Home > Finance and money > Alchemy, alchemy, we’ve all discovered alchemy!!

Alchemy, alchemy, we’ve all discovered alchemy!!

At the heart of the current financial crisis is one fundamental myth. It is a myth so pervasive that in a way it is almost unwritten. Despite this, its premise cuts so deep and so wide that to challenge it would shake the foundations of economics, public policy and our cultural mindset.

The myth is simply this: The expansion of credit in an economy is an accurate reflection of potential growth prospects.

Earlier blogs have touched on this subject, but I want to tackle this specific issue in more detail.

There is no denying that the amount of debt that individuals, corporations, and national Governments owe is constantly rising. And rising, and rising. Just looking at this at face value, it doesn’t appear to be a sustainable situation. Only a ruddy great improvement in economic productivity can turn the tide and start to make some in-roads to this mounting amount of debt.

So why is it treated so benignly, by the public, politicians and economists?

The current rationale is that debt servicing costs are manageable and therefore should not be of major concern. (A further argument offered is that increased debt represents solid investment for future growth, however this specific myth will be tackled in a subsequent blog posting).

This rationale misses two fundamental assumptions. Firstly, that the debt servicing is only currently manageable. Declines in the cost of debt (i.e. interest rates) have been a key secular trend lately and so this masks the rising growth in amount of debt owed. But cheap credit may not last forever. The second point, is that debt servicing can look sustainable in the short-term, if you only end up paying back interest. In these circumstances, the principal owed never declines. It is the familiar noose of the “never-never”.

The main premise outlined in my recent submission to the Independent Commission on Banking is that:

Credit Quality is inversely related to Credit Quantity

“The crux of the model is that the aggregate quantity and quality of credit issuance within a market is inversely related (Warburton 1999 Debt & Delusion, p47, p49). Rationing of credit is believed to result in an overall improved status of portfolio quality, whereas an increase of total credit issuance is connected with worsening quality.”

The paper then describes how the amount of debt growth (in the UK) has been driven by spurious pricing of credit risk, which is actually masking the underlying quality. To believe otherwise is to truly accept that modern banking practises have actually been able to “spread risk and somehow magically evaporate it in the vast complexity of the financial galaxy” (Carlotta Perez).

And so I plan to compile a roll call of all those rare economists who fit the bill of Alchemy debunkers:

Peter Warburton
Carlotta Perez
Frederick Soddy (real wealth rots & rusts, but debt grows mathematically)
Hyman Minsky (for describing Ponzi financing)
Steve Keen (for bringing Minsky to life with Systems Dynamics modelling)
………….?

Your help in extending this list would be much appreciated.

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Categories: Finance and money
  1. Jim M.
    November 29, 2010 at 10:34 pm | #1

    Hi forensic,

    I became aware of your blog after you paid a visit to Golem’s blog, where you posted a link to your paper. I left a comment there after reading your paper, suggesting that there were many areas of overlapping interest.
    On visiting your blog, I noted that you were aiming to compiling a list of Alchemy debunkers. With that in mind, I would draw your attention to the following paper:

    http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf

    In the appendix “They saw it coming” the author names 12 economists who may fit the bill.

    I hope this is of some use to you, and I thank you for your contribution at Golem’s.

    keep up the good work.

    Jim M.

  2. November 29, 2010 at 11:07 pm | #2

    Thanks for the link Jim.

    I’m aware of Steve Keen’s work, as well as Michael Hudson. I’ll go through the paper to see whether any of them do indeed make the key point I’m looking for. That is “excessive credit expansion is unrelated to underlying fundamentals”. Or to be more strict in my position “that greater aggegate credit quantity can only lead to deteriorating credit quality”. In other words, the bigger the credit bubble, the bigger the burst will be!

    May the forensic force be with you!

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