The ideas that credit use is good for growth and that interest rates can be used to manage growth, which together form the primary principle of policy, are undermined by the fact that the effects of accumulating debt are nonlinear.
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The primary principle of policy is identified by Cecchetti, Mohanty and Zampolli in their 2011 paper The Real Effects of Debt:
"As modern macroeconomics developed over the last half-century, most people either ignored or finessed the issue of debt. With few exceptions, the focus was on a real economic system in which nominal variables – prices or wages, and sometimes both – were costly to adjust. The result, brought together brilliantly by Michael Woodford in his 2003 book, is a logical framework where economic welfare depends on the ability of a central bank to stabilise inflation using its short-term nominal interest rate tool."
Their criticism of Woodford's theory is interesting:
"Money, both in the form of the monetary base controlled by the central bank and as the liabilities of the banking system, is a passive by-product. With no active role for money, integrating credit in the mainstream framework has proven to be difficult."
No active role for money is a far cry from "money makes the world go round", to be sure.
Integrating credit into economic thought may have been difficult. But that does not appear to have impeded the process of integrating credit directly into the economy. The policy, alternating between slow increase and rapid increase of credit growth, appears to have encouraged the reliance on credit and accelerated the growth of debt.
This perverse result was fostered by the view that credit expansion is always good for the economy. This is where non-linearity must come into our thinking: If the effects of debt are non-linear, credit expansion cannot always be good for growth.
The problem is that we use credit for money. Credit costs more than money. The cost of interest moves money (and economic growth) out of the productive sector and into the financial sector. On the supply side, it increases the cost and hinders the growth of output. On the demand side, it reduces both disposable income and aggregate demand.
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The excessive reliance on credit is not only a problem for the economy. It also impedes the evaluation of policy. In a comment that has troubled me for many years, J W Mason wrote:
"I don't think the idea of 'money' as something that has a quantity applies to the credit-money world of today". This is an example of the wrong-track thinking that emerges from the credit-based policy Woodford describes.
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