Failing to Connect the Boom to the Bust
Scott Sumner has a post up today that says “debt surges don’t cause recessions“. I think this is a lot like saying that eating a lot of food doesn’t make you fat. Of course, there are lot of variables that go into getting fat, but consuming a great deal of food is generally a pretty good way to get started down that road. Food’s a vital component of our lives so it’s not that food is inherently evil, but it can be easily abused. Anyhow, here are my thoughts on why debt does in fact cause recessions or at least substantially increase the odds of future recession:
1) Economic booms are generally associated with debt booms. Since bank money (what MR would call “inside money”) is the primary form of money in our fiat monetary system it’s perfectly normal for loans to increase as economic activity increases. People buy more things, invest, etc. Figure 1 below shows that the rate of change in liabilities increases during economic expansion. I think we’d all agree that’s to be expected.
2) Sometimes the boom gets out of control. Humans are irrational. So there are times when the boom turns into a big boom. Why? It can be any number of varying reasons, but let’s take the last housing boom as an example. Households and Wall Street began to believe that house prices could never decline in value. As the housing boom picked up this looked like a sure thing for everyone involved. The banks could sell more houses, households could speculate and flip houses and Wall Street could repackage all these AAA rated mortgages and resell them to their friends. It was a win-win. The boom starts to get out of control. Stability becomes destabilizing.
3) A bust requires a boom. The economy is cyclical by nature. And stability can be destabilizing. During the housing boom these irrational agents went overboard. Lending standards got too lax and too many homes were sold on the premise that low credit borrowers could pay it back. And when the bust occurred the economy went with it. Asset prices decline, people start losing their jobs, defaults pick-up, etc. The boom turns into a bust. What was so dangerous about the housing boom was the substantial decline in asset values. The housing market was the key asset from which trillions of different products were priced. So when the housing bubble burst we began to see imbalances all over the economy. Suddenly, bank assets were worth a lot less than they presumed and households were unable to afford houses they had purchased. And this all starts with the issuance of credit which made the housing bubble possible in the first place. After all, if people could have afforded the houses they purchased on credit we would have never had a housing bust to begin with!
4) So what do we find here? Since bank issued “inside money” is the primary form of money used in our fiat monetary system it’s totally normal and expected that a boom would result in credit expansions. As you can see in the chart below the rates of change in total liabilities tend to boom and bust with the business cycle. And this shouldn’t be at all surprising. When the economy booms people borrow more as they do more business, take more risk, etc. And when the boom slows and turns into a bust the credit cycle flips and the downturn ensues. Like food, we need credit expansions. But it’s when the credit cycle gets abused that we see the biggest booms and busts.
The bottom line to me is, you can’t even begin to understand the current economic machine without understanding this basic fact – we live in a fiat monetary system in which bank issued “inside money” is the primary form of money. Access to credit can exacerbate the boom as we just saw during the recent period of lax lending and unusual optimism. And the more credit the more potential for a boom (and a bust). So I wouldn’t say that rising debt levels always cause recessions, but rising debt levels certainly make it easier for economic agents to act irrationally and irresponsibly thereby substantially increasing the odds of a boom and a bust.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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31 Comments
It’s just common sense that inside money expands during a boom. As you said, the debt isn’t necessarily the cause, but it greases the engine and can make it more likely to run the car off the road.
Nice analogy.
At face value I agree with the statement “debt surges don’t cause recessions.“ However I would say, generally speaking, debt reduction causes a recession.
Inside money greases the engine as LVG said. So if we grease the engine too much the pistons might run too hot and too loose. And that makes the car susceptible to problems. It might take a bump in the road or a series of bumps to cause the crash, but the easy credit makes it possible for the car to become unstable to begin with. Good analogy there consistent with the one in my paper….
In 2008 the “bump in the road” was the huge increase in oil prices fueled by speculation that was totally unrelated to supply/demand. We also had 11,000,000 undocumented immigrants many of whom decided to bail on their mortgages and go home. Thank you John and Sara for encouraging them to do just that in 2008 and thus ruin our housing market, such as it was.
I think Sumner is sceptical that the housing Bubble was really a bubble; and that the sudden decline in house prices was due to Fed policy.
It seems like common sense to me. A lot of people got mortgages they couldn’t afford buying into the “home prices only go up” myth, the asset prices turned on them (as asset prices do), defaults were initiated and a vicious cycle ensued. I wouldn’t say the Fed was to blame entirely. But I also wouldn’t say the Fed could have stopped the meltdown either as I think Sumner believes they could have. This thing was well in motion by 2006 and there was no stopping the inevitable crash from occurring.
Certainly you can’t blame central banks for there are so many other moving parts however there does seem to be a correlation, I realize correlation is not a causation, between negative real interest rates and a subsequent housing bubble (Greece, Spain, US, and UK in the early 2000′s and Australia, Canada, China in the late 2000′s).
Isn’t this one of the most basic facts of our monetary system? Most of the money in the system is issued by banks as credit. So how can anyone says debt doesn’t cause recessions?
Most macroeconomists out there are not working within a framework that has debt creating recessions. There isn’t money in the model, or it’s not relevant, or it’s simply a vale, or they use an incorrect money multiplier. And even in models where monetary policy exists and can work, there still isn’t a way debt can create a recession in the Fisherian debt deflation or Minskyan tradition: one man’s debt is another man’s asset and they’re not differentiating among agents to allow for anything terrible to happen.
It really is that bad. You’re not going to get something realistic published in the leading mainstream macroeconomics journals, even after all that’s taken place in the last few years.
Although it’s sort of the conventional wisdom at this point, I think your average Joe Shmoe in the FIRE sector isn’t quite sure what to make of debt either. Most market practitioners think that it has something to do with the downturn, but very, very few have a coherent sectoral balance, SFC macro and/or MMT/MMR framework that they’re actually examining the economy in. Just turn on CNBC, or the much better Bloomberg. Pseudo-Austrian craziness and old wives’ tales about the Fed are way more common.
The bust wasn’t caused by housing values becoming too rich, but by bankers and lending using leveraged money to invest in mortgage securities.
For example, my house lost 40 percent of its value, but that doesn’t affect me at all, as far as my standard of living today. However, the guy holding my mortgage got a margin call and needed help from Uncle Sam.
Easy leverage led many actors to invest stupidly and the rest of us have to bail them out.
Homeowners had to be willing to buy the homes in the first place before bankers could lend. The boom is caused by demand.
Yes, but the bust — the financial crisis, the stock market dive, the continued weakness in the financial sector that has led to federal buyouts of Fannie Mae and other rotten debt — all of that was caused by the massive margin call that resulted from the drop in real estate prices.
Same thing happened in 1929 — it wasn’t that stocks fell, it was that investors were ruined because they lost more than their original stake.
Excellent post, Cullen. MR should be required reading for all economists to relearn how the monetary system actually works.
I just wanted to chime in. I just read Cullen June 28th 2012 version of MMR and noted a bunch of great edits. It is absolutely fantastic!
Thanks Dennis. I’ve worked really hard with the other guys to get things really detailed and accurate. No more of the fluffy analogies and vague story telling that we used under MMT. MR is crisp, clean, detailed and real. This paper has come a long way since it started out as a few paragraphs! Glad you enjoyed it.
I like the “car” analogy, it’s a very good tool. I finally get what you mean by “having more time” being a simple to explain ultimate goal of an individuals well being. Obviously it’s not some sort of worm hole.
Good post. One thing I would add is that the aggregate level of debt is important here (as I think your food metaphor alludes to). Rising debt also incurs rising interest costs. At low levels people may be able to pay the interest and still save a reasonable amount. As the debt-to-income grows, money is shifted from saving and consumption to interest and debt payments. This reduces demand over time and if aggregate debt is large enough can have cascading effects on corporations and banks. I expanded on this idea in my own reply to Sumner (http://bit.ly/OaOn1I).
So now i’m thinking, where is the next credit bubble preparing to burst? It’s not in consumer debt (still de-leveraging), not in housing (still reeling), commodities (not out of control), bonds (easily controlled by the fed), or even high rents (most don’t pay rent with credit cards or loans). The only area where the pump has been well-greased is the discount window lending by the fed, inflating paper-asset prices. The stock market is in a huge bubble, and commodities to a lesser extent; if rates go up and the loans decrease, the market should be hit extra hard.
Stock prices are unhinged by historical standards, but consider another kind of debt. It’s not going to have the same level of complex ABS and CDOs, but student debt’s going to be an enormous drag on consumer spending.
BTW the reason Sumner doesn’t believe debt causes recessions is because he believes in NGDPLT. In this regime, bad debt can always get inflated away over time (i.e. if you target 5% NGDP growth, and the economy “stagnates” with no real growth, then the debt gets slowly inflated away at 5%). So really, the post should be about why NGDPLT is wrong. (I have a hard time making up my mind because I find the contra analysis on the blogosphere rather limited, relying only on technical economic points rather on real-world and bahavioural issues. As, well, Sumner’s argument always comes back to some form of “look we’re doing inflation targeting and that stinks so if you’re going to do something that stinks why not pick the much less stinkier approach (NGDPLT).”)
There are numerous issues with NGDP targeting that I’ve tried to discuss on my blog. One is the myth of the money multiplier. The Fed has far less control over the money supply (including private lending) than is presumed and therefore inadequate ability to target NGDP on its own. Second, is the myth of monetary neutrality. Sumner and others assume that nominal factors (money) have no real effects in the long-term. The long-term, however, is a function of numerous short-term period. Money and debt do impact the real economy. Third, NGDP targeting permits high inflation and low growth, yet politically that would be unacceptable. Even if the Fed could approach its targets (which I doubt), its unclear the policy could be maintained credibly.
This is just the tip of the iceberg but hopefully provides some guidance.
Thanks. BTW your blog looks interesting; will give it a go, although at first, from the blog name, I thought I would get redirected to a porn site ;->
Funniest quote of the day!
I have a hard time making up my mind because I find the contra analysis on the blogosphere rather limited, relying only on technical economic points rather on real-world and bahavioural issues
It all comes down, of course, to their assumption that the Fed can make this inflation. That relies on
1) The money multiplier functioning in a more or less reliable manner. It’s been shown pretty decisively that this doesn’t actually exist.
2) An enormous degree of faith in expectations creating the inflation – literally, they think people and firms will pay attention to Fed announcements and prices will change accordingly. This is purely an assumption that arose because their models wouldn’t work. Expectations were basically a Deus ex Machina that allows you to explain away anything with a hand wave.
3) Historical precedent. No one can manage to get over the 1970s. They’ll claim the Fed was responsible for inflation then, and responsible for killing it, so why can’t we do it now? Never mind the fact that the Fed literally had negative risk free real interest rates at the time and we were experiencing enormous oil spikes that caused real shocks to the economy. They will conveniently ignore the disinflation occurring between oil shocks despite very low real interest rates.
Basically, their very, very simple macroeconomic models don’t reflect reality and they misread history. I wouldn’t waste my time with them.
Tulip mania, South Seas Bubble, 1920′s Wall Street stock frenzy, Japan property bubble, and U.S. bubble 95-2008. These were all credit driven expansions, that lead to BSR’s. How is it that economists do not use history as a laboratory to test their theories?
You can trace the credit expansion in the U.S. to when Bill Clinton signed GLB. Underlying all the expansions is something real, usually some sort of productivity improvement or technological know how. The 20′s were a time of great technological ferment, as well as the U.S. high tech revolution of the 90′s.
The future is so bright we gotta wear shades.
The rate of change of credit expansion means that “inside” money chases after goods faster than supply can come on line. Property in particular doesn’t follow supply and demand curves, so it asset inflates. Prices and inflation go up simultaneously, and since it can’t go on forever, it eventually collapses. (People cannot keep paying as there is no counter in productivity improvements.)
Once the collapse happens, debt remains on the books and demands to be paid. Inside money dries up due to reluctance to borrow or make loans, and assets drop in apparent value as “credit” is no longer chasing said assets. Now the economy enters into debt depression.
One of my money rules was abrogated, “Credit should only be borrowed if it goes for productivity improvements.”
I think a confusion may be that economics teaches that “inside” money is a net zero. That an asset (credit) is exchanged for a liability. Therefore no net gain or loss to the economy.
Steve Keen has done a fair bit linking rate of change of debt to aggregate demand and GDP growth. Others before him have done similar.
The two greatest financial busts of our time occured when debt levels (private debt not public debt) crossed over 300% of GDP.
So its not correct to simply say that rising debt levels lead to busts, but it is correct to say that once our debt levels cross a certain percentage of our incomes busts are imminent. This should be obvious. I can make a mortgage payment easily when its 15% of my income. Once it becomes 30% or more, if I suffer any loss of income or increase in costs of things like energy, food etc my financial stress rises.
Its not rocket science,we cant use 100% of our income to service past debts and still consume in the present
True. It depends on income growth and interest rates too, though. It’s easy to envision a more orderly march down in private debt after a run up if governments everywhere do the right thing and print a !@#$ ton of money. But they’ve never yet done the right thing without a war forcing them.
The credit cycle is made possible by the winners (net savers, net exporters) financing the loosers (net borrowers, net importers).
But debt borrowing and repayment capacities have limits, at which point reversals have to set in, ajustments, automatic stabilizers, etc.
It might be useful to consider a sort of economics homeotsasis, a property of the economic system to self-correct and converge to equilibrium. The bigger the dis-equilibrium (boom, the bigger and sharper the ajdustment (crash).
See more about the Limits of Divergence within the Eurozone in my blog PPP Lusofonia http://ppplusofonia.blogspot.pt/2012/07/eurozone-tests-limits-of-divergence-2.html
Cullen,
The New Arthurian Economics has a post following up on this discussion and ratio between “inside money” and “outside money”. Jumping off from a couple of his graphs I think I constructed a good metric that considers total private sector debt owed in relation to circulating money. This ratio is still only back to levels seen in 2000. The rest of these thoughts and charts are here http://bit.ly/NErA2b.