottom now, ready to go up", I said in March of 2016. "The first quarter of 2016, where we are right now [is the bottom]".

The next month I said: "I predict a boom of 'golden age' vigor, beginning in 2016 and lasting eight to ten years. It has already begun. In two years everyone will be predicting it."

And in August of that year I wrote: "what I'm looking at amounts to vigor starting about a year into the first term of the next U.S. President."

Why? Because Debt-per-Dollar -- private debt, per dollar of M1 money -- was at bottom in 2016 Q1 and ready to rise. Debt-per-Dollar is an indicator of financial cost for the economy as a whole.

And because, with Debt Service reaching a low, financial cost was low, creating favorable conditions for wages and profit in the non-financial sector.

I don't bring this up to brag that my prediction is right. (I don't even know yet if my prediction is right.) I bring it up because if we do soon experience the economic vigor that I expect, it means the data I'm looking at may be more important than most people realize.

Or maybe it was just dumb luck on my part, and Donald Trump deserves all the credit for improving the economy.

//

See also Where we stand dated 26 August 2017. And my Vigor Page.

//

Edward Harrison, 15 Jan 2018:

For the first time in several years, we are seeing economic growth everywhere in the global economy. No one is talking about recession. It’s just the opposite; people are raising economic forecasts and worried about overheating.

"In two years," I said two years ago, "everyone will be predicting it."

Shiller: What drives these decade-long swings in confidence?

Consumer Confidence Is Lifting the Economy. But for How Much Longer? by Robert J. Shiller Jan. 26, 2018

Amid the constant turmoil in domestic and global politics these days, the economy’s steady expansion has been a source of comfort. But look more closely and you will find that economic growth rests on a surprisingly amorphous base: consumer confidence.
...
We know that consumer confidence is a critically important advance indicator of economic booms and busts. At the moment, it is forecasting a continuing expansion. Yet the troubling fact is that we don’t fully understand how and why consumer confidence acts as it does.
...
The simplest explanation is the necessarily slow but consistent recovery from the crushing financial crisis of 2008 and 2009.
...
There is some truth to that explanation, but it is insufficient. It omits a critical yet elusive factor: animal spirits.
...
That kind of exuberance now seems to be fueling the stock market, where prices have outstripped fundamental valuations.
...
Such surges have happened before. The four major confidence indexes took a long ride up between 1990 and 2000...
...
The critical question, then: What drives these decade-long swings in confidence, including the upsurge that is still underway?

Take the current confidence cycle. While Donald J. Trump’s presidency may have exerted some impact on animal spirits in the last year, it doesn’t explain the preceding eight years of slowly improving confidence. And I am skeptical that the upward swing can be entirely explained by standard factors like government and central bank stabilization policy or technological innovation.

 
When consumer confidence is falling, people cut back their spending, try to save more, and pay down debt. Debt service costs soon start to fall, and fall for some time.

After a time, the reduced debt burden allows consumer confidence to begin rising again. With increased consumer confidence, spending increases and borrowing increases, perhaps tentatively at first.

The increased borrowing then translates into rising debt service; and rising confidence is able to support it for a while. But eventually the rising burden of debt causes consumer confidence again to fall.

This pattern of behavior fits pretty well with what Shiller says above. It is also clearly visible on the graph below, including the decade of the 1990s and the eight years before President Trump:

Graph #1: Consumer Confidence (blue) and Household Debt Service (red)

Shiller says we don’t fully understand how and why consumer confidence acts as it does.

It's the bills, I say. When the bills start to pile up, consumers lose confidence.

An interesting footnote on the Federal debt

From page 15 of The Economic Expansion of the 1990s (at Google Books):

The ratio of the interest-bearing national debt to GDP is frequently used by economists as a measure of the burden of a national debt to a nation's economy.

That sentence is footnoted. Here is the interesting part of the note:

The non-interest bearing debt of the United States consists of currency and coin in circulation.

I never think of coin and currency as a form of government debt. I'm not sure it's right.

On raising interest rates

One of the arguments for raising interest rates is that we need rates high enough that they can be cut when the next recession comes.

It seems to me anyone who makes that argument ought to admit in the same breath that it's raising interest rates that brings on recession. I don't know what to do about that, other than dismiss both the argument and the admission.

But I do know that the argument has been made. So suppose we take it at face value and say: Okay, how high do we want the interest rate to be? (Talking about the policy rate here, the Federal Funds rate.)

How high do we want the Federal Funds rate to be? I don't know the answer. But here's another question:

How high can rates go before they create another recession?

I don't know the answer to that one, either. But I know how high rates have been in the past. And I know that the trend of rates has been downhill since 1981.

And I'm pretty sure that the policy rate going up during 2004, 05, and 06 is what created the crisis of 07 and the recession of 08. Almost like the good old days (the 1970s) when the Federal Reserve created recession after recession on purpose to bring inflation down. And I'm pretty sure also that the policy rate going up, not in 1994 and 1995, but in 1999 and 2000 is what created the recession of 2001.

So when I make my interest rate trend line, I will omit data points for the peaks before the 2001 recession and the 2008 recession. Because I don't want to show what we have to do to create another recession. I want to show what we have to do to NOT create another recession.

Here's the graph:

Graph #1: The Federal Funds Rate and its High-Side Trend since the Peak

Looks like the Fed can safely raise interest rates to about 2%.

//

Update, 7 Oct 2020, the Federal Funds Rate thru September 2020. The rate went up to 2.4%, paused briefly, and started coming down. (2.4% was evidently a bit too high.) Then the pandemic hit, and the rate dropped to the floor:

 

The "Forgotten Crash" (1966)

Syll shows this graph

and asks: "Time for another crash?"

Philip George replies: "Probably not yet", which makes me feel better. Why? Because the Q of M, Philip says. That makes me feel even better, as I'm also a Q of M guy.

On my second glance at the graph I noticed, right in the middle: Forgotten Crash (1966).


In a little red book called Stabilizing America's Economy, edited by George A. Nikolaieff, there is an article taken from the Atlantic Monthly of July 1971: "Nixonomics: How the Game Plan Went Wrong" by Rowland Evans Jr. and Robert D. Novak. I'll quote a sentence from it. You'll notice the confidence with which Evans and Novak assert Friedmanesque monetarism. Don't focus on that.

Having choked off the money supply as an anti-inflation device in 1966 so tightly that it produced a serious slump in housing and construction (called by some a mini-recession), the central bank started pouring out money too quickly and too generously in 1967 and thereby spoon-fed a new inflation.

I first read that sentence probably in the late 1970s. That was the first and only time I heard of a mini-recession or near-recession in 1966-67. The only time, until I came upon An Appraisal of Federal Fiscal Policies: 1961-1967 (first published in 1968) by Raymond J. Saulnier, who mentioned in passing a "near-recession in 1966-1967."

Syll's graph is only the third time I've seen that near-recession documented -- and the graph doesn't actually even mention recession. If you go looking, you can find Leonard Silk in 1974 saying

The Johnson Administration got away with only a minirecession, not formally classified as a recession, in 1966–67.

So the information is available. If you know what to look for, you can find it.

The forgotten slump appears on graphs all the time. It is significant: It was the Fed's attempt to crush the Great Inflation in its opening moments. Still, if you don't know about it, chances are you'll look at an awful lot of graphs before you notice that the low is always in 1966-67, and never explained.

If you know about it, you can find out more. Now you know.

You wanna count what?

Somebody once explained to me that the growth of debt (back then) was probably due to the increase of women in the workforce. When women were not working they couldn't even get credit. When they went to work they could and did borrow, could and did accumulate debt. Thus the increase in debt.

So: More people in the economy, working, and more people in the family, working, and still people had to take on more debt? I did not find "women in the workforce" to be a satisfactory explanation of debt growth.

It should be obvious that if there is debt, somebody must have borrowed it. You can take the "somebody" and give it a penis or not, if that's your thing. But if there is debt, I know that somebody must have borrowed it. For me the important thing is how much debt is out there and how much it costs the economy. Not whether the borrower has a penis.

When Keynes wrote his General Theory, the first of "three perplexities which most impeded [his] progress in writing" was "the choice of the units of quantity appropriate to the problems of the economic system as a whole."

Let me repeat that: The choice of units appropriate to the problem of the economic system as a whole.

After some preliminary thoughts, he said:

In dealing with the theory of employment I propose, therefore, to make use of only two fundamental units of quantity, namely, quantities of money-value and quantities of employment... It is my belief that much unnecessary perplexity can be avoided if we limit ourselves strictly to the two units, money and labour, when we are dealing with the behaviour of the economic system as a whole...

Money and labor. Not genitalia.


You could make the argument that not all genders receive equal pay for equal work, and that not all races have equal unemployment rates. I would accept these arguments as true. But the problem is not solved by making unemployment equal and high. The problem is not solved by making pay equal and low.

It will be easier to solve the economic problems of non-economic subsets of the economy if the problems of the economy as a whole can be solved. If we fail to solve the problem of larger scope, when historians one day look back at us, some will surely think it was "equal pay for equal work" that caused the fall of our civilization