Wednesday, February 1, 2012

Debt: The Good, the Bad and the Ugly


At The Institute for New Economic Thinking, Lee Price interviews Moritz Schularick regarding his research into private debt. I have transcribed a portion of the interview, beginning about 3:40 in:

Q: What's led you to believe that you would have an even better understanding if you had a breakdown of the types of private credit?

A: That's where the link comes in to the title of our project -- finance and the welfare of nations -- is that the economic function played by lending differs substantially... It's not the same thing whether a bank extends credit to a company for a productive investment, or whether a household borrows from a bank to finance the purchase of an already existing house or an already existing apartment.

One is positively linked with economic growth and development. The other one is a financial transaction that, from a consumer point of view might seem beneficial, but it's much less clear what the welfare implications are of these housing booms.

Q: So you'll also be looking at whether investment was occurring that would improve the capacity to repay the debt later.

A: Right. This is crucial focus of them going beyond the aggregate credit data will be to as far as possible try to distinguish between lending and debt that was used for productive purposes, productive investment, to the degree we can define that, and lending that went into construction, went into mortgage lending, etc, to see whether there are different economic implications... consumer lending being the third kind ...

Now I'm gonna say this is a waste of time, investigating these differences.

And you will misunderstand, and you will think I cannot see the obvious differences between productive and nonproductive uses of credit. And then I could quote Adam Smith, or quote myself quoting Adam Smith to show you that I *DO* see the differences that Moritz Schularick sees and wants to study. And I say let's move along here, we don't have time for that.


Back in the 1970s, at the end of the Golden Age, the only way to keep the economy growing gangbusters was to let prices go up. And when policy suppressed inflation, policy suppressed growth. And growth never recovered.

Why? Because already by the end of the Golden Age, financial costs were making the productive sector less profitable. More to the point, those same costs were making the financial sector more profitable.

So then, when Supply Side economics made things better for business, it was finance that benefitted most. And since there was no thought given to reducing the reliance on credit, or to reducing private debt, or to reducing the financial costs to the non-financial sector, the productive economy never recovered. But finance grew.


At Angry Bear, Steve Roth responds to a Jazzbumpa post:

...the finance industry has created a huge pyramid of new financial assets (ultimately funded by bank fractional reserve lending/money printing). That new money is "locked up" in those assets, but it was created for that purpose in the first place. If real investment had offered similar risk-adjusted prospective returns, banks would have created money for that purpose.

Which raises the question: how to make real investment more attractive than financial investment?
I'd start by taxing financial-investment returns at the same rate, or higher, than real business profits. Rather than at a lower rate, as we do now...

This is exactly right. Finance grew, and production didn't, because finance was more profitable than production. And the question is exactly right: how to make real investment more attractive than financial investment?

Roth suggests using taxes to make finance less profitable. I like the idea. That's what taxes are for. Yet I must insist that the problem is simpler and the analysis cleaner than Steve Roth has seen.

When the productive sector increases its reliance on credit, it increases its own costs, reduces its own profits, and increases the profits of finance. Ergo, the growth of finance.

Finance is the problem, gentlemen, because finance is the problem.


In an interview I reviewed a while back, Robert P. Brenner made the following points:

1. The basic source of today’s crisis is the declining vitality of the advanced economies since 1973, and, especially, since 2000.

2. Since the start of the long downturn, state economic authorities have tried to cope with the problem of insufficient demand by encouraging the increase of borrowing, both public and private.

3. A stepped-up assault by employers and governments on workers’ wages, working conditions, and the welfare state ... prevented the fall in the rate of profit from getting worse.

Yes, exactly. However, Mr. Brenner fails to emphasize the fact that the cost of finance was a central element in the decline of wages and profit.

The problem with finance is cost. Sure, yes, yeah, if we use all our borrowed money for consumption spending it's not as good as if we use it all for productive investment. Probably. But no one yet sees that the fundamental problem with credit use is the cost of credit use. Robert Brenner misses it. Steve Roth misses it. Moritz Schularick misses it. And you miss it too.

When there is so much debt that the economy can no longer function, it doesn't really matter anymore whether that debt was used for productive purposes. The problem is cost. At this stage, today, the only thing that matters is the cost.

11 comments:

The Arthurian said...

I propose a system of tax incentives that pushes your income tax up as your debt increases, debt relative to income or something like that. A system that reduces your tax if you make more than the minimum payment on your debt, or if you make an extra mortgage payment, or like that.

A system that moves the cost of interest (or, simulated interest) out of monetary policy, and into fiscal policy, into tax policy.

Present policy affects everyone the same way. When interest rates go up, they go up for everyone. When they come down, they come down for everyone. Under the new policy, interest rates are high for those heavily in debt but low for those heavily indebted persons who are working to reduce their debt. Meanwhile, interest rates under the new system remain low for those with little debt, so that they may be encouraged to borrow and boost the economy.

Under the present system, the threat of inflation pushes interest rates up for everyone. If you are late to the party, you pay more than those who got there early, and your contribution to economic growth is hindered so that inflation may be minimized.

Under the new system, we recognize that the threat of inflation arises from the use of credit, and we use tax incentives so that people with the most credit-in-use -- in other words, people with the most debt -- are encouraged to reduce their debt. We undermine inflation by restricting the growth of spending among those who are most directly responsible for contributing to inflation.

Under the new system, we do not discourage growth. We encourage those who have not yet grown (and those who have not recently grown) to grow more; and we encourage those, who have recently taken on debt, to reduce their debt.

jim said...

The problem with debt is not the "cost". That is like saying the problem with food is the cost.

The recent financial crises revealed that the problem with debt is the failure of borrowers to understand (or correctly assess) the cost of debt.

In 2009 households discovered that they had in the preceding 18 mos. lost $15 trillion in net worth. That was like each US household (on average) getting a bill for $100k that they previously had no inkling was coming. Up until that bill arrived the cost of borrowing was looking pretty darn good.

So now armed with completely new knowledge about the cost of debt, the private sector is now unwilling to borrow even though the cost of debt is at an all time low.

Jazzbumpa said...

1) This strikes me as all kinds of wrong:

I propose a system of tax incentives that pushes your income tax up as your debt increases, debt relative to income or something like that. A system that reduces your tax if you make more than the minimum payment on your debt, or if you make an extra mortgage payment, or like that.

Let's just say it would be a) highly regressive, and b) stifling of any venture that requires new credit to get going, which is to say almost all venture.

2) Under the new system, we recognize that the threat of inflation arises from the use of credit,

Have you demonstrated this?

I demonstrated that it doesn't.

http://jazzbumpa.blogspot.com/2011/10/does-debt-cause-inflation.html

And, as I said to you in comments there, your assertion remains unproven, and my challenge remain unanswered.

3) Under the new system, we do not discourage growth. We encourage those who have not yet grown (and those who have not recently grown) to grow more;

Just exactly how does that work?

Your unwillingness to recognize that the specific uses of debt do make a difference leads you to a draconian one-size-fits-all solution that treats the symptoms while ignoring underlying causes.

Note:
Debt for capital improvement: good.
Debt for financial tail-chasing:bad.

The problem is that the finance sector is collecting rents, to everyone else's detriment, and using the proceeds to collect more rents. Think about the enablers: tax policy that favors rents over profits, lack of regulation over rent seeking activities, the systematic impoverishment of the working class that drives them to the use of debt to meet basic living expenses.

Any solution that does not address these things head-on is doomed at square 1.

Cheers!
JzB

Jazzbumpa said...

Another detriment, re: my point 1).

It would lead to a black market in debt.

Ponder the effects of that on society.

Very, very not good.

JzB

The Arthurian said...

Judge it first, Jazz, and think about it never.

Jim: "the private sector is now unwilling to borrow even though the cost of debt is at an all time low."

No, the cost of DEBT is not at an all time low. The cost of NEW USES OF CREDIT is at an all time low.

The cost of DEBT is the total accumulated cost of all interest on all presently existing debt.

Clonal said...

Art the solution to the deb problem is to abolish debt financing - no interest, no usury. Period.

You will ask - "How then will financing be done?"

Ans. By Equity participation. Let us take housing mortgages for instance. The bank buys the house - rents to the buyer, plus the buyer buys the house over time from the bank over time (in other words, the renters equity builds over time, while the bank's equity declines.) The contract can be reneged by either party at any time. When the contract is broken, the house is sold, and the proceeds of the sale are divided up in the proportion of the equity of each party at the time of the sale.

The benefit of this approach is that there is no incentive for the bank to get the house overvalued. There would have been no housing bubble in this scenario.

Business investments will again be purchase of equity, with equity buy back by the business.

Even in this approach, there is an imputed interest. However the losses and gains are shared by both parties. The collateral cannot be seized by the banks if the debt is not paid in full (as currently happens)

The Arthurian said...

Clonal, THAT would "lead to a black market in debt."

Anyway, you might as well try to abolish gunpowder, or nukes, or the sunrise.

All we have to do, I think, is avoid excesses.

jim said...

Hi Art,
According to FRED the ratio of personal interest payments to personal income is the lowest on record.

http://research.stlouisfed.org/fred2/graph/?s[1][id]=B069RC1#

Clonal said...

Art,

What I am suggesting is an accounting change, and a change of the way the ownership of an asset transfers when it is financed through borrowing. Bothe the lender and the borrower (renter) are now on a more equal footing.

The way I suggest prevents asset bubbles from forming, and reduces (eliminates) the incentives for banks to produce and ride asset bubbles.

The Arthurian said...

Sorry Clonal. I don't know enough about accounting, nor about your plan to evaluate it at all, no less make the irrelevant remark that I did.

I do think there is some value in trading in equity rather than debt.

Still, it seems to me there would have to be debt in the arrangement somewhere if "the buyer buys the house over time". But like I said, I don't know enough to evaluate the idea.

Jazzbumpa said...

Judge it first, Jazz, and think about it never.

WTF?!?

JzB