Through the Looking Glass

I'm so bored I went to Mises for something to read. Found the 2-22-2010 post by Robert Murphy: Two Cheers for Credit Cards. Pretty good writer. Pretty good article. The post does sound like an advertisement for credit cards. (At one point Murphy jokes: "No, American Express is not paying me to promote their card...") But set the sounds-like aside. Bob Murphy presents the following "cheers" for credit cards:

• Convenient Short-Term Loans
• Security
• Sorting
• The Power of the Free Market

"In terms of basic economics," he writes, "a credit transaction makes both parties better off, so long as the deal is voluntary and both sides understand the terms." This is indeed basic economics, though ordinarily the word "credit" is omitted. Still, by a basic assumption of economics, any voluntary, informed transaction makes both parties better off. So voluntary, informed credit transactions do, too.

(It is worth noting, however, that "a credit transaction" is really two transactions. Murphy's "Alice" explains: "The buyer is actually just taking a quick loan from the issuer and then paying cash to the merchant." Taking -- and repaying -- the loan is one transaction; buying the product is another.)

"In retrospect," Murphy says, "many customers of credit-card companies might regret their experience, but often the error was in 'taking things too far' ..." Agreed. We will come back to this.

"Finally, he writes, "the most interesting aspect of the giant credit-card industry is the simple fact that it works."

I guess you could say the giant credit-card industry "worked" while it was growing along with our indebtedness. Most people, since the financial crisis at least, would say that giant indebtedness is the problem. "Taking things too far" is the problem.

Indeed. Murphy himself identifies "responsible use of credit cards" as use where "the balances are paid down in full every month." But he also says "I have been carrying credit-card balances that are far too high" since grad school days. So Robert Murphy is personally aware of the problem.

Taking things too far. The problem is excessive reliance on credit. Our economy is insufficiently productive, and excessively financial. But even people who should know this -- people like Bob Murphy -- somehow fail to grasp the central issue. Stating his purpose in writing the credit-card article, Murphy says: "I want to describe some of the benefits of these seductive tools of a modern financial economy."

A modern financial economy. And that is the problem, isn't it. We want a productive economy, with finance facilitating production. What we have is a financial economy, with production serving finance.

"The responsible use of credit cards, in which the balances are paid down in full every month, can be a good way to build up a credit rating," Murphy says. "Of course, a credit rating is only necessary for people looking to borrow money."

We know that we've "taken things too far" with debt. But we also know that in this economy, we need to use credit. As Murphy says, "the ultimate reason most people pay their credit-card bills ... is that they don't want to ruin their credit score."

So... even though we've got too much debt... and even though we know we've got too much debt... we still want to keep a good credit score... because, God knows, we're gonna need to borrow more.

Does this make sense? Or have we gone through the looking glass?

Voluntary, informed transactions make both parties better off. But when most of those are credit transactions, they add a huge extra cost to economic activity. The excessive reliance on credit is fairly called "excessive" precisely because of that huge extra cost.

This brings me to Robert Murphy's conclusion, his main point, his purpose in writing: "As I have argued elsewhere, the credit-card industry shows the feasibility of allowing markets to police themselves without government enforcement."

Murphy is well aware of the economic problem. Yet for his conclusion he chooses to emphasize a political concern -- government interference -- rather than the problem he has accurately identified, the problem of excessive reliance on credit. For my part, I cannot say this often enough: If the problem is economic in nature, then the solution must also be economic in nature; and the analysis as well.

A little about me

Why is it that a "hundred-year flood" means once in a hundred years, but a "hundred-year storm" seems to last a hundred years?

I got two books for Christmas from my grandson's mom and dad --

• False Economy by Alan Beattie, and
• The (mis)Behavior of Markets, by Mandelbrot & Hudson.

Over the holidays I got most of the Beattie book read. But then I put it down, and didn't finish it until a week or so ago. I'm not a fast reader; and that is an understatement.

Anyhoe, what with the hundred-year snowfall we've been having these past two days, I started getting into the Mandelbrot book. I'm only through the Preface, but something about the book bothers me.

Markets are complex, and treacherous. The bone-chilling market fall of September 29, 2008 -- a 7 percent, 777-point plunge in the Dow Jones Industrial Average -- was, in historical terms, just a particularly dramatic demonstration of that fact. In just a few hours, more than $1.6 trillion was wiped off the value of American industry -- $5 trillion worldwide.

Mandelbrot's concern is not economics, nor markets in general, but financial markets in particular: stock markets. His objective, it seems, is to reduce the treacherousness of markets. Not to avoid the behavior that leads to disaster, but to improve the ability of investment bankers to dance close to the edge:

It is time to end the tunnel vision of our bankers and regulators. The accepted "close enough" is no longer good enough for the computer models with which they manage economies and markets. A pretty good grasp of typical market conditions is no longer adequate; what is needed is real understanding of how markets work and why prices move.

Mandelbrot offers a more complex economic model, so that Wall Street can take us close to the edge in safety. But I think he misunderstands the nature of economic behavior. No matter how close Wall Street is to the edge, if it thinks itself safe it will take us closer yet to the edge.

After the black cat crosses my path...

I walk into a bank, borrow $10, and run across the street to Starbucks for coffee.

Before getting out the bank, I have already put available credit to use. I have added to total debt, and I am not yet out the bank's door.

If a bus runs me over crossing the street and I never get to spend the $10, that credit is still in use and that debt still exists. If I die without spending it, the credit stays in use and the debt exists until my estate is settled....

Debt is not created by spending. Debt is created by the use of credit.

Following up on the wrong story

Well there ya go. Don't count the consumer prices that went up, so ya can say prices went down. And don't mention wholesale prices at all. That way we can reach the solid conclusion that prices are stable.

That's what we need to say on the 18th, so the next day's news makes sense.

Telling the Wrong Story

Wholesale prices jump 1.4 percent? Wow!

I gotta read that story:

Consumer prices rose less than expected in January while prices excluding food and energy actually fell, something that hasn't happened in more than a quarter-century.

The Labor Department said Friday that consumer prices edged up 0.2 percent in January while prices excluding food and energy slipped 0.1 percent. That was the first monthly decline since December 1982.

The benign inflation news gives the Federal Reserve more time to keep interest rates at record-low levels to shore up the economy and should ease worries in financial markets that a Fed rate hike is more imminent.

Nothing at all in the article about wholesale prices. But if you don't count the prices that went up last month, it turns out prices went down.

Oh, there it is. In the blurb under the photo:

FILE - In this Feb. 1, 2010 file photo, a worker completes a fuel delivery at gas pumps in Lynnfield, Mass. Wholesale prices shot up at double the expected pace in January, propelled higher by big increases in energy costs.

(Why is the Sacramento Bee using a photo from Massachusetts?)

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.)

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.