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:
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.