In my cursory investigation into the machinations of modern banking, one thing has become abundantly clear. The George Bailey model of small town banking died a long time ago. In its place is the towering might of large scale financial institutions.
The key weapon at their disposal is the markets.
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:
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.
The traditional school of economics that guides policy makers and permeates our underlying principles and culture is that referred to as the Neoclassical school.
As an arch priest of this school the likes of Ben Bernanke deny that credit is anything but a transfer of holdings between one party and another, and therefore is irrelevant to their models of the world.
This is despite overwhelming evidence from an academic who writing in 2009 demonstrated that those economists who did foresee the crisis all acknowledged the role of credit. He identified four common elements:
1) a concern with financial assets as distinct from real-sector assets,
2) with the credit flows that finance both forms of wealth,
3) with the debt growth accompanying growth in financial wealth, and
4) with the accounting relation between the financial and real economy.
On the one side were the hard money Austrian school proponents (such as Peter Schiff etc.) and on the other we had the likes of Steve Keen and others who embraced the Minsky Instability Hypothesis (such as Peter Warburton).
The reason that these people were able to foresee the problem building up is because they all recognise the fact that money used in day-to-day exchanges can in fact get separated from reality. Excessive credit, brought about by over-optimistic expectations of future growth is by far the most plausible explanation of why the cycles occur.
Which is why a recent speech by Andrew Haldane of the BoE is quite remarkable in its tentative recognition of the role of credit expansion in fuelling sub-optimal lending practices.
Mr Haldane has a noteworthy history of hard hitting publications. But, two things still worry me. Firstly is whether his proposals will ever make the light of day in terms of real policy change within the BoE.
And secondly is that it may be too little, too late. For the pyramid of credit has grown excessively high, whilst most of the modern world appears content to carry on worshipping at its feet.
UPDATE: January 24, 2011
Mish Shedlock has weighed in to the World Economic Forum’s recent publication endorsing further credit expansion for the globe:
Building on the critique by Steve Keen, Mish lists 18 flaws in the report which make it a damning indictment of modern economic thought.
The UK’s debt level has been growing and growing in recent years, reaching nearly seven times our annual GDP.
But this is a good sign, is it not? I mean, no-one would lend to a country and people that couldn’t pay it back, would they? So the fact that we are in so much debt, must mean that we’re a good investment. That we can and will pay it back by growing our economy. Right? Well…. maybe that’s the wrong way of looking at it…….
Attached is a recent submission to the Independent Commission on Banking that paints a rather worrying picture of our economy & finances.
This site is the start of a journey through the labyrinth of finance, economics and the nature of human behaviour.
It doesn’t always claim to be right about everything, but it should at least get you thinking, and (hopefully) responding.