Explaining the growth of private-sector debt

Originally posted 19 April 2011

I've done several posts lately on the same theme and largely all showing the same graph of public and private debt.

I've tried to suggest that private debt is the big debt, and that the big debt is the big problem.

Before I get too far off that topic I want to restate my thinking on the reason private debt grew so large.

Debt is not the result of spending, nor of excessive spending. Debt is the result of credit-use, plain and simple.

All of our economic policies encourage the use of credit, because we think we need credit for growth. None of our policies encourage the repayment of debt.

So we accumulate debt, and we just let debt accumulate. It's policy.

Meanwhile, on the other hand, and at the same time we think that printing money causes inflation. So (despite what you've heard from everybody else on the planet) our economic policy has reduced the quantity of money relative to GDP.

So we have less spending-money, and we use more credit. That is my explanation of the growth of debt. Simple, right?

It's all policy. We think we need to use more credit for growth (no matter how much debt we have). And we think printing money causes inflation (and using credit doesn't). It's all just bad policy.

And apparently almost nobody realizes that the cost of all that debt is the cost that drives prices up and living standards down, and hinders economic growth besides.

Lars leaves things out

At The Market Monetarist, Lars Christensen writes

I find it incredible that anybody seriously would question the negative supply side consequences of higher minimum wages. This is not a political issue, but a simple question of understanding the laws of supply and demand.

So he reduces it to a simple matter of supply and demand. And he puts up the crossbones of a supply-and-demand chart and I'll tell ya, he explains it pretty well and he is as clear as can be. But does that mean I think he's right?

No.

What Christensen has done is to take a matter of great (whether they know it or not) significance to an awful lot of people who don't make an awful lot of money, and make it so simple that it seems undeniable.

But it is the difference between "simple" and "simplistic". Lars is simplistic.

Simple is better. Simple doesn't leave things out. "Everything should be made as simple as possible, but not simpler."

My friend Gene Hayward had some thoughts on the Minimum Wage the other day. His post is a bit more involved than Christensen's. (He uses four graphs and works out a bit of his thinking in the post.)

Elasticity of Demand for Labor. That's the thing Gene includes and Lars leaves out. Basically Gene is saying Maybe the crossbones don't look like Lars's perfect X. Gene thinks the Demand for Labor line is a little more upright, so that the decrease in employment is less than it looks on Lars's graph. Gene makes a good argument.

Mike Sproul

I still remember figuring out that Milton Friedman's phrase "money relative to output" is a way of saying scarcity makes things valuable: It is a way of saying the idea that "scarcity makes things valuable" applies to money just as much as it does to the things we buy with money.

Friedman's ideas went up a few notches for me that day. The more so because economics, according to the textbook, is the study of scarcity.

Friedman's idea became one of my fundamental building-blocks of thought, as much as the line from Keynes that the engine which drives enterprise is not thrift, but profit. What I'm saying is, Friedman's idea is embedded in the very foundation of everything I think about the economy.

So every time I run into comments from this guy Mike Sproul on blogs and stuff, he stops me dead in my tracks. Sproul says, if I have it right, that money gets its value not from scarcity, but from the assets that back money. It's the old idea that paper money backed by gold was valuable because of the gold backing: Not a difficult idea to accept, in its own right, but as unlike Friedman's as demand deposits are from Krugerrand.

Ran into Sproul recently in comments at Free Banking: Drawing the line:

First, there's gold. Then there are paper claims to gold, then there are bookkeeping entries that are claims to those paper claims, and so on. All those claims have varying degrees of liquidity, so we draw arbitrary lines where nature did not put any lines, and start talking about M1, M2, etc. The whole exercise is a classic case of asking the wrong questions.

Here's the right question: Whose liability are those claims? Paper dollars issued by the Fed are the Fed's liability, and their value is determined by the Fed's assets. Checking account dollars issued by Chase bank are Chase's liability, and their value is determined by Chase's assets. Credit card dollars issues by Visa are Visa's liability, and their value is determined by Visa's assets. Those various kinds of dollars have varying degrees of liquidity, but when it comes to the question of what determines the value of those dollars, asset backing counts for almost everything, while liquidity counts for almost nothing. It is therefore a huge mistake to divide various kinds of money according to their liquidity, while paying no attention to asset backing.

Even the first time I ran into Sproul, he was talking about the value of money in relation to assets and liabilities:

the quantity of checking account dollars does not affect the value of green paper dollars, since the Fed's assets and liabilities are unaffected by the actions of private banks.

Now, that one I have trouble with. I can always fall back on the notion that I'm an idiot, a mere hobbyist trying to make sense of the world. I've been "taught" almost nothing about the economy, and maybe my understanding of things is like a river that took a wrong turn when a trickle of a tributary of my thought went the wrong way around a pebble, once upon a time. But I cannot see how the value of the dollar is "unaffected" by the actions of private banks.

Banks and borrowers create money that is indistinguishable from and interchangeable with the green paper dollars issued by the Federal Reserve. Is there a pebble here?

Certainly, most of the U.S. trade deficit is created by private spending of bank-created money. And certainly, the trade deficit affects the value of the dollar. Is there a pebble in this?

At the root of Arthurian economics is the view that most of the increase of prices in my lifetime has been caused by the expansion of credit, not by running the printing press. This view is confirmed by the fact that after the crisis the Fed's main focus was to prevent the deflation that would come from the collapse of credit. Is there a pebble?

So, I have trouble sometimes with things Mike Sproul says.


In the Free Banking comments, he said something I liked:

Back in 1840, when checking accounts were relatively new, people denied that checking account dollars were money, on the grounds that checking account dollars ultimately had to be paid in paper or coin. In 1710, people denied that the new-fangled paper notes were money, since paper notes were ultimately paid in coin. Today, people deny that credit card dollars are money, since they are ultimately paid with a check, a paper bill, or in coin. In every case, it has taken people a while to realize that there is a permanent float of dollars (paper, checking account, or credit card) that is never paid down, and that permanent float should be counted as part of the money supply. Credit cards were introduced in 1950, so if past history is any guide, it will be about the year 2080 before economics textbooks count credit card dollars as part of the money supply. By then, of course, there will be some new kind of money, and economists will deny that it is money.

His opening thought here, in 1840 people denied that checking account dollars were money, I like that. I said something similar myself on this blog one time, and I'm happy to accept Sproul's thought as confirmation of my thought. The right side of the pebble, and all that. I'm okay with his 1710 thought, too.

But I'm not okay with his view that "credit card dollars are money". Oh yeah yeah yeah, we use credit for money, definitely, and that is definitely the problem. It's a problem because credit isn't money. Credit isn't money, because after I pay for something with credit, I still have to pay for it with money. Credit doesn't discharge the debt.

The use of credit is qualitatively different from the use of checking account dollars and "new-fangled paper" notes. Pay for something with gold, or with new-fangled notes, or pay by check, and you have no further obligation to pay for the thing you bought. The debt is discharged. This is not the case if you use credit to pay for something. Pay with credit, and the debt remains. Paying with credit is not the same as paying with money. Sproul is wrong about this.

In my comment at that Free Banking post, I linked to a PDF (6-page article in a 12-page PDF) on the "True Money Supply" (TMS) by Joseph T. Salerno. Salerno writes:

... money serves as the final means of payment in all transactions. For instance, credit cards are not counted as part of the TMS, because use of a credit card in the purchase of a good does not finally discharge the debt created in the current transaction.

That's right. In 1840, checking account dollars were money because you could use them to "discharge the debt". In 1710 the new-fangled paper notes were money, because you could use them to discharge a debt. But today, if you use a credit card to pay for something, you add to your debt. You don't discharge it. Credit cards are not money. Credit is not money. This is why using credit for money is a problem.

Noah Smith: The effect of excessive debt on economic growth

Okay. In context, Noah doesn't say it in the way the title of my post suggests. However, he says it:

There was plenty of borrowing and lending in the zero-growth periods of the Ming Dynasty, and the Ottoman Empire, and any other long period of economic stagnation.

It's no coincidence, this relation between "plenty of borrowing" and "stagnation".

I don't think I ever looked at this ratio before...

Courtesy of Random Eyes and FRED and Jerry: a graph comparing current receipts to current expenditures of the Federal government, FRED graph #1Cf:

Graph #1: Federal Receipts relative to Federal Expenditures

Mostly above the 1.0 level until 1970. After 1970, mostly less than one-for-one.

Even before 1970, a downtrend seems evident.

After 1990 the big uptick to about 2000 is the Clinton balancing act. A big up, a big down, and another big down by 2010.

Before 1992 or so, the path of the blue line seems a lot more jiggy in the late 1960s and '70s than in the 1950s and early '60s. Perhaps an effect of the Great Inflation.

Biggest spike of all occurred right around 1950, but it was short-lived. Can't say much about that one, as there is almost no data leading up to it.


What drove receipts down, relative to expenditures? Oh, it looks to be an eensie bit downhill till the mid-1960s, sure, but look what happened when the Fed started creating recessions to fight inflation: DOWN in the near-recession of 1967. DOWN in the recession of 1970, and no bounce-back. DOWN in the recession of 1974, sharply down. And DOWN in the double-dipper of 1980-82.

That sequence of events took receipts down from 100%-plus of spending, to 80%.

// Update:

Graph #2: Same concept, but using Federal Deficit numbers

Blue line, same as Graph #1. Red line shows the same ratio figured a different way. The patterns are very similar, the big drop during the Great Inflation is still there. But the numbers are not so high in the 1950s and early 1960s.

The blue line is based on "current" expenditures. The red line is based on "deficits".

A wild ride

Suppose I lend you a trillion dollars, and you pay me fifty billion in interest. At the same time, you lend me a trillion dollars and I pay you fifty billion in interest. Our net interest is zero.

Our net interest is zero, but between us we took a hundred billion circulating dollars, and took them out of circulation. If the economy needs those dollars it will have to borrow them again at interest, adding to the accumulated financial costs that already burden the economy.

The result is a concentration of wealth and an increase in the cost of production.

The monetary authority may choose to deal with increasing costs by allowing prices to rise. Eventually, this can lead to an economic "shock" when the prices of imports are increased to compensate for the inflation. If the imports in question are fundamental and in wide use, like oil, the result may be devastating.

After a time, the world will look back on that troubled era and think of the problem as a problem with oil prices when in fact it was a problem created by the excessive growth of finance. The misunderstanding will make this problem a difficult one to solve.

The concentration of wealth is evidence of the excessive growth of finance.

Monetary policy is ineffective? Gee, I wonder why.

At Unlearning Economics, the current post links to an older one where, in comments, Unlearningecon writes:

If you think about your household income, you receive your income plus however much you borrow. So say your income is £10 and you borrow £5, your total income is £15. But to keep it constant you must continue to borrow £5 a year. To increase your income, you must borrow more than that each year. If you reduce the amount you borrow to £2, your income will fall ... even though you are still borrowing.

In the mainstream framework this cancels out at a macro level. However, in the endogenous framework, the banking system is effectively the economy’s ‘bank’ and so it scales up – money paid back goes out of circulation and into the banking system.

He links to a Keen post (we looked at it yesterday), then continues:

The point is that you can think of money paid back into the banking system as out of circulation. So if you imagine that, say, only the CB lent out money, you would see that paying it back to them would take it out of the economy.

It's an important point. Dunno if I missed it in the Keen post or if Unlearningecon is taking the thought in his own direction. But I like it.

The economy is transaction. Exchange. The economy is measurable in dollars of spending. If you take a dollar out of the spending stream and sit on it, that's very nice but it does nothing for the economy.

It doesn't matter who takes money out of the economy -- the Fed, or an individual saver. A dollar not being spent is not a participating dollar.

Oh, sure: you can lend your dollar into the economy so that it becomes a participating dollar. But with that dollar comes a cost to the economy.

If the economy needs a dollar, and the Fed just prints one, somebody will complain about inflation and loss-of-value and cost. A loss, perhaps; but this isn't really a cost. Not like Adam Smith's factor costs are costs. And not like the cost of interest.

Savers and lenders compete with the monetary authority by performing comparable economic acts, putting money in and taking money out of circulation. As savings accumulate, the competing power grows, weakening the monetary authority.

Subtle distinctions in simple things

In an old post at Naked Capitalism, Steve Keen writes:

Firstly, and contrary to the neoclassical model, a capitalist economy is characterized by excess supply at virtually all times: there is normally excess labor and excess productive capacity, even during booms. This is not per se a bad thing but merely an inherent characteristic of capitalism—and it is one of the reasons that capitalist economies generate a much higher rate of innovation than did socialist economies (Janos Kornai, 1980). The main constraint facing capitalist economies is therefore not supply, but demand.

Not supply, but demand. Yes.

And really not demand, but cost. Cost is always the limiting factor. It is always cost that cuts short demand.

It seems Steve Keen agrees:

Secondly, all demand is monetary...

"roughly offsetting movements" and economic growth

It is 4:56 AM as I write this.

I love the mornings. I wake with a clear head and often with a fresh understanding of something that puzzled me the day before. I turn the computer on, and I write. Even the dogs are still asleep.

...and I've been up for three hours now.


From Fisher Dynamics, page 3, in a discussion of "the overall trends in leverage in the economy", Mason and Jayadev write:

And sixth, while in some periods the private and public balances show roughly offsetting movements (1950-1980, 2008-2010), in others they move roughly together. In the 1980s and 2000s, there are are significant increases in all three sectors' leverage.

The three sectors represented are Federal government, Households, and Nonfinancial Businesses.

Figure 1 from the Fisher Dynamics PDF

The "roughly offsetting movements" are the 1950-1980 decline of Federal debt (relative to GDP), offset by an increase of household and business debt; and the 2008-2010 increase of Federal debt, offset by a decline of household and business debt. (The word "offset" here implies only "movement in the opposite direction".)

The "move roughly together" comes after 1980, when all three sectors show increase.


The good economic growth of the 1950s and '60s was fostered by the growth of private debt, because we live in a world where we use credit for growth. In the early 1960s, private debt was still relatively low, and not much of a burden.

By 1970 debt had accumulated enough that the cost of debt service was hindering economic growth. Fed Chief Arthur Burns astutely recognized "cost-push" pressures at work, but attributed those pressures to labor when the source was financial cost. To alleviate cost pressures the Fed allowed prices to rise, creating the Great Inflation.

Despite the inflation -- or, because of it, really -- economic growth was good in the 1970s. But times change, and inflation became unacceptable. In the 1980s, accommodation by the Federal Reserve went out the window. In its place we saw increased Federal spending and bigger deficits. The good economic growth of the 1980s was fostered by rapid increase of the Federal debt.

Either way -- by monetary accommodation or fiscal -- money growth kept the private sector afloat, postponing a day of reckoning that finally arrived in 2008.

Because we use credit for growth, the key to a good economy lies in maintaining the affordability of debt. When debt was relatively low it was affordable. When inflation was high, erosion kept a growing debt relatively low and affordable. And, when Federal debt growth was rapid, that debt provided the funds to make a growing private debt affordable via sectoral balances.

Today debt is high, inflation is low, and Federal debt growth is seen as a problem. No method remains to make private debt affordable. And the economy cannot grow.

The quick, easy solution is to reduce debt by forgiveness, and prevent accumulation of debt by the design of policy.

Sequester versus the rising benchmark

From usgovernmentspending.com:

US Federal Spending Since 1900

Federal spending began the 20th century at less than 3 percent of GDP per year. It jerked above 24 percent as a result of World War I and then declined in the 1920s to 3 to 4 percent by 1929. Federal spending started to increase after the Crash of 1929, and rose above 10 percent in the depths of the Great Depression.

Federal spending exploded during World War II to nearly 48 percent of GDP, and then declined to about 15 percent in the late 1940s.

In the Korean War of the early 1950s federal spending increased to over 20 percent of GDP, and then declined to about 17 to 18 percent by the end of the 1950s. In the 1960s federal spending began a slow increase to about 22 percent of GDP in the early 1980s, and then declined modestly to about 18 percent by 2000.

In the 2000s federal spending increased modestly to about 20 percent of GDP before exploding to 24 to 25 percent in the Crash of 2008.

I would say something a little different. I'd say Federal spending started out very low, and I won't even try to explain why that may have worked out okay. But then after World War One, Federal spending fell to "3 to 4 percent by 1929" -- and it was too little to prevent the Great Depression.

After World War Two, Federal spending fell to 15 percent. There was a recession or two soon after, but no big depression. 15 percent was not too little, in the late 1940s.

After the Korean war, Federal spending fell to 17 or 18 percent. Again, there was a recession or two soon after, but no big depression. 18 percent was not too little, in the 1950s.

After climbing to 22 percent in the 1980s, Federal spending fell to 18 percent by 2000. Then it rose to 20 percent, but that was too little to prevent the Great Recession.

In the 1920s and '30s, four percent was too little to prevent a crisis. Now, 20 percent is too little to prevent a crisis. Why the change? Why is this benchmark so high?

"How much is the government spending?" -- This is not the right question. The question is: Why is 20% too little? What changed, that Federal spending at 20% is not enough to keep the economy going?

A lot of people say the growth of Federal spending is the problem. But that's a circular argument. The growth of Federal spending -- and the rising benchmark for how much Federal spending it takes to avoid a crisis -- is evidence of some other problem. Our task is to understand this other problem. The right questions are the ones that help us understand.

My understanding is that the growth of private debt hinders the growth of the economy, and our other problems arise from slow growth.

Glasner on finance

In Falling Real Interest Rates, Winner-Take-All Markets, and Lance Armstrong, David Glasner writes:

... insofar as reduced marginal tax rates contributed to an expansion of the financial sector of the economy, reduced marginal tax rates may have retarded, rather than spurred, growth. The problem with the financial sector is that the resources employed in that sector, especially resources devoted to trading, are socially wasted, the profits accruing to trading reflecting not net additions to output, but losses incurred by other traders.

I wouldn't say "socially wasted", but that's just me. Glasner's important point is that an expansion of the financial sector may have retarded growth. Now, that's not something you see economists say every day!

In Of the Component Parts of the Price of Commodities Adam Smith identified three things needed to create something of value: material to work on, the working, and tools to work with -- land, labor, and capital.

He called these "the three original sources of revenue". The sources of all income.

Creating things of value was central to Smith's analysis, because the creation of things of value is the source of the wealth of nations. Work is the connection between the world of things and the world of value. If someone will pay you to do something, it is because they value whatever it is that they want done. When you do it for them, income is created. And if you add up all the income created in a year, you get GDP. (And you know how important GDP is.)

Smith pointed out that not all activities create value directly:

The interest of money is always a derivative revenue... All taxes, and all the revenue which is founded upon them, all salaries, pensions, and annuities of every kind, are ultimately derived from some one or other of those three original sources of revenue

All income arises from the three factors of production.

All income is cost. The cost is worthwhile because of the production derived from it; this is the meaning of the word "value".

But not all costs arise from the three factors of production. I recently referred to the interest of money as the factor of facilitation.

The problem with the financial sector is that the resources employed in that sector generate cost but not production. Granted, finance facilitates production. But there is no linear, one-for-one increase of output per dollar of financial cost.

Finance brings non-linearity into the picture. This is how it happens that questions of debt productivity and credit efficiency arise.

Comparable questions arise regarding the size of government, and for exactly the same reason. But everyone looks at the size of government, and no one looks at the size of finance, and therein lies the problem.

To paraphrase David Glasner, the income that accrues to finance is losses incurred by productive factors.

BTW That's mostly private debt

Got an email from Marcus Nunes just now. He came across an image at Espectador interessado and thought of me!

Menzie and the Multiplier

At Econbrowser: Evolving Views on Fiscal Multipliers

Perhaps the most important insight arising from the debates over fiscal policy during and after the great recession is that the multiplier depends critically on the conduct of monetary policy.

Coenen et al. (2012) show that in DSGEs, the degree of monetary accommodation is critical. When central banks follow a Taylor Rule or inflation forecast based rules, then multipliers are relatively small. However, when monetary policy is accommodative – that is interest rates are kept constant – then the cumulative multiplier is greater.

First, it is interesting that many types of models, including DSGEs, when modified to account for accommodative monetary policy, indicate larger multipliers than found in the previous – pre-liquidity trap – literature.

In comments, 2slugbaits adds:

The key isn't just whether or not the economy is in recession, but the size of the output gap and the response of the central bank. No one doubts that the fiscal multiplier is low if the Fed decides to sterilize any stimulative effect by raising interest rates.

Menzie Chinn in comments:

I define accommodative monetary policy the way most economists do these days: keeping the interest rate constant (or dropping it) as a fiscal impulse is applied, such that the interest rate is less than that implied by a Taylor rule or an inflation forecast based rule (this is the definition in for instance the Coenen et al. paper published in AEJ: Macro cited in the survey.)

Julian Silk in comments:

The whole debate, all of it, is an argument over the assertion that government spending can't be valuable in this sense, so let's get rid of government.

Low interest rates are one thing. Low accumulated debt is quite another.

I took an old copy of Mason and Jayadev's Fisher Dynamics PDF and snapshotted Figure 2 -- a graph which shows (among other things) the nominal effective interest rate on household debt. From the paper:

The effective interest rate i is total interest payments divided by the stock of debt at the beginning of the period.

I used MS Paint to add gridlines to the graph. (To keep the lines running square to the graph I used the "rectangle" tool.) Got this picture. Then I guessed the numbers and created a table of "Effective Interest Rate" data. Annual data.

I s'pose it would have been easier to ask Mason for a spreadsheet. Maybe next time.


Okay. So let's pretend all debt bears interest at the effective household interest rate figured by Mason and Jayadev and jiggered by me. Well, Federal debt probably has lower rates. For "all debt" I'll use Debt Other than Federal Debt for 1980-2010, same years I took from Mason and Jayadev.

I downloaded the data from this FRED page. (The linked page shows the same data as my recent Debt Other than Federal Debt graph, but annual numbers this time.)

Here's what I got for Total Effective Interest Paid in Billions:

Graph #1

Up it goes, till the crisis... Here's the same data, relative to GDP:

Graph #2

First reaction? It's high, but it's all over the place!

Rebound reaction? Wow, I have to do the years before 1980!

Turns out that the early-90s decline, the early-2000s decline, and the late-2000s decline on Graph #2 all match up with declines in interest rates:

Graph #3

But aside from the times when interest rates were rapidly dropping, the general trend of interest rates was down, and the general trend of interest payments was up. Why? Because debt was accumulating. We were paying interest on more and more debt.

Graphs & data contained in this Google Docs spreadsheet.

Borio and Long Cycles

Borio writes of a financial cycle with a length on "the order of 16 to 20 years". He uses this estimate, it seems, only for contrast with ordinary "business-cycle frequencies". He is making the point that the financial cycle is not the same as the ordinary business cycle. I can accept that.

I don't see anything else in Borio's article that contradicts my view that the financial cycle is actually much longer than 16 to 20 years. But how long is this "longer" cycle?

My Debt-per-Dollar graph (from the linked post) peaks in 1933, and again in 2007. Philippon's graph of "financialization" shows comparable peaks, plus one in the late 1890s. But these peaks are endings of the "strong phase" of the financial cycle. The strong phase itself occurs before it ends, obviously.

Based on the acceleration points shown on Philippon's graph, I want to say the strong phases of the financial cycle began in the 1980s this time, in the 1920s last time, and in the 1890s the time before. And based on Min's observation, the cycle Lord Overstone saw probably began in the 1830s.

From the 1830s to the 1920s, two cycles in nine decades, average length 45 years.

From the 1890s to the 1980s, two cycles in nine decades, average length 45 years.

From the 1890s to the 1920s, as little as three decades.

From the 1830s to the 1980s, three cycles in fifteen decades, perhaps 50 years long.

The units are crude: decades, as opposed to years or quarters or months or days. Crude units are appropriate, I think. I deal in trends and tendencies, not in moments to buy and sell. Anyway, it's obvious that this cycle has a variable length. By Philippon's graph the strong phase of the 1890s lasted only about a decade, and that of the 1920s not much longer. But the strong phase that began in the 1980s lasted a full twenty years and more.

Probably has something to do with the flexibility that comes from not being on a gold standard. Flexibility, meaning they could increase the quantity of money whenever growing financialization made money tight (tight, relative to accumulating debt). In that case, one can think of the inflation since the 1960s as a policy response to growing financialization. Meaning that the problem goes back at least to the 1960s.

And again, as Borio writes, an incorrect policy response "can prolong weakness and delay a strong, self-sustaining recovery." There was less chance of that happening when we were on the gold standard. Today it is more important than ever to get policy right, to avoid prolonging problems and making things worse. Clearly, differences in length of the financial cycle can be attributed to the fact that the Federal Reserve has a finger in it.

Actually, from the 1920s to the 1980s is six decades -- long, in comparison to the cycle lengths ballparked above. That length also is an indication of the flexibility, and a consequence of the flexibility that comes from having the Federal Reserve manage our money. What I'm saying is, the strong phase of the financial cycle might have been ready to start before the 1980s. But it was undermined or counterbalanced by the Great Inflation. As Claudio Borio says,

the financial cycle depends critically on policy regimes.

Financial liberalisation weakens financing constraints... Not surprisingly, financial cycles have become twice as long since financial liberalisation in the early 1980s...

Obviously in my view, the correct policy response would have been to put limits on the growth of financialization. Instead, we took limits off. Why? Because we don't think in terms of long financial cycles. As Claudio Borio says, we cannot understand the economy if the financial cycle is ignored.

A four-part series on Claudio Borio's VOX article started on the 12th

Borio and the Great Moderation

The other day I showed Borio's graph:

Graph #1: The Business Cycle (red) and Borio's Financial Cycle (blue)

and I wrote:

You can see that before 1984 or so, the blue waves of the financial cycle show much less up-and-down variation than the red wiggles of the business cycle. But since that time, the up-and-down variations of the financial cycle have been much larger.

The blue waves are much larger than the red after 1984, and much smaller before. But also, the red waves are much bigger when the blue is small. And the red is smaller when the blue is big. This change in the red line is an example of what has been called the "Great Moderation."

But the change in the blue line is certainly not an exercise in moderation.

A four-part series on Claudio Borio's VOX article started Tuesday

Borio, Brenner, and the Result of Excessive Financialization

Borio writes:

financial-cycle information also helps construct real-time estimates of sustainable output that, compared with traditional potential output estimates, are much more reliable in real time, and more statistically precise... Such estimates, for instance, would have shown that, during the boom that preceded the Great Financial Crisis, output in the US was growing well beyond sustainable levels.

See where he's going with this? In the years between the Fall of the Towers and the financial crisis, output was unsustainably high.

Unsustainably high. For contrast, here's Robert Brenner:

Economic performance in the U.S., Western Europe, and Japan has steadily deteriorated, business cycle by business cycle... Most telling, the business cycle that just ended, from 2001 through 2007, was -- by far -- the weakest of the postwar period...

In the weakest business cycle of the postwar period, output was unsustainably high.

Graph #2: Employment (log scale) Since 2001 in Red

Oh, I believe it. Both things are true, Borio's unsustainable growth, and Brenner's crappy growth. That is the problem, isn't it? These days, we can't even sustain crappy growth.

A four-part series on Claudio Borio's VOX article started yesterday

Borio and Beyond

Hat Tip to Tom Hickey for the link to Claudio Borio's Macroeconomics and the financial cycle: Hamlet without the Prince? at VOX. Borio says there is a financial cycle and it differs from the ordinary business cycle, and we cannot understand the economy if the financial cycle is ignored.

It's a great article with lots of insights for policy -- half of them being things I never thought of, to be sure. And you know, if I didn't like the article I wouldn't be talking about it. But I wouldn't be talking about it if I didn't have a different story to tell...


"Since the early 1980s, the financial cycle has re-emerged as a major force," the introductory paragraph says. Re-emerged. "Well-known references" to the financial cycle "go back to at least Lord Overstone (1857)", Borio adds in a footnote.

He presents this graph:

Graph #1: The Business Cycle (red) and Borio's Financial Cycle (blue)

The wiggly red line represents the ordinary business cycle. The wavy blue line represents Borio's financial cycle. You can see, before 1984 or so, that the blue waves of the financial cycle show much less up-and-down variation than the red wiggles of the business cycle. But since 1984, the up-and-down variations of the financial cycle have been much larger. Much stronger.

Beginning in 1984, the graph appears to show one complete "S" pattern (ending around 2003) followed by the first half of a second "S". For Borio, these seem to count as one and a half reps of the financial cycle. For these cycles since the 1980s, he points out, the "typical length is of the order of 16 to 20 years".

But Borio misinterprets the evidence. The large variations of Borio's blue line show a wavelike pattern, but they do not show the financial cycle. That cycle is bigger than Borio's 16 to 20-year waves. Remember Alan Greenspan saying that the financial crisis was the kind of thing that happens once in a hundred years?

Borio's big blue waves together make up the strong phase of a much bigger cycle.

The whole time-period of Borio's large blue waves, beginning around 1984 and lasting, I presume, well beyond the last date of his graph, that whole period is the strong phase of one major financial cycle. The weak phase of that cycle goes back in time from the 1980s to the Depression of the 1930s. This cycle is much longer than 16 to 20 years.

Comparison of the financial cycle to the business cycle is misleading. If we have a few good years of GDP growth, they show up as a bigger wiggle in Borio's red line. That one particular business cycle will stand out from the rest. But when the financial cycle "re-emerges" all the waves are magnified from that point onward, until the financial cycle re-submerges again.

Borio's graph only goes back to around 1970. If you took it back in time, you would see a repeating pattern: large waves for a time, then small waves for a time, then large waves again for a time, and then small waves again: clusters of large and clusters of small repeating, back to the time of Lord Overstone and before. The 16 to 20-year cycle Borio describes is not so much a cycle as it is part of the strong phase of a cycle in which clusters of large (strong) waves and clusters of small (weak) waves alternate in a repeating pattern.

It is the strong phase of this financial cycle that "re-emerged" in the 1980s.


Here is Thomas Philippon's picture of that greater financial cycle, showing great peaks during the Great Depression and again today:

Graph #2, from Has the U.S. Finance Industry Become Less Efficient?
[Missing graph replaced 18 May 2017]

The strong phase since the 1980s appears on this graph as a more rapid increase than we see from the 1940s to 1980. A similar rapid increase appears in the 1920s -- the "Roaring '20s" -- and peaks at the Great Depression. And a third rapid increase comes during the 1890s, and peaks before 1900.

All three of these "rapid increase" periods would show "strong phase" waves, if we had numbers like Borio's to look at. The rapid approach to the peak -- in our time, before the Great Depression, and in the 1890s -- is the time of excessive financialization, the time of excitement in the financial cycle.

By contrast, when financialization is at a minimum, economic growth tends to be strong and the financial cycle shows little excitement.

A time of excessive financialization is a time of excessive debt. Here is my debt-per-dollar graph. Going back only to 1916, it reiterates two of the three peaks Philippon's graph shows:

Graph #3: Total Debt relative to Circulating Money

Here is interest rate data from Robert Shiller. Rates fall during the rapid-increase phase, as financialization rises to a peak:

Graph #4. Source: Robert J. Shiller's Irrational Exuberance

Shiller's interest rate data, going back to 1871, shows three peaks. So does Philippon's. If interest rates typically fall while financialization rises to a peak, then the fall of interest rates from the 1870s to the 1890s must have been accompanied by increasing financialization and increasing debt.

Philippon's graph confirms increasing financialization since 1880, with a peak before 1900.

Finally, here's an old note from Min at Worthwhile Canadian:

The U. S. also had a run-up of private debt before the depression of 1837 - 1843.

That would be four peaks -- including the one Lord Overstone saw.


Borio is right: There is a financial cycle, and it differs from the ordinary business cycle. And we cannot understand the economy if the financial cycle is overlooked.

Related post: "deflation is not necessarily harmful"

On the Difference between Credit and Debt

Cuttings from mine of 5 Feb:

No debt produces anything. New uses of credit can sometimes be for productive purposes. But after that money's spent, nothing remains but the evidence that it was credit we were spending: Nothing remains but the debt. And the cost of debt over time is equal to the economic boost we get from credit use. Equal, or greater.

Borrow a dollar today, spend it today, and boost the economy today. Tomorrow, all that remains is a dollar of debt, the cost of interest on it, and the cost of repayment. These costs do not boost the economy. Just the opposite. This is true, no matter who borrowed the money. It is true, no matter what the money was used for.

To boost the economy, a new use of credit must be large enough to completely offset the drag created by existing debt, and then some. But the use of credit makes existing debt bigger. See the problem?

"Aristocracy May Be Engendered By Manufactures"

I quoted Smith earlier today, on the three orders:

The whole annual produce of the land and labour of every country, or what comes to the same thing, the whole price of that annual produce, naturally divides itself, it has already been observed, into three parts; the rent of land, the wages of labour, and the profits of stock; and constitutes a revenue to three different orders of people; to those who live by rent, to those who live by wages, and to those who live by profit. These are the three great, original and constituent orders of every civilized society, from whose revenue that of every other order is ultimately derived.

The first order there, those who live by rent: In Smith's time that was the aristocracy.

A while back also, I quoted Smith:

As any particular commodity comes to be more manufactured, that part of the price which resolves itself into wages and profit comes to be greater in proportion to that which resolves itself into rent.

I suggested then that he was describing economic forces that would result in the demise of aristocracy.

I also quoted Will and Ariel Durant a while back, referencing "Plato's reduction of political evolution to a sequence of monarchy, aristocracy, democracy, and dictatorship". At the time, I added: We are well past Aristocracy, near the end of Democracy. Be careful what you wish for.


The title of this post comes from Alexis de Tocqueville, from Democracy in America, from the title of Chapter 20 of Book Two. It's a short chapter. Tocqueville opens by saying "I have shown that democracy is favorable to the growth of manufactures". He ends the chapter thus:

I am of opinion, upon the whole, that the manufacturing aristocracy which is growing up under our eyes is one of the harshest which ever existed in the world; but at the same time it is one of the most confined and least dangerous. Nevertheless the friends of democracy should keep their eyes anxiously fixed in this direction; for if ever a permanent inequality of conditions and aristocracy again penetrate into the world, it may be predicted that this is the channel by which they will enter.

Tocqueville's "manufacturing aristocracy" is the same as Smith's "those who live by profit". In Tocqueville's time, and Smith's, it was "most confined and least dangerous". But Tocqueville warned us to keep our eyes "anxiously fixed", lest those who live by profit should become a new aristocracy. Fair warning.

By the way: Wikipedia describes Tocqueville as "An eminent representative of the classical liberal political tradition".

In any event, these excerpts and these concepts capture a transfer of wealth and power from one segment of society to another -- a turning of the Cycle of Civilization.

An Interest to Deceive

Thoughts on a post from Cafe Hayek: The economics that’s in demand, tagged for "Hubris and humility"...

I don't generally go to Cafe Hayek, so I could have this all wrong. But it looks to me like post author Russ Roberts has a thing for "spontaneous order". That's when you just leave the economy alone, and it works better because you left it alone, because it has spontaneous order.

Sort of like evolution, I guess, as opposed to intelligent design.

Roberts says

we get the economics we deserve, the economics that most everyday people want to hear. I’ve often wondered why my viewpoint (or Don’s or Pete’s or Adam Smith’s or Milton Friedman’s) has such limited traction in the marketplace for ideas.

So, according to Roberts, we get the economics that fools want, when what we should get is the spontaneous order embraced by wise men like Russ Roberts and Don Boudreaux and Pete Boettke and Adam Smith and Milton Friedman. "Interventionism, market failure, Keynesianism–they are all doing 'better' in the marketplace" than the spontaneous-order lot.

However, Adam Smith warned that "those who live by profit" are not to be trusted. He said they are "an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it."

Smith did not "rely on invisible hand processes" as Roberts puts it. Smith cannot be lumped in with those others who oppose, or are claimed to oppose, "interventionist" economics.

Once again, there is trouble at the premise: Adam Smith was the "father" of economics, and Russ Roberts gets him wrong.


At Adam Smith's Lost Legacy, Gavin Kennedy writes

Smith in [The Wealth of Nations] noted how merchants secretly combined to resist employee wage demands while opposing the rights of employees to combine to pursue their collective interests.

Adam Smith’s advocacy of the philosophy of Natural Liberty was quite different from laissez-faire (words he never mentioned). Natural Liberty, as expressed by Smith, equalised the rights of all participants in commercial society, employers, labourers and consumers. This does not prevent modern economists from associating laissez-faire with Adam Smith’s name...

Again Gavin Kennedy, in comments:

Smith did not make a general statement that public benefit arose from self-interested actions by merchants and others. That opulence was a general benefit as an alternative to abject poverty was suggested to his readers. But self-interests could also work against public benefits. For example, in self-interested actions by merchants in favour of narrowing competition, protection and tariffs, monopolies, 'conspiring to raise prices'. Also when landowners used primogeniture laws and entails to control inheritances, when sovereigns raised taxes or borrowing to fight dynastic wars.

Gavin's is a site to visit often. Russ Roberts' place, perhaps not so much.

The Third Order

I have presented this story before. It is not my story, but Adam Smith's -- and he related it more than once himself. When I presented it before, I took it from Book One, Chapter VI of The Wealth of Nations. This time it comes from the Conclusion of Book One, Chapter XI, and it has a different ending.

Smith's paragraph that begins "His employers constitute the third order" I have broken into five paragraphs and shortened (as noted by "..."), but otherwise changed not a word.

The title here is mine:

The Invisible Hand Picks Your Pocket, by Adam Smith

The whole annual produce of the land and labour of every country, or what comes to the same thing, the whole price of that annual produce, naturally divides itself, it has already been observed, into three parts; the rent of land, the wages of labour, and the profits of stock; and constitutes a revenue to three different orders of people; to those who live by rent, to those who live by wages, and to those who live by profit. These are the three great, original and constituent orders of every civilized society, from whose revenue that of every other order is ultimately derived.

The interest of the first of those three great orders, it appears from what has been just now said, is strictly and inseparably connected with the general interest of the society. Whatever either promotes or obstructs the one, necessarily promotes or obstructs the other. When the public deliberates concerning any regulation of commerce or police, the proprietors of land never can mislead it, with a view to promote the interest of their own particular order; at least, if they have any tolerable knowledge of that interest...

The interest of the second order, that of those who live by wages, is as strictly connected with the interest of the society as that of the first. The wages of the labourer, it has already been shewn, are never so high as when the demand for labour is continually rising, or when the quantity employed is every year increasing considerably. When this real wealth of the society becomes stationary, his wages are soon reduced to what is barely enough to enable him to bring up a family, or to continue the race of labourers. When the society declines, they fall even below this...

His employers constitute the third order, that of those who live by profit. It is the stock that is employed for the sake of profit, which puts into motion the greater part of the useful labour of every society. The plans and projects of the employers of stock regulate and direct all the most important operations of labour, and profit is the end proposed by all those plans and projects.

But the rate of profit does not, like rent and wages, rise with the prosperity, and fall with the declension of the society. On the contrary, it is naturally low in rich, and high in poor countries, and it is always highest in the countries which are going fastest to ruin. The interest of this third order, therefore, has not the same connection with the general interest of the society as that of the other two.

Merchants and master manufacturers are, in this order, the two classes of people who commonly employ the largest capitals, and who by their wealth draw to themselves the greatest share of the public consideration... Their superiority over the country gentleman is, not so much in their knowledge of the public interest, as in their having a better knowledge of their own interest than he has of his. It is by this superior knowledge of their own interest that they have frequently imposed upon his generosity, and persuaded him to give up both his own interest and that of the public, from a very simple but honest conviction, that their interest, and not his, was the interest of the public.

The interest of the dealers, however, in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public. To widen the market and to narrow the competition, is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens.

The proposal of any new law or regulation of commerce which comes from this order, ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

Not quite the Beatles, but

Will you still need me
Will you still read me
When I'm sixty-four...


Today's the day.

Come back in half an hour. I got a little something from Adam Smith.

Gavin's magnificent conclusion

At Adam Smith's Lost Legacy, Gavin Kennedy writes:

I read most of Ayn Rand’s paper-back philosophy books and novels in the 50s-60s. I was struck then by her fatal weakness: to “save the world” she requires the world to adopt her objectivist philosophy, or at least behave as if they did, a most unlikely outcome. Therefore, it ain’t likely to happen.

I never read Ayn Rand. But I feel very much about Marx as Gavin does about Rand. To suit Marx, we all must agree to the famous one-liner From each according to his ability, to each according to his need. And we must choose not to withhold ability or effort. And we must choose not to embellish need.

I just don't think it's in human nature. Therefore, it ain’t likely to happen.

Gavin provides a perfect ending:

Smith did not require the conversion of everybody to new morality or to a universal conformity to logic. In fact he wrote of humans as they were. He made no predictions about the future (except about the future of the former British colonies in North America becoming the wealthiest economy in the world by around 1875). Instead he studied the past to understand within the limitations of knowledge the present; we might be better doing the same.

Inches

Total Credit Market Debt Owed since 2006, in two parts: the Federal portion, shown in red, and everybody else's debt combined -- our debt -- shown in blue.

Just before 2008 -- about a sixteenth of an inch to the left of the left edge of the gray bar -- there began a slowdown in our debt (ours, as opposed to the Federal debt).

The next thing that happened was that a recession started. We got the gray bar.

Then about a sixteenth of an inch after the recession started, there was a momentary fall of Federal debt, the red line.

Then about an eighth of an inch later, the Federal debt started going up rapidly, a policy response to the recession. Another quarter-inch later, toward the end of 2008, there was a slight reduction of the upward pace of Federal debt -- a reduction which persisted for a good inch or more, until the further tiny reduction of 2011.

Oh by the way... The red line, the Federal debt, is measured by the numbers going up the right side of the chart. The highest number there is about 12 thousand. The blue line, our debt, is measured by the numbers going up the left side of the chart. The highest number there is 48 thousand. Our debt is about four times the size of the Federal debt.

Debt Other Than the Federal Debt

From mine of the 4th:

Graph #1: Debt Other Than the Federal Debt

So it looks like 44 thousand billion is the new floor. We're going to pay interest forever on 44 thousand billion dollars -- and more, if the economy ever starts growing again.

McArdle: "No one has a plan in their pocket to increase the trend rate of economic growth"

Megan McArdle, from All We Need is Growth:

With robust economic growth, our debt-to-GDP ratio will start to decline, our tax revenues will start to rise, and the rolls of programs like unemployment insurance and food stamps will start to fall. All sorts of problems start looking easier with robust economic growth.

That's right. With robust growth, GDP grows relative to Federal spending. But there's more: With robust growth, the demand for government social spending diminishes. The rolls of programs like unemployment insurance and food stamps will start to fall.

With robust growth, Federal Spending (FS) goes down, GDP goes up, and the FS/GDP ratio improves dramatically. It's like we're burning the candle at both ends.

McArdle:

So why are people focusing on the tedious and painful business of austerity, when growth would be so much better? For the same reason you've probably opted to pay off the Mastercard, rather than waiting until you have time to publish a bestselling novel: it's not so easy to deliver robust economic growth on demand.

Right again: "it's not so easy to deliver robust economic growth on demand."

What we have is (on the one hand) people calling for government to get out of the way so the private sector can grow, and (on the other) people calling for government to step up and spend, to make the private sector grow. You cannot know how frustrating this is for someone who sees a third path.

The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.

McArdle:

Whatever you may have heard, no one has a plan in their pocket to increase the trend rate of economic growth--indeed, so far we've failed to get it back to the levels that preceded this "one time factor". Telling budget wonks that "we need more growth" is a bit like telling a cancer patient "you need more health". I mean, yes, Dr. Insight, but can you be more specific?

Here is the plan: We must reduce private sector debt, because it is private sector debt that hinders private sector growth.

Is this not specific enough?

McArdle:

By the end of this year, the federal debt held by the public will probably be something like 78% of GDP. That may not be high enough to exert a serious drag on growth, but it's getting pretty close.

Seventy-eight percent of GDP, huh? You can see that, in the blue line here:

Graph #1: Federal Debt (blue) and Everyone Else's Debt (red)
(Both relative to GDP) (Federal "held by the public" per McArdle)
Click Graph for FRED Source Page

78% is about where everybody else's debt (the red line) was in the mid-1950s. Since then, it went up. But if Federal debt at 78% is "getting pretty close" to being "a serious drag on growth" as McArdle says, then how about other debt at 100% or 200% or 300% of GDP? Of course it is a serious drag on growth! All debt is a drag on growth.

You might say but Federal debt doesn't produce anything!

No debt produces anything. New uses of credit can sometimes be for productive purposes. But after that money's spent, nothing remains but the evidence that it was credit we were spending: Nothing remains but the debt. Debt is evidence of credit use. And the cost of debt over time is equal to the economic boost we get from credit use. Equal, or greater.

Borrow a dollar today, spend it today, and boost the economy today. Tomorrow, all that remains is a dollar of debt, the cost of interest on it, and the cost of repayment. These costs do not boost the economy. Just the opposite. This is true, no matter who borrowed the money. It is true, no matter what the money was used for.

To boost the economy, a new use of credit must be large enough to completely offset the drag created by existing debt, and then some. But the use of credit makes existing debt bigger. See the problem?


The subtitle on McArdle's post is "Everyone would like to fix our budget with growth rather than austerity. Unfortunately, no one knows how."

I'm telling you how.

The Fed wants us to borrow more

DeLong opens a recent post with these words:

If you have a depressed economy where the central bank wishes to but cannot lower short-term interest rates...

I can stop reading right there. Oh, DeLong has a formula that I can't decipher, and two really good quotes, but I don't need to read all that before I have something to say. My objection arises at his opening thought.

The central bank wishes to lower interest rates, but cannot...

Sure, I can see there might be a problem here. Policy is hindered. But wait:

The central bank wishes to lower interest rates...

Here's where my objection arises. The central bank wishes to lower interest rates. But why? Interest rates are already at the "lower bound". If that's not low enough, there must be some other problem.

What problem? Let's look. The Fed wants to reduce interest rates more, to get people to borrow more. So they are tinkering with the price of credit.

Let's look at the cost of credit.

What is the cost of credit? Is it just the interest rate? Of course not. You don't pay interest unless you borrow some money. So the cost of credit is the total interest payment on all that borrowed money.

If you want to lower the cost of credit, you can do it by lowering interest rates. But of course you "cannot lower short-term interest rates" (as DeLong says) once they get to the lower bound.

So when interest rates are very low, as they are today, if you want to lower the cost of credit still further, you cannot do it by lowering interest rates. You can only do it by reducing the total amount of borrowed money outstanding.

We're doing that, of course. We've been deleveraging since 2008. Or we were, anyway, until we flat-lined in 2010:

Graph #1: Debt Other Than the Federal Debt

And of course, it is largely through the efforts of the Federal Reserve that we stopped deleveraging.

So it looks like 44 thousand billion is the new floor. We're going to pay interest forever on 44 thousand billion dollars -- and more, if the economy ever starts growing again.

It just doesn't make sense.


As of December 2012, there was $3,260.2 billion dollars of spending-money in our economy.

Now look at the debt graph again. Accumulated debt other than Federal debt rises from 41 thousand billion (in 2006) to 47 thousand billion (in 2008), then falls back to 44 thousand billion. That's an increase of 6 thousand billion followed by a drop of 3 thousand billion.

And we have just over 3 thousand billion dollars of circulating money, which is the money we use to pay off debt. So by the numbers, the drop in debt from 47 thousand billion to 44 thousand billion would by itself have been enough to almost entirely wipe out our circulating money.

Why do we have so much debt? More to the point: Why do we think we need so much debt? What the hell is the Fed thinking, that they want to get us borrowing more again?


So, we have 44 thousand billion dollars of debt, and interest rates that are so low we can't get them lower, and we want to get the cost of credit down.

Can you think of a way to do it? I can. I say we stop trying to reduce interest rates, and start trying to reduce debt.

But wait, wait: The Fed wants us to borrow even more.

And this problem arises in the opening line of DeLong's post: in his assumptions. DeLong never bothers to wonder whether the Fed's goal is reasonable.

See the problem?

The Factor of Facilitation

I typically call finance a "factor of production " like labor and capital and natural resources. But the thing of it is, finance facilitates production. Finance is not itself productive. If output goes up it is because there is more labor (or better skill) or more capital (or better technology) applied. Finance facilitates this process, or hinders it. But finance does not otherwise contribute. Money is not a "real" factor, not in the sense of real versus monetary. So really, finance is the factor of facilitation, not one of the factors of production.

Maybe I'll call it that from now on.

So anyway, what happens is that when we apply more factors of production we generally increase both the factor cost and output. But when we apply more of the factor of facilitation, we don't get any more output from that alone. We only get more output if increasing the "F of F" causes an increase in the "F of P".

Costs go up with the F-of-P, and costs go up with the F-of-F as well. But output only goes up with the F-of-P. So an increase in F-of-F is likely to be inflationary. This is why people talk of "good debt" and "bad debt". If an increment of debt (F-of-F) leads to greater use of F-of-P, then output grows. So this F-of-F was "good" debt.

But if the F-of-F doesn't boost the use of F-of-P and fails to boost output, well, people will say it was bad debt.

Noah Smith and the Value of Finance

Parsing Noah's of 20 Jan: How much value does the finance industry create?

In his opening lines Noah links to a couple relevant files that sound most interesting. I'm not gonna go there. I'm gonna be lazy and trust Noah's judgment, and just review his post. For now. Noah writes:

In 1980, finance took home about 5% of all the income in America; in 2007, about 8%. This has led many people to question whether all this activity is worth what we pay for it; in other words, how much of the increase in finance-industry GDP is actually value added, and how much is "rent" extracted from the rest of the economy?

Well, sorry to disappoint you but it's all value added. By definition.

It's the wrong question. How much is value added and how much is rent is the wrong question. No matter. Noah likes John Cochrane's answer enough to quote it:

I don’t claim to estimate the socially-optimal “size of finance” at 8.267% of GDP, so there...After all, if a bunch of academics could sit around our offices and decide which industries were “too big,” which ones were “too small,” and close our papers with “policy recommendations” to remedy the matter, central planning would have worked.

Pissed me off. Irrelevant, ego-driven politics. But then (oops) I read his next sentence;

A little...modesty suggests we focus on documenting the distortions, not pronouncing on optimal industry sizes.

Kiss my ego remark goodbye. A little modesty has exposed itself. Here, let me cherry-pick another one, so I can say John Cochrane has it exactly right:

Third, we often discover a “government failure,” that the puzzling aspect of our world is an unintended consequence of law or regulation. The regulators got captured, the market innovated around a regulation, or legal restrictions stop supply and demand from working.

Yes, or... or maybe the government failure is a policy failure, or rather a failure of economists and policymakers to understand the "drug interactions" of their remedies.

Noah likes it:

In casual discussions of finance in the media and blogs, we've heard all of these ideas before. The idea that finance is excessively large due to collusion with the government (policy failure) is probably the most prominent - this is the idea that big banks have the government in their pocket, allowing them to dump their risk onto the taxpayer (through bailouts) while keeping their gains for themselves.

But, oh, that's tiresome. Remember "Japan, Incorporated" from back in maybe the 1980s? Know what that was? Wonderful, from the American media perspective. Know what else it was? Collusion. But things were good in Japan (Oh, it must have been the 1980s, or anyway before the start of Japan's lost decade)... Things were good in Japan, so people thought of Japan's business-government collusion as "cooperation" and they said good things about it.

Sorry for the history lesson. But it's not really a history lesson. It's a lesson about how to do things wrong. Here, let me show Noah's remark again, with just a trace of editing:

In casual discussions of finance in the media and blogs, we've heard all of these ideas before. The idea that finance is excessively large due to collusion with the government (policy failure) is probably the most prominent - this is the idea that big banks have the government in their pocket, allowing them to dump their risk onto the taxpayer (through bailouts) while keeping their gains for themselves.

I let the introductory sentence stand. I captured the concept. I scratched out the conclusion. See how much of that paragraph is conclusion?

Almost all of it.

Not Noah's fault. It's not his argument. He's just reporting it. Anyway, it turns out that the paragraph I quoted and scratched out was only half of Noah's paragraph. The rest wasn't even worth scratching out, I guess. But it ended with this line:

Maybe value is being created and we just don't understand it."

Maybe value is being created by what seems to be a bloated financial sector, and we just don't understand it. Noah picks up on that and runs with it. He says there's a lot economists don't know.

Noah says "economists urge caution" and provides an analogy:

As a doctor, you wouldn't say "I can't figure out how this organ is helping the body function, so let's just take it out." Similarly, it would be foolish to say "I don't see how this finance industry is adding value, so let's regulate the heck out of it." We start with the presumption that things are there for a reason - in biology, because evolution put them there, and in economics, because...evolution put them there.

Yeah.

No.

Yeah, evolution turned finance into a bloated monster. No, it wasn't a natural process. It was a process of misunderstanding -- an unintended consequence of economic policies that conflict with each other. Like Cochrane said, more or less.

Oh, no. That was me.

But of course value is being created. Value is in the eye of the beholder. The guys paying for those bloated financial services are the same guys who value them.

The rich guys?

Nope. Us. You know, the borrowers. The ones creating the demand for all those loans. We are the customers that keep the finance industry afloat. Bloated and afloat. We think there's value in it, or we wouldn't do it. Right?

Eh. Not really. The playing field isn't level. All of economic policy is tipped a certain way. And you can tell which way it's tipped by the results we get. For example, we keep accumulating more debt and more debt until we have a crisis. That's natural? Pfft! If it was natural we'd have had the crisis already by 1974. Maybe before that.

The crisis was delayed by policy. Policy did things, unnatural things to extend and preserve the expansion of finance. Policy made unworkable finance workable. But it was still unnatural, and it couldn't last.

And it didn't last. But poor Noah, I guess my explanation is too simple for him. Noah is poking around in the dark with analogy and a stick:

Of course, if the organ explodes and threatens the rest of the body, then you take it out... And if you can, you figure out why this organ, or this industry, tends to explode, and you figure out if there are ways you can prevent an explosion, or see it coming, without creating nasty side effects.

Oh, but then his next sentence is good!:

But the question of whether finance is unstable and tends to explode (and how to deal with that) is very different from the question of whether its compensation is equal to its value added.

Told you: The "value added" question is the wrong question.


Noah spends the balance of his post trying to justify the idea that bloated finance creates value. I lost interest. Dammit, Noah: Value is in the eye of the beholder!


So, what conclusions do I draw, to bring these remarks to an end?