Something old, something new, something borrowed...

There's a commonly used phrase -- debt and deficits -- that is sometimes a source of confusion. But there is a simple difference between "debt" and "deficit." A deficit represents new borrowing. Debt is the total amount of borrowing accumulated and not yet repaid.

"Debt" is old debt. "Deficit" is new debt. That's the significant difference.

But I don't care about the phrase "debt and deficits." Everybody else has talked that to death. I want to focus on the descriptive words new and old. New debt is a use of credit that boosts economic activity in the current year. Old debt is a measure of the hangover from credit-use. It burdens economic activity every year thereafter, until it is paid off.

If a new use of credit is yin, then the resulting debt is yang. If a new use of credit is a bonus for economic growth, the resulting debt is a penalty. New debt is not the problem. Failure to repay debt is the problem. Debt management is the problem.

The little graph shows the annual addition to "credit market debt outstanding" as a portion of the total. The addition is almost never more than ten percent of total. 90% of our debt is old debt. If we want to cut debt, there's plenty of old debt to cut.

If we want to reduce the size of the finance industry, we can cut old debt.

Every problem is an opportunity. For any number of reasons, we want to reduce debt.
Well, we are in luck. There is plenty of debt to reduce. Plenty of opportunity. We just need to abandon debt accumulation as a policy, and adopt a policy of debt repayment in its place.

Debt Management

I discovered "debt management" in December, 1992, in the Encyclopedia of Economics. According to that book, debt management is a strategy used by national governments and others who wish "to maintain a permanent total volume of debt."

"To maintain a permanent total volume of debt."

Let's put that in perspective. In his 1996 book The Truth about the National Debt, Francis X. Cavanaugh -- "the senior career executive responsible for debt management policy advice in the Treasury Department" -- wrote:

"We have never raised the taxes needed to pay off the World War II debt and probably never will; we just keep rolling it over, refinancing with issues of new Treasury securities to replace the old securities as they come due."

Rolling it over, not paying it off. That's how debt accumulates. It's why debt needs to be "managed." But debt accumulation and debt management didn't begin in the 1990s. Thirty years earlier, Time magazine observed that people no longer expect

"that Government will ever fully pay off its debt, any more than General Motors or IBM find it advisable to pay off their long-term obligations; instead of demanding payment, creditors would rather continue collecting interest."

Creditors would rather continue collecting interest. As Oscar Wilde said, "It is better to have a permanent income than to be fascinating."

Permanent income. Perpetual debt. The Skeptical Optimist summarizes the notion of debt management:

This is perfectly sound financial practice. Successful businesses roll over their long-term debt all the time, just as the federal government has been doing for generations.

Everybody thinks accumulating debt is okay. And, well, it is okay, until it becomes a problem.

Maintaining a permanent total volume of debt. Rolling it over. Refinancing. Providing a permanent income to our creditors. Debt management, they call it. An ironic term, surely. Like methadone maintenance, it keeps us on the stuff forever.

I Love My Job

I get to sit at a desk, use AutoCAD all day, and draw. (And they call this work!) And I create little utility programs in VBA, hook them up to toolbar buttons, and use those buttons to make my job faster and easier. Maybe not everybody would like this job. But I sure do.

I don't work for a company that makes drawings. I work for a company that makes stuff out of wood and metal parts. My job is to find out what the boss wants, or what the customer wants, and translate that into something useful for the guys in the shop, the guys who create the stuff we sell.

My job, really, is to make it faster and easier for the company to produce the stuff we produce. I don't produce the stuff myself. I facilitate production.

You have to know by now. This post is some kind of analogy. Yep: I'm like the finance industry, producing paper that helps the work get done.

In our economy we have the productive sector and the finance sector. The finance sector is like me, producing paper that facilitates production. The productive sector is like our shop, where the real work gets done.

My boss could decide to close the shop, and produce drawings for other companies instead. That would make our company like... like the Cayman Islands, say, where the only industry is finance. Some companies do that. But not every company can do it. If nobody's making things, then nobody needs the paper.

There has to be balance between production and facilitation, production and finance. If too many guys are making drawings in our economy, some will go out of business. That's the "invisible hand" at work.

But the invisible hand doesn't seem to work for finance. When Ford makes more money financing cars than it does making cars, it's a sign that finance plays too big a role.

For some reason when we get too much finance, finance becomes more profitable than production. This draws more people and more money into finance and makes the imbalance bigger. The imbalance grows until it is unsustainable.

And then you get a financial crisis.

If this is true -- if the imbalance between finance and production creates serious economic problems -- then there must be a Laffer Limit for finance. There must be a point at which continuing to do the same thing begins to have the opposite effect.

There must be a best point, or a best range, where we have just the right balance between finance and production. That is the point where finance facilitates the most production. Increase finance a little more, and the cost of finance begins to add too much to the cost of doing business. And then economic growth will be less than expected -- except in the finance industry.

I couldn't begin to guess what the perfect-balance point would be. But I know we have too much finance per unit of production. So I say set a target: shoot for cutting debt by half. Shoot for cutting finance in half. Simon Johnson of The Baseline Scenario says the same. He thinks finance should be about 4% of GDP, not 8% as it is today.

The Laffer Limit

I woke up at 4:30 this morning with the phrase "Laffer Limit" in my head. So I googled it. Google turned up 38 hits, but only listed 14. The rest were "very similar."

Of the 14, 9 had the word tax (or taxes or taxation) in the text displayed along with the search results. One of the others had the phrase "the top rate on earned income." And one contained "not a moral license for government to take as much as it can." So eleven of 14 hits -- 78.6% -- are immediately identifiable as related to tax issues.

Of the remaining three, one is a URL with no text. One concerns the passing of Robert Novak. And one links to a Google book. I'm betting these three also associate the phrase "Laffer Limit" with taxes. That would make all of the results tax-related.

The Laffer Curve was all about taxes. It was a sort of shared experience, a simple, profound analysis that we intuitively understood, and it held out the promise of lower taxes.

The Laffer Curve was all about taxes. But the Laffer Limit is a practical maximum. In one of those Google hits, J.H. Cochrane refers to "the 'Laffer limit' of taxation." That suggests there can be Laffer limits on things other than taxes.

If you are a government trying to raise revenue, increasing the tax rate brings in more revenue up to a point; beyond the Laffer Limit it brings in less revenue.

If you are a gardener fertilizing your flowers, adding more fertilizer improves the garden up to a point; beyond the Laffer Limit it starts ruining the garden.

If you watch an economy using credit for growth, using more credit increases growth up to a point; beyond the Laffer Limit it starts ruining the economy.

The Laffer Limit refers to the notion of a practical maximum.


Laffer Limit: The point at which continuing to do the same thing begins to have the opposite effect.

Updated 30 Jan 2010

Simon Says...

Allow me to repeat part of Simon Johnson's statement (from Thursday's post):

The issue is not finance per se, i.e., the process of intermediation between savings and investment. This we obviously need to some degree. But do we need a financial sector that now accounts 7 or 8 percent of GDP?

In other words: We need finance. But we don't need it to be such a big part of our economy as it is today.

I agree.

Here, from a year-old post by ContraHour on Seeking Alpha, is a glance at how big finance has become:

The topmost trend-line shows the accumulation of total debt. At the right-hand side, the next one down from the top is "Domestic Financial," equivalent to Simon Johnson's "modern finance."

At the right-hand side, the most recent numbers show domestic financial debt is the biggest component of the debt. At the left-hand side, the oldest information shows domestic financial debt as the smallest component. Clearly, domestic financial debt has been the fastest-growing component of debt.

Finance is the cancer.

The Larger Problem

This is a follow-up to yesterday's post, which took brief excerpts from a post by Simon Johnson of the Baseline Scenario. Here's the complete post by Simon Johnson, and my thoughts along the way:

The Nature of Modern Finance

Is modern finance more like electricity or junk food? This is, of course, the big question of the day.

If most of finance as currently organized is a form of electricity, then we obviously cannot run our globalized economy without it. We may worry about adverse consequences and potential network disruptions from operating this technology, but this is the cost of living in the modern world.

On the other hand, there is growing evidence that the vast majority of what happens in and around modern financial markets is much more like junk food – little nutritional value, bad for your health, and a hard habit to kick.

Really?? We're talking about the roots of most serious economic problem in eight decades here, and we're comparing finance to electricity and junk food? Simon Johnson's "big question of the day" -- What a disappointment!

Not to be rude, but it's no wonder we can't solve our economic problems. We can't even discuss those problems intelligently. You would never -- never -- find Adam Smith or Alexis de Tocqueville or John Maynard Keynes using such dumbed-down comparisons.

"Electricity" is a necessity. "Junk food" is a problem. Neither "necessity" nor "problem" is a technical term. Neither requires that readers be coddled. I don't mean to criticize Mr. Johnson's writing style. But ideas are expressed in words. The better the words, the better the expression.

Is modern finance a necessity or a problem? That's a better question, but still not a good one. Unfortunately, modern finance is both a necessity and a problem.

That is the larger problem.

The issue is not finance per se, i.e., the process of intermediation between savings and investment. This we obviously need to some degree. But do we need a financial sector that now accounts 7 or 8 percent of GDP? (For numbers over time, see slide 19 in my June presentation.)

We "obviously" need "some" finance in our economy, Johnson says. He is concerned about excessive finance, as I am concerned about the excessive reliance on credit. It's the same concern. We should see eye-to-eye on this.

As far as we know, finance was about 1 or at most 2 percent of GDP during the heyday of American economic innovation and expansion – say from 1850. The financial system of the nineteenth century worked well, in terms of mobilizing capital for new enterprises.

Ah, but modern finance does not exist solely for the purpose of "mobilizing capital for new enterprises." As I said on the 15th:

Used to be, we'd use credit for growth. And for special circumstances.
Now we use credit for everything.

Modern finance. The mature economy. Excessive reliance on credit. We use credit for everything, and that creates problems.

For some reason, Mr. Johnson can only almost see this larger problem.

Those banks had much higher capital-asset ratios than we have today. Even the dominant players were smaller in absolute terms and relative to the economy – JP Morgan, at his peak, employed less than 100 people.

No one is suggesting we go back to the nineteenth century (although abolishing our central bank would certainly have undesirable consequences in that direction). But is it really healthy – or even sustainable – to have a finance sector as large as what we face today? (It is surely not a good idea for finance to account for 40 percent of total corporate profits, see slide 16 – such performance, in an intermediate input sector, suggests someone else in the economy is being severely squeezed.)

Someone else is being squeezed. This is such an important point. It ought to be emphasized, not buried at the bottom of a paragraph that spans centuries with three dashes, two sets of parentheses, an unanswered question, and one technical drizzle of syllables ("an intermediate input sector").

Someone else is being squeezed. In other words, the profit flowing into finance is flowing out from somewhere. (Profit is income, by definition.) Income elsewhere in the economy is less, because profits are so great in the financial sector. In the twelve pages I wrote:

The growing cost of interest [in the economy as a whole] left less to divide up as wages and profits. Wages and profits both suffered as a result.

Simon Johnson speaks of "profit" where I write of "cost." He speaks of the "financial sector" where I write of "interest" as a factor cost. Our words differ, but we describe the same phenomenon. We see the same problem: excessive reliance on credit.

There is a great deal of research that finds finance is positively correlated with growth, but this work has a couple of serious limitations – if you want to derive any robust implications for policy.

First, it is about the amount of financial aggregates (e.g., money or credit, relative to GDP) rather than the share of financial sector GDP in total GDP. I know of no evidence that says you are better off with a financial sector at 8% rather than, say, 4% of GDP.

Johnson objects to research that looks at not-quite-the-right numbers. He objects to evaluating "money or credit, relative to GDP." He prefers to look at "financial sector GDP." But as credit-use grows, so grows the financial sector. I think the objection here is minor. (It matters to me, because my oft-repeated "excessive reliance on credit" is probably a financial aggregates thing.)

Second, the research shows correlations not causation. So all we really know is that richer countries have more financial flows relative to GDP, not that more finance raises GDP in any linear fashion. Attempts to dig into causation tend to show that financial development is not the bonanza that it is cracked up to be.

Third, we know finance can become “too big” relative to an economy. Ask Iceland.

Ask Iceland? (I guess I do object to Simon Johnson's writing style, after all.)

The work in this area is still at any early stage. Given what we’ve seen over the past 12 months, which way should we lean: towards believing in the positive power of finance, until the opposite is proven; or towards being skeptical of finance in its modern form, until we see evidence that this actually makes sense?

I can't believe he says "The work in this area is still at any early stage." I can't believe he's only looking back "over the past 12 months." And I can't believe he offers only the two absurd extremes: "believing in the positive power of finance, until the opposite is proven," or disbelieving in the positive power of finance, until the opposite is proven.

The extremes are the problem, after all.

Too much is too much. Yes, finance is good, but too much finance is not good. People know this. People have been up in arms about debt since the 1980s. People know when it is too much. But Simon Johnson, the "authority on financial crises," is considering only the past twelve months. And he's saying the work is still at an early stage.

Surely out skepticism should extend to financial innovation. Show me the evidence that this kind of innovation really adds value, socially speaking – rather than providing a very modern way to extract amazing “rents”.

By Simon Johnson


I'm just disappointed, that's all. I finally find a guy who has been nose-to-nose with the economic problem. But it turns out he doesn't know what the stink is.

Yeah, idunno

I read somethin' the other day, online somewhere. Somethin' like this:

Finance accounts for 8% of GDP, but 40% of the profits.

It's not new news, but it finally clicked for me. So I spent an hour trying to track down the source, to no avail. But along those same lines, I did find this:

Profits from the financial sector comprise an even larger percentage of our GDP since the crisis erupted. Johnson thinks their share of corporate profits, which was an astonishing 40% in 2003, may actually be higher now, given that the rest of the economy is in bad shape. Banks have doubled their share of GDP to 8% from 4%, he said.

-- from an article by Jennifer Schonberger (October 8, 2009) at The Motley Fool. The Johnson noted therein is Simon Johnson:

Johnson is an authority on financial crises like this one. He's the former chief economist of the International Monetary Fund, a professor at MIT's Sloan School of Management, a senior fellow at the Peterson Institute for International Economics, and co-founder of The Baseline Scenario.

And then there is The Nature of Modern Finance at The Baseline Scenario, written by Simon Johnson (September 1, 2009):

But is it really healthy – or even sustainable – to have a finance sector as large as what we face today? (It is surely not a good idea for finance to account for 40 percent of total corporate profits... – such performance, in an intermediate input sector, suggests someone else in the economy is being severely squeezed.)

And this:

I know of no evidence that says you are better off with a financial sector at 8% rather than, say, 4% of GDP.

So, yeah, finance accounts for 8% of the GDP, and 40% of the profits. The evidence comes from Simon Johnson, from the Baseline Scenario, and the Motley Fool. But the organizing of the evidence in a striking way waited for the blogger whose work I could not find a second time.


I would have thought finance was more than 8% of GDP. Still, it's twice what it was. That's significant. And if you figure none of the lending counts in GDP -- only the wages and salaries of people in the finance business count -- then, yeah, that's one healthy chunk of GDP.

An unhealthy chunk, rather.

I'd call it excessive reliance on credit. Oh yeah, I do call it that.

Pahl-uh-See

Economic pahl-uh-see.

The purpose of policy is to change the economy.
Economic changes are often the result of policy.
Not always, but often, policy is the cause of change.

Is the economy different today? Policy may be the cause.

Consider the changes.
Not only the changes we like.
Not only the changes we want.
All of the changes -- any of the changes -- may be a result of policy.

Consider this:
Things we don't like about our economy may be unintended consequences
of economic policy.

Nuff said?

apropos of... interesting

From False Economy by Alan Beattie. (Chapter 7)

The telegraph and railroad developed together, the lines running alongside one another. In 1849, the New York and Erie Rail Road pioneered the use of the telegraph to control running operations. Five years later it was standard practice among the railroad companies.

These twin technologies, incidentally, helped establish their own standardization, including one of the most fundamental of all measurements: time. In the mid-nineteenth century there were more than two hundred different local times in the United States. Towns might be only a few minutes ahead or behind the time in the next town along. Even the American railroad companies used a total of some eighty different times, since journeys took so long that there was plenty of opportunity for people to change their watches. As railroad travel quickened and expanded, the potential for confusion multiplied, and in 1883 the railroads imposed a uniform system of time, with the four time zones that persist today: Eastern, Central, Mountain, and Pacific.

The railroads imposed it.