"Without debt, economies cannot grow"

Cecchetti et al, 2011 (PDF; page 3):

For all these reasons, financial deepening and rising debt go hand in hand with improvements in economic well-being. Without debt, economies cannot grow and macroeconomic volatility would also be greater than desirable.

On the one hand they offer "financial deepening and rising debt" without end. On the other hand they show us a world "without debt". Those are the extremes of the spectrum: using no credit at all, or the perpetual approach to using no money at all, and credit for everything. They are defending the view that financial deepening and rising debt are always good. And that comes from a paper that opens with these words:

Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be disaster.

I should add that immediately following the "Without debt, economies cannot grow" sentence, they go the other way again:

But financial development is not some magic potion. The accumulation of debt involves risk...

Hey, I don't have a problem with considering both sides of a problem. My problem is that Cecchetti, Mohanty, and Zampolli think that constantly rising debt goes "hand in hand with improvements in economic well-being". Shouldn't that idea be challenged as weak and baseless on the face of it? But weak and baseless or not, that's apparently what they think. And that's despite all their idle chatter about wisdom and moderation.

Add to this, then, my objection that they offer only all or nothing, with no middle ground. With no middle ground, they leave no room for the possibility that the level of credit use which best promotes economic growth is somewhere in the middle ground. All or nothing, those are the choices they offer.

No.

Talk is cheap. It's easy to say debt is a double-edged sword. But it's hard to assimilate that idea and work it into all your thinking. And that's what economists have to do.

Debt as a multiple of "Funds Readily Available for Spending"

Click either graph for an enlarged view:

Graph 1

Same thing, on a log scale:

Graph 2: "That's got to be man-made."

"Funds Readily Available for Spending" is the money we use to pay our bills. Nuff said.

Loans vs credit cards

If you are someone who always says "money is credit", you may have trouble with this post.

I think that when people say "money is credit" they mean "money is created by borrowing it", an idea that I can and do accept. However, I always distinguish between money and credit because I need to distinguish between money that does, and money that does not, involve borrowing and repayment and interest. Surely there is a difference between money I receive in my paycheck and money I receive as a loan.

In addition, for this post, I need to distinguish between money used to make final payments, and money used when payment is deferred.

In my view:

1. When you borrow money you receive credit (i.e., money plus the obligation to repay), and
2. When you spend the borrowed money, the obligation to repay remains with you, and the recipient receives money, not credit.

That last part -- "and the recipient receives money, not credit" -- is the topic of this post.


In a long blog post I've been working on, I write

When you take out a loan and spend the money, or when you use your credit card, you are putting credit to use.

I follow up on that thought a few lines later, saying

When you borrow and spend, or when you use a credit card, you are putting money into the economy.

But this is not accurate. I could say

When you borrow and spend, or when you use a credit card, you add to total spending.

That would be correct. But it doesn't allow me to make the next point that I want to make:

When you pay down a debt, you are taking money out of the economy.

For my logic to be clear, I need to have the use of credit "put money in", and the repayment of debt "take money out". However, even though a loan does put the money into the economy when you spend it, using a credit card does not. The problem is that, by comparison to loans, credit cards represent an advance in financial innovation. Things happen differently with credit cards.

With loans, you decide you want one, and you go to the bank to make the arrangements. With credit cards, you take one out of your wallet and use it. There is even an chance that you received the credit card by mail, unsolicited. In this case it's clearly not your decision to take a loan. It's the credit card company betting that if you have the credit card, you'll use it. Essentially, they are giving you a loan even though you didn't ask for it. They are "nudging" you into the use of credit; and (as is typical with behavioral econ) the nudge too often works.

With loans, you have the money in your wallet or your checking account or in your high-tech version of one or the other, but you have the money, and when you spend the money it moves from your account to the account of the seller. You will still have to pay off the loan, yes. However, at this point the seller has been paid and your transaction with the seller is complete.

The process is different for credit cards. With credit cards, you have the credit card in your wallet. And when you use it an amount of credit is transferred from your account to the seller's account. The seller does not receive money, but rather credit -- a place-holder for money. Therefore, I cannot say

When you use a credit card, you are putting money into the economy.

This topic came up recently in my Incomplete transactions post, where I quoted from The Evolution of Consumer Credit in America:

When a cardholder charged a meal, the restaurant sent the bill to Diners Club, and Diners Club then paid the price of the meal, minus a small commission, directly to the restaurant’s bank. Finally, Diners Club sent the cardholder a monthly statement (bill), and the cardholder sent Diners Club a check.

That was the Diners Club innovation: It inserted itself between buyer and seller, created credit for everyone else to use, and took full charge of the payments of money.

Any chance creating that credit-card credit is a form of counterfeiting?

//

Allow me to review and summarize.

Without a credit card, you first get the loan and then spend the money, and at that point the seller receives the money.

With a credit card, you create a new loan on the fly when you pay for your purchase, but the seller receives credit instead of money. An additional transaction is required, between the seller and the credit card company, for the seller to get the money.

Because of this financial innovation I am not able to say that putting credit to use puts money into the economy. Credit card use puts credit into the economy. So I have to stop and re-think things.

When I take a loan, I receive credit (money plus the obligation to repay). But when I use a credit card I receive only the obligation to repay. No money. (Plus I receive the thing I bought, but that's the original transaction and it happens with loans, with credit cards, and even with cash!)

When I spend the money I borrowed, the seller receives money. But when I use a credit card, the seller receives credit. So an additional transaction is required, where the seller exchanges the credit for money from the credit card company.

Either way, loan or credit card, I still have the obligation to repay, which also creates an additional transaction, this one between me and the credit card company.

//

Let me condense these thoughts.

When I take a loan new money is created, and when I spend it the seller receives money.

When I use a credit card, new credit is created, and the seller receives credit. There is a follow-up transaction between the seller and the credit card company where the credit is exchanged for money. And there is a follow-up transaction between me and the credit card company where money is exchanged for credit, fulfilling my obligation to repay. However, both of these follow-up transactions occur after the initiating transaction is complete. Money is not used at all in the initiating transaction.

No money is created when a credit card is used. A possible exception is the use of a credit card to get cash. But the statement is true for purchases: No money is created when a credit card is used.

Hm.


Up top, I said:

1. When you borrow money you receive credit (i.e., money plus the obligation to repay), and
2. When you spend the borrowed money, the obligation to repay remains with you, and the recipient receives money, not credit.

Now I want to add:

3. When you use a credit card you receive the obligation to repay (but no money), and
4. The seller receives credit, not money.
5. An additional transaction is required for the seller to exchange the credit for money.

In both cases, of course, an additional transaction is required for you to fulfill your obligation to repay.


Spending borrowed money "puts money in" and repaying the debt "takes money out".
The use of a credit card "puts credit in", and repaying the debt "takes credit out".
Okay. Maybe this is the reason J.W. Mason says

I don't think the idea of "money" as something that has a quantity applies to the credit-money world of today

and all that. Fair enough.

But there is something Mason's statement does not address: The growth of finance creates growing financial cost in our economy. And, since the financial and nonfinancial sectors are different and distinct, it is possible that growing financial cost can harm the nonfinancial economy.

More than just "possible" I think. I find it necessary that we reduce the size of finance in order to reduce the cost of finance. (Note that in credit card "follow-up" transactions both the buyer and the seller are likely to be paying interest or a "commission" to the credit card company.)

If it is necessary to reduce the cost of finance, which it is, then this "credit-money world of today" has got to go. We should cut credit-use by half, and by half again, and after that we'll see.

As always, it all comes down to policy. Don't let them forget it, either.

But not a happy accident

Òscar Jordà, Moritz Schularick, Alan M. Taylor in Macrofinancial History and the New Business Cycle Facts (2016):

In the age of credit, monetary aggregates come a distant second when it comes to the association with macroeconomic variables. Real changes in M2 were more closely associated with cyclical fluctuations in real variables than credit before WW2. This is no longer true in the postwar era. As Table 10 demonstrates, in recent times changes in real credit are generally much more tightly aligned with real fluctuations than those of money.

and

The growing correlation between credit and inflation rates is noteworthy. In the pre-WW2 data, the correlation between loan growth and inflation was positive but relatively low. In the post-WW2 era, correlation coefficients rose and are of a similar magnitude to those of money and inflation.

Yeah, and it's good that they point these things out. But really, what else would you expect??? Probably half of our economic policies are dedicated in one way or another to expanding the use of credit, or the availability of credit, or both.^[1]  So of course we use credit. So of course credit has come to replace money as the transaction medium of choice. So of course the things that used to be associated with money are now associated with credit-use. So of course we find J.W. Mason saying

I don't think the idea of "money" as something that has a quantity applies to the credit-money world of today

and

I don’t think a “quantity of money” has been an important part of orthodox macroeconomics or any major heterodox school for many, many years.

and

Basically, once you say “the central bank sets the interest rate”, M disappears from the analysis.

Of course: Mason has a very good understanding of the way the economy works. But I wonder if he ever thought about how and why our world changed from a “quantity of money” world to a "credit-money world". And now I'm thinkin maybe more than half our economic policies serve to expand the use or availability of credit, or both.


As if confirming our transition from a world of money to a world of credit, and the findings of Jordà, Schularick, and Taylor, Christina D. Romer writes

Monetary policy, in particular, appears to have played a crucial role in causing business cycles in the United States since World War II... The role of money in causing business cycles is even stronger if one considers the era before World War II.

Well, now we know.
The role of money was stronger before World War II; the role of credit is stronger since.^[2]  Oddly, though, the word "credit" doesn't even appear in Romer's article. And I don't ever see economists saying the transition to credit was the result of economic policy. It was an accidental result, in my view, but this does not relieve policy and policymakers of responsibility.

Come to think of it, when I said credit is our "transaction medium of choice", I didn't really mean we "chose" it. It's more like we were tricked and trapped and encouraged and induced into using credit, by the design of policy. But I still say our transition to credit was an unintended consequence of policy that had been created for the purpose of boosting economic growth.


James Hamilton pointed out that Jordà, Schularick, and Taylor

also find that the skewness of GDP has become more negative– big movements up have become more subdued relative to downturns.

Seems to me this should count as a cost, not a benefit, when we're tallying up the costs and benefits of our accidental transition to cashlessness.



Notes
1. For example, the debt of the government-created agencies Fannie Mae and Freddie Mac was "equal to 46 percent of the current national debt" -- almost half -- and that was back in 2003. Good thing it's not counted in the Federal debt, huh? Too bad our mortgages are counted in our debt!

2. Credit-use became dominant (and money of secondary importance) in the early 1960s. See The Sweet Spot on my old blog.

An "optimum level of credit use"? Yeah!

Back in 2014, Steven Hansen asked Is Credit Fueling Economic Growth?  He quoted Noah Smith:

Maybe credit really does drive growth. Maybe excess credit really does force a boom to turn into a bust. But no one has yet come up with a really compelling, testable explanation for how that happens.

Sure they have, Noah, though perhaps not expressed in the particular model you require. Cost. The explanation is cost: the rise of financial cost. Cost, Noah.

Need I repeat myself?

Down the page a bit, Hansen writes:

Also there is little question that consumer credit is becoming a larger and larger element in the economy - but:

• prior to 1980 it seems there was a positive correlation between consumer credit to gdp ratio and GDP growth;

• since 1980, consumer credit to gdp ratio has had an inverse correlation to GDP growth.

Could it be true that at some point of growth, consumer credit growth works against GDP growth?

Yes, Hansen, but it's tough to untangle. A lot was going on around 1980: deregulation, supply-side economics, you name it. Credit use was only one part of it all (and credit use was enhanced by some of it). And consumer credit was only one part of credit.

Further yet down the page:

My opinion is that too much consumer credit outstanding constrains economic growth, and too little consumer credit outstanding constrains economic growth. The optimum consumer credit levels are likely a sliding scale based on a slew of dynamics - and I suspect one of the larger dynamics is rate of inflation (the higher the rate of inflation, the higher the optimum level of credit).

Glad to see I'm not the only one who says there must be an optimum level of credit. But, fuck, it's not only "credit outstanding" you have to think about. There are also the new uses of credit, the ones that add to credit outstanding, just like deficits add to the Federal debt.

New uses of credit put money into the economy when the money is spent. The borrower is left with a debt (or "credit outstanding" as Hansen says). Then, when the monthly payments begin, money starts coming back out of the economy. The new use of credit, the borrowing and spending, increases economic activity. Repayment of the debt reduces it.

So...

1. The amount of credit we have in use use is called debt. Putting new credit to use adds to that debt. 
2. A new use of credit provides boost to the economy. Paying down the resulting debt creates a more or less "equal and opposite" drag on the economy. And
3. Debt, oddly, is not the problem; repayment is. But you can't have one without the other.

Super simple stuff.

"the level of debt doesn’t matter"

Steve Keen:

I couldn’t convince several of the academics in the audience of the importance of private debt: they kept coming back to “one person’s debt is another person’s asset, therefore the level of debt doesn’t matter”.

Yeah, I think I get what the academics were sayin...

The Level of U.S. Private Debt

Why would it be a problem? Cost, maybe?

No, no, I see their point: It's probably better just to adamantly refuse even to think about it. Cough cough.

How did we get so much private debt, and why was nothing done to prevent it?

How we got all that debt is simple: Policy didn't prevent it. In fact, policy encouraged it. But what's done is done. There is a better question: Why? Why was nothing done to prevent it?

Cecchetti, Mohanty, and Zampolli:

"For a macroeconomist working to construct a theoretical structure for understanding the economy as a whole, debt is either trivial or intractable. Trivial because (in a closed economy) it is net zero—the liabilities of all borrowers always exactly match the assets of all lenders."

I'm leaving out the part about "intractable" because they've already answered my question: "net zero". It comes to nothing.

Steve Keen:

"conventional economists ... ignore private debt as just a “pure redistribution”, to quote Ben Bernanke."

Pure redistribution: For every dollar my debt costs me, somebody else earns a dollar. It's the net-zero thing again.

Paul Krugman:

This is how you want to think about debt: it’s not a burden on the nation’s resources, because it’s mainly money we owe to ourselves, and it’s a problem not because we have to tighten our belt but because debt is currently leading to spending that’s less than we need to maintain full employment.

Krugman at least acknowledges that excessive debt reduces aggregate demand. But really, he's only changing the subject.

Debt's "not a burden," he says, "because it’s mainly money we owe to ourselves". Again, the net-zero thing. He enhanced the story, but he can't let go of net-zero.


Asymptosis summarized such explanations with exceptional clarity:

"Economists will tell you that gross debt levels don’t matter because one person’s debt is another’s holdings. (Net: zero.) They ignore it."

Yeah, I know: Net zero. But isn't it a weak argument? I mean, really. That's the whole story? Are we doing economics here, or are we just jerking off?

The "net-zero" argument is absurd. It's like balancing your checkbook (remember those days?), getting the errors to zero out, and then saying the zero means you didn't spend any money last month.

There's gotta be a better explanation. I need a better explanation.

I kept an eye open for a long time, and finally found a different story, from Patrizio Lainà:

"Interestingly, mainstream economists have given warnings about the public debt to GDP ratio (see e.g. Sargent & Wallace 1981), but at the same time they have almost completely neglected the private debt to GDP ratio. This might be due to Fama's (1965 & 1970) widely used efficient market hypothesis, which simply implies that private debt does not matter because it is always on the “right” level and no economic imbalances, such as bubbles, should occur. This, in turn, indicates that there is no need to study private or total debt."

The efficient market hypothesis. At least it's not net-zero again. And if the EMH has been debunked, that's good: It just means the "private debt does not matter" argument has no solid foundation.

Beyond that, something finally clicked for me, and now I have my own explanation, apart from net-zero and the efficient markets thing. My explanation is simple: As long as economists think credit-use is good for growth, they cannot see private debt as a problem.

I think mine is the strongest argument.