There is one thing...

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

It's really good:

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

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

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

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

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

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

A brief description:

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

Also:

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

And:

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

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

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

They find that policy works. But not always:

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

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

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

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

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

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

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

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

But then, they also say:

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

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

They point out that their result, their

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

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

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

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

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

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

Dammit. They still think like bankers.

Are you high?

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

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

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

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

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

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


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

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

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

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

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

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

You are not alone. In the PDF they note that

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

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

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

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

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


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

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

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

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

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

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

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

Just tell 'em their logic is circular.

Seeing past the aberrations in Debt-to-GDP

Total debt, relative to GDP:

Graph #1: Total Debt relative to GDP

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

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

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

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

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

Something like this:

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

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

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

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


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

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

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

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

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

Where we stand

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

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

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

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

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

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

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

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

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

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

//

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

//

Edward Harrison, 15 Jan 2018:

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

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

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

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

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

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

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

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

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

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

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

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

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

An interesting footnote on the Federal debt

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

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

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

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

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

On raising interest rates

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

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

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

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

How high can rates go before they create another recession?

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

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

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

Here's the graph:

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

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

//

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

 

The "Forgotten Crash" (1966)

Syll shows this graph

and asks: "Time for another crash?"

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

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


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

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

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

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

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

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

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

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

You wanna count what?

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

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

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

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

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

After some preliminary thoughts, he said:

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

Money and labor. Not genitalia.


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

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

My, how the story has changed!

Andy Kiersz, Business Insider, 2 June 2017:

Since about the turn of the millennium, the labor-force participation rate, or the share of American civilians over the age of 16 who are working or looking for a job, has dropped pretty dramatically, with an acceleration in that drop taking place after the 2008 financial crisis and the ensuing Great Recession.

There are several causes for that drop. An August 2015 analysis by the President's Council of Economic Advisers suggests that about half of the drop comes from structural, demographic factors: the baby boomers, an immensely large cohort of Americans, are getting older and starting to retire.

 
David P. Goldman, Asia Times, 11 Jan 2018:

As Professor Edmund Phelps suggests, an aging workforce is more concerned about job security than about wage gains. Americans are retiring later because they are healthier and because they can’t afford to retire, so that the available pool of labor is greater.

 

Interest Cost by Sector

The first graph shows the distribution of interest costs among sectors of the economy.

I want to point out that it's a stacked graph. That means, for example, that the purple sits above the blue, not behind it. And the visible green (the very thin strip located between purple and red) is all there is of the green.

Working from the bottom up: blue shows all government (Federal, state and local) interest cost; purple shows household interest cost; green shows nonprofit institutions; and red shows domestic US business. The unused area above the red shows "other" sectors. Adding that in brings the total up to 100%, all interest paid.

Graph #1: Shares of Total Interest Paid, by Sector

In 1960, where the graph starts, total government share of interest cost (blue) is 22.6%. The household share runs from there up to a little over 50%, so about 30% of the total. The share paid by nonprofit institutions (green) is essentially zero. The share paid by domestic business runs from a little over 50% to a little below 100%, so almost 50% of the total. And "other" starts out in 1960 at around 2% of the total.

FRED calls it "monetary" interest paid in order to distinguish it from "imputed" interest.


At a glance, the dividing lines between sectors run fairly flat. This means that each sector's share of the total is roughly constant. By no means perfectly constant, but roughly. When you think of government debt, you picture it going up, up and insanely up, but you don't see that on this graph.

You don't see government sector interest cost going up up up on this graph, because all the sectors had debt and interest going up up and up. So the shares are roughly constant.

In other words, it is not the debt and interest cost of government that created our economic problems. Nor is it the debt and interest cost of households or nonprofits or domestic businesses (or "other") that created those problems. Rather, it is debt and interest cost in the economy as a whole, rising to too high a level, which created our economic problems.


The second graph shows the interest paid by the same four sectors (omitting "other"), but this time each sector's share is shown as a percent of GDP. Since the 1960s, perhaps earlier, financial cost increases until it makes recession inevitable, then falls for a time, and then increases until it makes the next recession inevitable:

Graph #2: Interest Paid by Sector, as Percent of GDP

Blue is total government, purple is households, and red is domestic US business.


Old Rubber Stamp font by Rebecca Simpson.

Dolts for Better Theory

So let us not talk falsely now, The hour is getting late.

- Bob Dylan

The Washington Post: A black hole for our best and brightest, Jim Tankersley, 2014.

Subtitle/Topic: "Wall Street is expanding, and the economy is worse off for it."

Wall Street is bigger and richer than ever, the research shows, and the economy and the middle class are worse off for it.

Yes. But get a load of the next few sentences:

There’s a prominent theory among some economists and policymakers that says the big problem with the American economy is that a lot of Americans don’t have the talent to compete in today’s global marketplace...

Wait a minute -- That's damned insulting! We don't have the talent? We're dolts?

While it’s true that the country would be better off if more workers had more training — particularly low-skilled, low-income workers — that theory misses a crucial, damaging development of the past several decades.

It misses how much the economy has suffered at the hands of some of its most skilled, most talented workers, who followed escalating pay onto Wall Street — and away from more economically and socially valuable uses of their talents.

It's not that America has no talent, they argue. America has a lot of talented people, but they all went into finance.

Wow. That's just as insulting as the "prominent" theory. I'm a dolt either way.

The non-prominent theory is that talent was drained away from "more economically and socially valuable uses", and absorbed into finance. Really? Morality in hindsight? That's all they got?

And who gets to decide what's "economically and socially valuable"? Then, who gets to decide how the decision-makers are doing? And who watches the watchers? It's all nonsense and drivel and moralistic crap. Worse, it reeks of Big Brother.

The problem is that the demand for finance is overstimulated, largely by policy. The dolts who went into finance made a lot more money than the dolts who didn't. But if the problem is excessive finance, then the dolts who did are part of the problem. And the dolts who didn't, aren't.

But now we revere the finance guys, who made their money by screwing the rest of us. I guess we really are dolts.

The financial industry has doubled in size as a share of the economy in the past 50 years, but it hasn’t gotten any better at its core job: getting money from investors who have it to companies that will use it to generate growth, profit and jobs.

The focus is wrong. I've heard before that finance has doubled in size, and I think that's right. But I think the assertion is wrong, that finance "hasn’t gotten any better at its core job".

My god man, do they really want finance to get better at its job than it already is? Wouldn't it be better to shrink finance back down to the size it was 50 years ago? Of course finance got "better" at its job over the past 50 years. Of course it did. The WaPo article is nonsense.

Why is it hard to understand that simply "being too big" can be a problem? The baby boom is said to have created many problems for the economy. And you can't turn a page these days without reading that increasing the minimum wage creates problems for the economy. But finance? The problem is not that finance is too big, WaPo says, but that it "hasn’t gotten any better". It's a crock.

In 2012, economists at the International Monetary Fund analyzed data across years and countries and concluded that in some countries, including America, the financial sector had grown so large that it was slowing economic growth.

See? Finance is too big. And it's Big Finance that says it. WaPo repeats it, but doesn't listen to itself.

And this:

It’s not that finance is inherently bad — on the contrary, a well-functioning financial system is critical to a market economy. The problem is, America’s financial system has grown much larger than it should have, based on how well the industry performs.

"Not inherently bad". That's morality again. Moral superiority. We're trying to do econ here. Stop wagging your finger and start thinking about cost.

"A well-functioning financial system is critical to a market economy." The bleedin' obvious, Basil Fawlty would say.

"The problem is, America’s financial system has grown much larger than it should have". Yes, that's it exactly. And they should end the thought right there. But no; they put a condition on it:

"... larger than it should have, based on how well the industry performs."

Based on how well the financial industry performs ?

How about, based on how well the economy performs. Finance isn't free. Everything they do has a cost, regardless of how well the financial industry performs. Assume a best-case scenario: everything finance does is top-notch. It still has a cost. And the more finance does, the more is the cost of finance.

Here, let me dumb it down for you:

If finance has grown faster than GDP -- and the article says it has -- then the cost of finance has grown, relative to output. In other words, finance pushed prices up.

Holy crap: Cost-push inflation! And they said it couldn't happen.

Keynes on Excessive Finance

From Chapter 8, Section IV of the General Theory:

We cannot, as a community, provide for future consumption by financial expedients but only by current physical output. In so far as our social and business organisation separates financial provision for the future from physical provision for the future so that efforts to secure the former do not necessarily carry the latter with them, financial prudence will be liable to diminish aggregate demand and thus impair well-being ...

"Non-financial" in name only

Nonfinancial corporate businesses -- the ones that produce and service real output -- own financial as well as non-financial assets. Back in the 1950s and '60s, their financial assets were a bit less than a quarter of all their assets. Today, financial assets are a bit less than half their assets. The financial share has doubled.

Graph #1: Financial Assets as a Percent of Total Assets, for Non-Financial Corporations

The financial share of assets ran low in the 1950s, then increased gradually until the early 1980s. Thereafter, the financial share increased rapidly until the 2001 recession, when it appears to have hit a hard upper limit.

The change from slow increase to rapid increase suggests that the change was induced by a change in policy, perhaps tax policy, in the early 1980s.

The fact that the graph shows unrelenting increase suggests that the asset holders prefer financial to non-financial assets. Perhaps the returns are higher for financial assets. Perhaps the returns are lower but the convenience of not having to produce physical output adds value to returns from financial assets. Either way, as the graph shows, financial assets have increased as a share of all assets of nonfinancial corporate business.


Dirk Bezemer and Michael Hudson:

The financial sector does not produce goods or even “real” wealth. And to the extent that it produces services, much of this serves to redirect revenues to rentiers, not to generate wages and profits.

Like the financial sector, the financial assets of non-financial corporations do not produce goods or "real" wealth, and largely serve to redirect revenues away from wages and profits.

Repetition helps

Household debt: recent developments and challenges (PDF) by Anna Zabai of BIS.

From the abstract:

In a high-debt economy, interest rate hikes could be more contractionary than cuts are expansionary.

From the main text:

Monetary policy is likely to have asymmetrical effects in a high-debt economy, meaning that interest rate hikes cause aggregate expenditure to contract more than cuts would cause it to expand (Sufi (2015)).

From the conclusion:

Monetary policy could have asymmetrical effects in an economy with high levels of household debt, meaning that an interest rate hike would be more contractionary than an equally sized rate cut would be expansionary.

When I was reading the conclusion of the paper, the concept finally hit home:

To get equal upward and downward effects from changes in rates, you need smaller rate hikes and bigger rate cuts. In short, high levels of debt push interest rates down.

Anna Zabai of BIS on Household Debt

https://www.reddit.com/r/Economics/comments/7j5pv9/household_debt_recent_developments_and_challenges/

https://www.bis.org/publ/qtrpdf/r_qt1712f.pdf

Household debt: recent developments and challenges (PDF) by Anna Zabai of BIS. From the abstract:

Financial institutions can suffer balance sheet distress from both direct and indirect exposure to the household sector... In a high-debt economy, interest rate hikes could be more contractionary than cuts are expansionary.

The second part of that excerpt is interesting: asymmetry in monetary policy. Also, by implication, in a low-debt economy interest rate hikes could be less contractionary than cuts are expansionary. This could perhaps mean that there is a middle ground where hikes and cuts are symmetrical. In other words, a Laffer curve for debt and growth, again.

The first part of the excerpt exposes the paper's focus on household debt. This is myopia. In our most recent crisis, household debt was the problem (let's say). Therefore, household debt is always and everywhere the problem, and is the only private-sector debt problem worthy of discussion.

No.

Debt lets households smooth shocks and invest in high-return assets such as housing or education, raising average consumption over their lifetimes. However, high household debt can make the economy more vulnerable to disruptions, potentially harming growth.

Here's the thing: The cost of debt is potentially harmful to growth. Therefore, debt is potentially harmful to growth. Therefore, household debt is potentially harmful to growth. I don't have a problem with saying household debt is potentially harmful to growth. But I have a serious problem with a failure to say that not only household debt is potentially harmful to growth. And it should be obvious that the problem is cost. But it doesn't seem to be obvious -- and not only in this BIS paper.

In order to assess the implications of elevated household debt levels, it is crucial to have a sense of whether households can bear the resulting debt burdens without resorting to large adjustments in consumption should circumstances worsen.

Good sentence.

One might add that the implications of elevated business debt levels can be assessed by its effect on the cost of value added, and probably on the price of traded shares of stock.

One might add also that the implications of elevated financial business debt can be assessed by the risk of onset of financial crisis.

One might add a word on public debt also. Because public debt has a cost, too. However, public debt growth (at least since Keynes) is generally a response to problems arising from private debt. The notion that the economy can be improved by reducing public debt (while ignoring private debt) is most foolish.

If all the noise about the Federal debt was redirected to the concept of reducing the need for Federal debt by reducing the amount of private debt, our economic problems could be solved in a matter of minutes.

Aggregate Demand & Irony:

From an aggregate demand perspective, the distribution of debt across households can amplify any drop in consumption. Notable examples include high debt concentration among households with limited access to credit...

Without limited access to credit, the high debt concentration would get even higher. Therefore, increasing access to credit is not a solution to this problem. Unfortunately, increasing access to credit is a standard tool of policy. That's what got us in trouble in the first place. Isn't it obvious?

Pure Irony:

Monetary policy is likely to have asymmetrical effects in a high-debt economy, meaning that interest rate hikes cause aggregate expenditure to contract more than cuts would cause it to expand (Sufi (2015)). This is because credit-constrained borrowers cut consumption a lot in response to interest rate hikes, as their debt service burdens increase. However, they do not expand it as much in response to cuts of equal magnitude. They prefer to save an important fraction of their gains so as to avoid being credit-constrained again in the future...

(Bold added. Irony in the original.)

A little something for the supply side guys:

From an aggregate supply perspective, an economy’s ability to adjust via labour reallocation across different regions can weaken if household leverage grows over time.

Here ya go:

A growing body of evidence points to the existence of a “boom and bust” pattern in the relationship between household debt and GDP growth (Mian et al (2017), Lombardi et al (2017), IMF (2017)). An increase in credit predicts higher growth in the near term but lower growth in the medium term.

Of course! And regarding the second sentence there, note that "An increase in credit" is an addition to debt. The reason you get "higher growth in the near term" is that the increase in credit translates into extra spending (in the near term). The reason you get "lower growth in the medium term" is that the extra spending has dissipated by then, and you're just left with the extra cost of the additional debt. Isn't it obvious?

This boom-bust pattern appears to be robust across different samples. Table 2, following Mian et al (2017), takes a first stab at exploring the relationship between household debt and GDP growth by looking at correlations.

A first stab? Maybe it isn't obvious.

The first row confirms the existence of a boom-bust pattern. Higher debt boosts growth in the near term but reduces it over a longer horizon.

Is it obvious now?

Elevated levels of household debt could pose a threat to financial stability, defined here as distress among financial institutions.

Just a reminder: Our recent crisis was related to household debt (let us assume). But that does not mean that other private sector debt is not also a problem.

Their thought continues:

In most jurisdictions, this is chiefly because of sizeable bank exposures. These exposures relate not only to direct and indirect credit risks, but also to funding risks.

The problem arises, in other words, not only from the risk of household defaults, but also from problems with the banks' own funding. So you can blame the households for borrowing too much. But you must blame the lenders for putting themselves at risk. And you must blame policy, for putting our economy at risk.

Irony, again:

Financial stability may also be threatened by funding risks (Table 1, column 7). In Sweden (as in much of the euro area), banks fund mortgages by issuing covered bonds, which are held primarily by Swedish insurance companies and other banks. This network of counterparty relationships could become a channel for the transmission of stress, as any decline in the value of one bank’s cover pool could rapidly affect that of all the others.

So it goes.

Okay. We finally get to private debt other than household:

This discussion suggests that household-based credit measures could be good predictors of systemic banking distress, much like broader credit measures (eg Borio and Lowe (2002), Drehmann and Juselius (2014), Jordà et al (2016)).

Borio. Borio is my buddy. (I don't think he knows it, though.)

The next sentences are worth repeating:

Among these [credit measures], the credit gap – defined as the difference between total credit to GDP and its long-term backward-looking trend – and the total DSR are of special interest. While the credit gap is typically found to be the best leading indicator of distress at long horizons (eg Borio and Drehmann (2009), Detken et al (2014)), the total DSR provides a more accurate early warning signal closer to the occurrence of a crisis (Drehmann and Juselius (2014)). Going forward, establishing the predictive performance of an appropriately defined “household credit gap” and of the household DSR seems especially relevant.

The "credit gap" is an interesting concept. Expect to see more on that, on this blog.


The conclusion of the paper is not satisfying. Well, I take that back. This part is interesting:

Monetary policy could have asymmetrical effects in an economy with high levels of household debt, meaning that an interest rate hike would be more contractionary than an equally sized rate cut would be expansionary.

I missed it before: To get equal up- and down-effects from changes in rates, you need smaller rate hikes and bigger rate cuts. What they are saying is that high levels of debt push interest rates down. High debt levels may also reduce the "natural" rate of interest, if there is such a thing.

That's interesting.

The rest of the conclusion, maybe not so much:

Central banks and other authorities need to monitor developments in household debt...

Macroprudential instruments such as loan-to-value caps (on the borrower side) or credit growth caps (on the lender side) are designed to force borrowers and lenders to internalise the impact of large credit expansions on the probability of a systemic crisis, thereby aligning private and social incentives. If these measures do succeed in stemming household credit growth, thus containing debt levels, they would also afford central banks greater future room for manoeuvre in setting monetary policy.

With apologies to Anna Zabai: Too intent a focus on household debt. Not enough concern with the "broader credit measures". I understand that the paper is specifically about household debt. And if the lessons learned here are woven into a tapestry of concern for debt in general, there is much of value here. But please don't forget about the rest of the debt.

Please don't forget about the rest of the debt.

US Population back to 1929

POP, FRED's number for Total US Population, only goes back to 1952. But FRED does show both Real disposable personal income and Real Disposable Personal Income: Per Capita, annual data, going back to 1929.

Divide the one by the other. Multiply by a million to make the units match POP. Now you've got US Population all the way back to 1929:

Graph #1: US Population back to 1952 (red) and back to 1929 (blue)

It's not perfect. Usually on "comparison" graphs like this, the red line is centered on the blue. In this case, the bottom edges of the lines are aligned. FRED's POP number is ever so slightly less than my number. Rounding, maybe. But hey, it's close enough for me. For now.

Show it as "percent change from year ago" values, and there is the baby boom! Wow:

Graph #2: Growth Rate of US Population since 1930; Baby Boom highlighted

The growth of RGDP relative to RGDP per Capita shows a similar pattern, but only starts between Batman's ears. You don't get the full effect.

Households and Hedge Funds

See Note 1

"The eye that looks ahead to the safe course is closed forever."

- Paul-Muad'Dib

I've been reading Tim Taylor more, lately. I think I finally realized how good he is. From his 1 Jan post, quoting Adam Smith:

We trust the man who seems willing to trust us. We see clearly, we think, the road by which he means to conduct us, and we abandon ourselves with pleasure to his guidance and direction... We are afraid to follow the man who is going we do not know where.

And from his 1 Jan 2015 post, quoting John Courtney Murray:

The immediate situation is simply one of confusion. One does not know what the other is talking about. One may distrust what the other is driving at. For this too is part of the problem—the disposition amid the confusion to disregard the immediate argument, as made, and to suspect its tendency, to wonder what the man who makes it is really driving at.

In sum, we will not follow a man if we don't know where he is going. We fear he wants to take us somewhere we don't want to be.


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

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

I understand. Cochrane says to start out by telling people where you are going to end up. I think it's great advice. It reminds me of a something from a book my parents gave me back in 1956, Exotic Aquarium Fishes by William T. Innes. I was seven. It was my favorite book for years and years. The book is gone now; I lost it when we moved. I'll paraphrase.

Innes quoted an old preacher explaining why his sermons were so good:

First I tell 'em what I'm gonna tell 'em. Then I tell 'em. Then I tell 'em what I told 'em.

I still remember that advice. I understand perfectly well. But I cannot do it. I can't put the punchline up front.

I like to present a chain: First this, then this, then that. The "this" and "this" should be obvious, and the "that" is where they lead me. But "that" comes at the end, because it is the destination. It's where I'm getting to. It's not where I'm starting from. Can't help it.


Start with things you know, and keep going until you get to something you don't know. Then see if you can figure it out. That's Descartes. To me, that's science.

If I start with the answer, then you'll know where I'm going right from the start. Maybe you'd trust me more and fear me less, as Adam Smith suggests. Maybe.

I don't think it's fear. Maybe distrust: You don't know where I'll take you, and you don't want to end up in a place you don't want to be. You wouldn't want to be stuck having to say something nice about Donald Trump, for instance. And if I don't put the punchline up front, there is always a chance that you might agree with something I say, and only later find out it says something nice about Trump.

Heaven forbid.

Maybe you wouldn't want to agree that the explosion of Federal debt started long before 1980, or that the gap between productivity and pay opened up well before 1974. That could take you out of your comfort zone. But the economy doesn't care about your comfort zone. And me, I'm with the economy.

If the explosion of Federal debt didn't start well before 1980, the numbers would show it. If pay didn't start falling behind productivity until 1974, the numbers would show it. So would I.

You want to go with 1980 for the explosion of debt, and 1974 for the productivity-pay gap, yeah, that's fine. Look up somebody who puts his answer first and then provides all the evidence that fits.

I'm not disagreeable on purpose. I just tell you what the numbers tell me.


Conservatives spend their time understanding how the economy works. Liberals don't.

Conservatives think the economy is a system, and that if you understand the operating principles you can shoot down the liberals. Liberals secretly think the conservatives are right. They think that if you understand the operating principles of the economy you are led inescapably to conservative conclusions.

In order to avoid the conservative conclusions, liberals avoid trying to understand the economy altogether. They go so far as to deny that the economy is a system. They pretend you can pass laws to create whatever outcomes you want. Need higher wages? Raise the minimum wage. More hours of daylight? Pass a law to make the sun set later.

Here's the thing. Yeah, the liberals are wrong. But they are wrong in thinking that if you understand the operating principles of the economy you are led inescapably to conservative conclusions. That's what they have wrong.

Conservatives get to conservative conclusions because they are conservative. If liberals would begin by accepting that the economy is a system complete with operating principles, and follow the logic where it leads, liberals would get to liberal conclusions as surely as conservatives get to conservative ones.

And then, the discussion would at least have a logical base.


Now really: If I told you the ending at the start, would you have read this thing?

Two sides to every story // Not Investment Advice

Jeremy Grantham:

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism.

If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.

Grantham probably means you should expect profit margins to come down, which will hurt stocks.

To me, the important thing he's saying is there is something wrong with the system.

Grantham was quoted in an article dated October 2015, now more than two years ago. Here's corporate profits as a percent of GDP thru the third quarter of 2017:

Graph #1: Corporate Profits as a Percent of GDP
Not the best context for profit, but I have nothing else handy

No mean reversion yet. Profits are half again as high as they were in the 1950s and '60s. Twice as high as in the '80s and '90s. No mean reversion yet.

How long do we have to wait for the mean to revert, before we can safely say there is something wrong with the system ?

//

More recently, Grantham is still pushing the same story. Bloomberg, 3 Jan 2018, reports:

Grantham cited the recent acceleration of U.S. equity prices, a concentration of leadership in stocks and growing media coverage of events such as bitcoin’s surge and Amazon.com Inc.’s success as signs that the final phase of a bubble could be coming in the next six months to two years.

Another two years?

I grabbed some stock market performance data from FRED:

Graph #2

It's not price/earnings ratios or anything like that. It's just numbers from FRED. But if you look at where the purple and green lines were from 1975 to about 1987, and draw a straight line thru that, you come out right on top of the red line. Purple and green are now well below the red.

That doesn't mean a lot, because if the economy deteriorated you would expect the green and purple to be lower than what an old trend predicts. Still, by this measure, stocks are not outrageously high.

The graph uses a log scale. That's why the trends are straighter than you might expect.

The only "bubble" I can see on the graph shows up as purple gaining on green between 1995 and 2000. I don't see anything like that happening now.

Benefit of the doubt? Maybe purple is gaining on the other lines in the last few years. Maybe. It could be like the first couple years after 1995 when that bubble was just getting started.

Hey, I'm not a stock market guy. (Buy green, sell purple?) But my impression is still that, except for the one bubble in the 1990s, it's pretty much a straight-line increase. The recent years don't look like another bubble to me.

It looks to me like Grantham is repeating the mantra that gave him name recognition. Bloomberg:

Grantham, 79, is best known for his accurate prediction in 2000 that U.S. stocks would lose ground for the next decade.

Me, I'm sticking with my prediction of economic vigor, the thing that's going to give me name recognition. Financial costs are down, and that frees up money to be spend on things other than debt service. I expect that money to be spent on stuff that counts in GDP and puts people to work. You know, like a normal economy when it is doing well.

I could be wrong. Grantham could be right. But if we don't get economic vigor like we had in the latter 1990s (perhaps along with a bubble like we had in the latter 1990s) then Grantham is definitely right: something has gone badly wrong with capitalism.

Labor Share as Index and as Percent

Labor Share as INDEX:

Graph #1

Labor Share as PERCENT:

Graph #2

Looks a lot higher as an index, no?

"Inequality is a symptom"

Remember when we mixed metric and English units back in 1999 and crashed our Mars orbiter? The universe didn't care.


At Quartz: A Nobel Prize-winning economist thinks we’re asking all the wrong questions about inequality, 27 December 2017:

America is trying to come to terms with its economic inequality. Does inequality spur growth or kill it? Is it a necessary evil—or necessarily bad? Angus Deaton, an economics professor at Princeton, and the recipient of the 2015 Nobel Prize in economics, is asked questions like these all the time—and he doesn’t see the point.

“These are questions I am often asked,” Deaton writes in a column (paywall) for Project Syndicate. “But, truth be told, none of them is particularly helpful, answerable, or even well posed.”

Deaton believes the biggest misconception about inequality is that it causes certain economic, political, and social processes. But that’s backward. Economic inequality is a symptom ...

That's right. For people, inequality may be a problem. But for the economy inequality is just the way things worked out, given the policies and policy errors (GASP! Did I really say that?) of the last 40 years and more.


28 Feb 2011, The Usefulness of Good and Bad:

unemployment and foreclosures are problems for people. Not for the economy. If you want to fix the economy, you have to look at the economy’s problems.

You have to look for the things that produce the results you don't like. You have to track down causes. Why do you think I have so many posts saying "the debt didn't 'explode' after 1980", and so many posts about the gap between productivity and compensation, and stuff like that? Because that explosion and that gap and that stuff typically started long before 1980, long before 1974, long before the dates people usually identify as the start of those problems.

Sure, because people identify it as a problem when it becomes a problem for people. But if you want to fix it, you have to look back in time to when it was first a problem for the economy. You have to see the birth of the problem, and then you know what to fix.


21 May 2016, Self-correcting? What do you mean by that?:

I say things like: Jobs? You think 'jobs' is the problem?? Okay. But it's our problem. A problem for people. It's not a problem for the economy. If you want jobs from the economy, you have to give the economy what it wants.

I say things like: The economy does not care about inflation or unemployment. Those are not problems for the economy. They are problems for people. For the economy, they are simply ways to correct imbalances.

I say things like: We should use policy to keep the ratio of private debt to public debt at a low level, a level where the economy constantly wants to grow vigorously.

The economy doesn't care that you don't like inequality and unemployment and slow growth. It doesn't care about such things. If you want to fix those things, you have to do it by tweaking things the economy does care about.

Wages and Salaries arising from Government Employment

BEA data from Table 1.12 at FRED, National Income by Type of Income: Compensation of Employees. In particular: wages and salaries arising from government employment, as a percent of wages and salaries arising from all sources:

Graph #1: Wages and Salaries arising from Government Employment

From 14% of total in the late 1940s, rising to 21% in the early 1970s, but falling since that time, and below 17% as of 2014. Government's share of wages and salaries has been falling since 1975.

That's gonna be all levels of government, not just Federal.

"Never Confuse Them Again"

Heh, look at me, I'm trying to get people to see the differences between private debt and public. Fat chance. There are still people, a lot of people apparently, who can't tell the difference between an existing debt and an addition to debt.

It's a good thing I write for my own satisfaction. Sometimes there doesn't seem much hope of achieving anything else.