When credit is too much of a good thing

By Edward Hadas
April 9, 2014

What does credit do after it has finished the job it was designed for? The supply of credit ought to stop at funding productive activity. But the reality is different. Surplus credit fuels dangerous asset price inflation and funds profligate governments. As leverage increases, so too does the risk of crisis and recession.

Credit, otherwise known as debt or loans, is not necessarily monstrous. It can be a most helpful economic beast of burden, carrying resources to the places where they can be best used. Loans from households to businesses fund helpful investments, and loans from rich older households to poor younger ones help spread property, especially houses and cars, more equitably. Even loans to governments can be a useful alternative to taxes.

However, credit too easily goes astray and there is no natural force to rein it in. Without firm regulatory guidance, credit seems to expand indefinitely, until the financial system explodes. That has been the pattern since the end of the Second World War.

Academics Moritz Schularick and Alan M. Taylor showed in a 2012 paper that the ratio of bank credit to GDP in developed economies fell during the Great Depression and then expanded steadily and rapidly. Combining the 14 countries studied, the ratio surpassed the previous pre-Depression peak of about one by 1970, and started the 2008 crisis at just below two.

Their work does not directly include government debt, but that has also increased, from 60 percent of GDP in the G7 countries in 1990 to 83 percent just before the crisis, according to the International Monetary Fund, and 122 percent this year.

Economies typically become more credit-intensive as they become richer. But excessive credit growth is dangerous. In another paper, Schularick, Taylor and Òscar Jordà point out a consistent pattern in developed economies: a “stronger increase in financial leverage … in the prior boom tends to correlate with a deeper subsequent downturn.”

Little of the new credit created in the last few decades has served the overall economy. Schularick and Paul Wachtel recently ran the numbers for the United States. They show that the business sector has not borrowed from the rest of the economy since 1960. The pattern is similar in other developed countries. In other words, business profits were high enough to fund all desired investments.

Instead of funding growth, the proceeds of new private debt were mostly used to buy existing property, commodities, collectibles and financial assets. That pushed up asset prices but did not add much economic value.

Some new credit seems to have gone into consumer loans which pumped up the spending by poor Americans, although the use of mortgages as sources of cash complicates the analysis. Such lending for consumption is a bad substitute for what is sometimes called “pre-distribution” – making incomes more equal in the first place.

Then there is the increase in government debt. The proceeds of new loans were mostly used to avoid levying unpopular taxes. In a better run political system, that would not happen. More recently, the proceeds of debt have mitigated the effects of the financial crisis. In a better run economy, that would not be necessary.

Credit grew to an unhealthy size and then wreaked havoc. It remains too large and out of control – the ratio of total non-financial debt to GDP is higher now than before the crisis. Yet central bankers and politicians do not seem to have registered the risk of too much credit.

Yes, central bankers are talking more about macroprudential regulation, and governments continue to promise balanced budgets or even surpluses whenever economic conditions allow. However, there is almost no hard analysis of the mix of productive and unproductive debt, and no sign of any effort to change attitudes or practices.

The key change needed is psychological: the recognition that the value of an asset should only increase when the asset produces more of value to society. If that principle was accepted, the practical moves to stop unproductive lending would come almost naturally.

Regulation would play a big role. Supervisors of banks and other financial intermediaries would classify loans by use as well as by safety. Loans to support investment would be strongly favoured. Carefully controlled residential mortgages are fine – they convert rental expenditure into helpful purchasing power.

The tax system could help. The old idea of a punitive tax on unearned capital gains on land should be revived. Speculation becomes less attractive if the government takes virtually all of the gains.

Finally, fiscal arrangements need a rethink. Government deficits may sometimes be required to keep demand up. But if there really is unused capacity in the economy, it can be put to work just as effectively by the government printing money instead of borrowing it.

Right now, these plans are unpalatable to voters and many economists. But unproductive credit is a dangerous creature. Unless it is tightly controlled, it will surely ravage the economy once again.

10 comments

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Does the term “Other peoples money” mean anything to you? Yes, it’s psychological, and also a cultural thing Mr. Hadas. I highly doubt it will change in the near future. After another major crash and the US is no longer the favored reserve currency maybe it will happen.

Posted by tmc | Report as abusive

“instead of funding growth, the proceeds of new private debt were mostly used to buy existing property, commodities, collectibles and financial assets. That pushed up asset prices but did not add much economic value.”

It could be Venice during its decline in the 18th century.

And all that money changing hands is than used to claim that GDP is the highest in the world and therefor the country is an economic power house to puff government bonds so the country can fund foreign adventures in the ME to take control, through big oil, of oil resources.
The resources were the prize and the credit crunch was a way to reign in too much domestic consumption and thus preserve the value of enormous private wealth in the hands of a small percentage of the population.

All that easy credit did just what it was supposed to do. Didn’t it? And everyone was used in a very agreeable way – for awhile – while it was doing just what it was intended to do. And the big wealth can look at the small free and their greed and say – “Don’t blame us – you were doing it too.”

If you loose your shirt in a rigged casino, don’t blame the owners. You were stupid enough to believe them.

What I hate about these bastards – the big fish and their ambitious prey – is I was always small fry and didn’t trust the casino either, but now have no meaningful employment since 2008. I was able, with small funds and my own labor, whenever possible, to provide myself with a cost effective and comfortable standard of living almost at poverty levels. And I didn’t envy my sister at all who made ten times that. My sister and her class – actually her bosses – are now free to buy the government and run it into the ground.

So many of the ambitious small fry deserved to be fried – they can be arrogant jerks too, and I hope the big fish choke on their bones.

Mountains of bones too. A video on present day Iraq I just viewed on You Tube is claiming over a million dead. We weren’t hearing that from embedded “journalists” and government sponsored news stories.

Posted by paintcan | Report as abusive

@Hadas: Very True!

@tmc: If only the empire promoters could be made to pay the price.

Posted by xcanada2 | Report as abusive

This article aims right at the heart of the biggest failure of modern economics and government policy: to concentrate on quantity over quality. It is purely logical to anyone that what a nation does with its money is infinitely more important than how much money it has.

Posted by BidnisMan | Report as abusive

“Instead of funding growth, the proceeds of new private debt were mostly used to buy existing property, commodities, collectibles and financial assets. That pushed up asset prices but did not add much economic value.”

When governments INTENTIONALLY factor in a continuous rate of deliberate inflation they accomplish two things. They steal purchasing power from those with the least ability to economically “make themselves whole again” AND they make the affluent “invest” their liquid assets into a form that appreciates at a rate faster than inflation, whether at home or abroad. They can’t just “sit on it” without losing purchasing power.

The “increase in asset prices” was an achieved investment goal! But one more illustration of “unintended consequences” of government action or inaction. For every action there is a proportional reaction, whether or not predictable

“…if there really is unused capacity in the economy, it can be put to work just as effectively by the government printing money instead of borrowing it.” In the “Great Recession” there was a LOT of “unused capacity in the economy”. Our government not only printed money, but borrowed it too!

It should be quite obvious that “we, the people” did not benefit so much from this (well, maybe those with “unemployment benefits” that go on and on). Was infrastructure built or refurbished. Were the unemployed hired and put to work?

Specifically what WAS “government’s goal” if there occurred no identifiable benefit to American citizens?

Posted by OneOfTheSheep | Report as abusive

“We the people” is the greatest illusion ever perpetrated by a government. The SCOTUS just retired that idea and made it “we the very wealthy people”. That’s all the founders were really thinking of at the time anyway. But they tended not to have such a vast difference in income scale anyway or they tended not to express it in conspicuous consumption, not in New England anyway. The south had slaves and the wealthy planters amassed mega fortunes, accumulated thousands of acres of plantation spreads with tenant farmers and slaves, and built the most lavish estates on the English gentry model. The old Dutch in New York did the same thing but with limited slavery. Everyone else tried to live off the land as best they could and tended not to have much cash. And almost everything they bought was expensive. They tended to keep their buildings and effects for generations.

So relax OOTS – with the next election you might get the president of your dreams and the Congress for hire and you might even get the severe reduction of the 99% so your money has almost pharonic immortality and never ever looses a fraction of a cent’s worth of purchasing power over the ages. Than you can build a tomb for you and yours, have yourself embalmed and take it all with you.

Actually the Egyptians probably had inflation. The Pharaohs were always looking for more gold or the economy stagnated. The Romans had inflation as did every subsequent period. As long as people used coinage at all there was inflation. People like to hoard money and inflation frustrates that and forces them to do something with it before it either shrinks in value due to idleness or they force the rest of their fellows into poverty and slavery to preserve its value.

I was just telling a guy up here yesterday – the Spanish crown had to declare bankruptcy three times in the 16th century at the same time they were pulling in tons of gold taken from the New World. It flooded the economy with gold, prices rose and the government still couldn’t pay the debts it incurred.

So modern democratic economic theory allows for some inflation, large wealth accumulation but also balanced with taxation so they don’t revive the tendency of economies to stagnate as they tended to do historically.

But where are the new aristocrats going to put all their tenants? That’s the role of mortgages and consumer credit. That’s 20th and 21st century tenant farming.

We’re just running out of things to buy. The high standard of living is actually frustrating job creation because you can only gild the lily and regild it so much times before gilding ceases to do much anymore. And we can now pay fortunes embalming the living with extensive age defying surgery and end of life extension of care. There’s not an ounce of productive benefit in any of that either unless you have stock in hospitals and nursing homes.

Maybe Syria and Iraq were the right medicine for the wrong people? We should be overrun with insurgencies and “freedom fighters” so there is something for the next generation to rebuild? It kills off hundreds of thousands, maybe millions, of the 99% and evokes Darwinian survival of the fittest with bells on. But I don’t think either government can worry right now about what that does to inflation? It bankrupts the governments and saddles the survivors with enormous debt.

I just heard last night on a You Tube video that the Iraq military is using a fraud of an invention that made the British supplier 85 million dollars and that is supposed to detect explosives. It is a hand held plastic device with a wire but no power supply, some tech looking circuitry in the plastic handle and a radio antenna sticking out in front and each set has several plastic credit card size plates that have names of explosives printed on them that the military claims works about 30% of the time. He was selling them for up to $65,000 a piece. He hasn’t be charged with fraud probably only because the procurement officers would be cashiered and prosecuted for collusion and receiving kick backs. I’m sure a lot of Iraqi billing both to this government and the new one is full of stories like that. That’s who really erodes the value of your money, not the person receiving unemployment benefits or food stamps. They don’t set the prices – the people who own the stores do that.

What the unemployment benefits and food stamps do is mask the weakness of the economy and the problem of growing social inequality. It also acts like a sedative to intense rage. Food-stamps and unemployments benefits are the Prozac of this economy.

Posted by paintcan | Report as abusive

Excuse me – this sentence is wrong- “People like to hoard money and inflation frustrates that and forces them to do something with it before it either shrinks in value due to idleness or they force the rest of their fellows into poverty and slavery to preserve its value.”

The old societies didn’t circulate much money among common folk. So inflation must have been very low. The aristocrats could spend it like it was water and there was an ethic that demanded they be easy with it and maintain as large households as they could afford and to live as lavishly as they could maintain, building lavish homes, buying fine paintings and furniture and dressing sumptuously and employing as many servants as their station allowed was expected of Gentlefolk. But you read very contradictory accounts so it’s hard to make generalizations. To control inflation, governments would institute sumptuary laws and limit expenditure by class. Controlling infalation must have been why sumptuary laws were created. Why else?

The old definition of nobility was: the high born may have the best of everything but they weren’t supposed to care about it. It is why gambling was a special passion of the rich and life at Courts. War and gambling were their prerogatives and their trade mark. Veblen mentions that too. War and gambling are a lot alike – you stake it all on the prospect of more. But we’re not talking about the modern industry with machines designed to favor the house. They are supplying an addiction.

Posted by paintcan | Report as abusive

Paintcan, citing an example from the 1500′s after the discovery of the New World is hardly relevant here.

The only reason we have excess credit is because of inflation. And I mean the correct definition of inflation, an increase in the money stock. You cannot have a stable economy with an unstable monetary system. Hadas specifically mentions how our economy has suffered from booms/busts post WW-II and guess what, that is exactly when we began straying from the gold standard. Eventually we cut the last tie under Nixon and our money stock has soared ever since then. If our money stock remained stable then where would the excesses for speculators come from?

Posted by Bastiattheman | Report as abusive

…..so tell this to the Fed…..

the Fed has a value system that rewards income from capital, not much else..

..misallocation is fine, productivity is irrelevant. asset inflation is great…..

Posted by Robertla | Report as abusive

Complicated problem with complicated answers? Don’t blame our government, as this easy money stuff is old news and perpetrated by “We The People”
I often hear: Sweetheart we can’t afford this – Nah, we can take another loan or use credit cards(@25% int.)
END predatory lending and greedy banking.

Posted by Doc62 | Report as abusive