Arnold Kling  

Lectures on Macroeconomics, No. 10

What's Wrong with Deleveraging... DeLong vs. Kling...

A long-standing controversy in monetary theory and macroeconomics involves the question, "Is it money, or is it credit?" In most of the macro theory of the past thirty years, the focus is on money. This is nice because you get to write down M and stick it into equations. Thinking about credit does not lend itself to equations. But if equations are the proverbial lamp post, and we've lost our watch somewhere else, then we should dare to look elsewhere than under the lamp post.

Suppose we have a butcher, a baker, and a candlestick maker.

The butcher says to the baker, "I'd like a cake. I'll pay you for it when I get paid for my hamburger, which should be soon."

The baker says to the candlestick maker, "I'd like a candlestick. I'll pay you for it when I get paid for my cake, which should be soon."

The candlestick maker says to the butcher, "I'd like some hamburger. I'll pay you for it when I get paid for my candlestick, which should be soon."

If they are all willing to extend credit to one another, you can see how this economy will work. The baker will bake a cake and sell it to the butcher, etc. Everybody gets what they want, and everybody gets paid.

In general, though, trade does not take place this way. Instead, trade is facilitated by an institution that is trusted by all parties. That institution might be currency. Or it might be banks.

Suppose we have an economy that has come to depend on banks for supplying trade credit. You can see that if the banks are very generous, lots of businesses can operate on the basis of accounts receivable. Maybe some of these businesses even operate unsoundly--perhaps their capital expansion plans are based on overly optimistic assumptions.

Suppose it turns out that the baker bought too many ovens, issued bonds to pay for them, and it turns out that he cannot repay the bonds. His bank no longer wants to advance him funds against receivables, because the bank is afraid that the receivables might not actually materialize or, if they do materialize, the bondholders will claim them. So the baker's bank credit dries up.

You can see that if bank credit dries up for a lot of businesses, economic activity can decline. The butcher can no longer get bread, the baker can no longer get candlesticks, and the candlestick maker can no longer get hamburger.

What are the policy implications? If the banks are still lending but the baker has too many ovens, then it seems as though the best thing to do is just let the baker and his creditors suffer. The economy's capital needs to be re-deployed, and there is nothing to be done about it. People are not as wealthy as they thought they were.

If the baker has not over-extended, but bank credit dries up for no good reason, then government can improve the outcome by stepping in to replace the banks. If the government provides credit, or it induces the banks to expand credit, economic activity can be restored.

In real life, a slowdown in credit can reflect both factors. That is, borrowers may have over-extended, and there are adjustments and wealth losses to be endured. But in addition, banks may have become exceedingly cautious, denying credit in ways that produce a needless contraction in economic activity. The ideal government policy then involves letting failed firms fall by the wayside while promoting credit expansion for viable economic activity. But how does the government know what is viable economic activity and what is the desperate flailing of insolvent firms?

The challenge is difficult enough for a government that is motivated solely by economic considerations. In practice, one can be certain that the political bias will favor bailouts of failed firms. This is the opposite of the correct economic approach, since it keeps capital misallocated.

Previous lectures:

1. Introduction
2. Misconceptions about Labor Markets
3. Unemployment as an Adjustment Problem
4. Why Wage Cuts are Rarely Used
5. The Dotcom Recession was, by one indicator, rather severe
6. Labor Markets in the Post-industrial Economy
7. Imperial Origins of Money
8. The Relationship Between Government Money and Private Quasi-Money
9. The Nonfinancial Sector and the Financial Sector

Comments and Sharing

CATEGORIES: Macroeconomics

COMMENTS (7 to date)
winterspeak writes:


Do you ever suspect that your analogies shed more (ahme) light than heat, and that there are far simpler and more accurate ways to think about all of these things?

Have you spent some time to get even a basic understanding of what money is in a fiat currency system? Do you have any sense for how fiat money gets created by a government, gets into the real economy via banks, and is then extinguished through taxes?

Let me give you a hint, the creation of fiat money happens in t-tables on balance sheets, it does not happen through reams of green paper coming of printing presses.

Does that give you any insight into the distinction between money and credit, and how real that distinction might be?

Bill Woolsey writes:

Your analogies start off being supposedly complete accounts of the economy, and then, as soon as problems develop there are other sectors of the economy thrown in.

Now we have the oven maker.

Supposedly our three tradesmen want to sell. For what exacty? Currency? Who issues that? How?

Those of us who insist that it is money that counts point out that a desire to earn and not spend is an increase in the demand to hold money.
It doesn't necessarily have to do with a desire to borrow.

If the quantity of money is given, the market process that adusts the nominal demand to nominal supply (or real supply to real demand) is a change in the purchasing power of money. Inflation or deflation.

Deflation is very disruptive.

Therefore, macroeconomics.

Of course, money is tied to lending because most money is funds lent to banks(generally "deposits.") That is why money and banking focuses on the impact of banking on the supply of money.

If you assume away the macroecnomic problem--then all you have is sectoral shifts. For example, I consume my income rather than attempt to save it and lend it, because I don't trust anyone.

No one wants to finance my risky project. They want to use all of their income to fund current consumption.

The lack of investment is inflationary. Everyone wants more consumer goods now, and in the future, we can't produce as many because we haven't produced capital goods. Everyone was too worried about the risk. It might happen. And when we a "recession" based upon a shift from investment to consumption-- let me know.

When we observe reductions in spending, sales, and production across the economy.. then there monetary disequilibirum.

One key to macreconomic reasoning is to always ask, "so what are they doing with the money that they don't spend?" When the answer is, "they are just holding it," then.... you are talking about monetary disequilibrium.

fundamentalist writes:

Very nice analogy! Clearly explains the way that business relies mainly on credit. The old Currency School in England of the mid-19th century didn’t understand this, so they limited the growth of currency by the bank, but not the growth of credit. As a result, they experienced again the inflation/deflation cycle that they thought they had killed with limits on currency creation.

Gary Rogers writes:

That sure seems to explain money velocity. The same transactions would take place without credit, but each party would have to wait to get paid before making a purchase so everything would slow down. As soon as the candlestick maker learns that the baker has too many ovens and may not be able to pay his bills, he will ask the baker to wait for his candlestick until he can pay in cash.

Does this explain the trillions of dollars the fed and treasury have dumped into our economy to provide liquidity? It seems like there is more going on than simply a loss of monetary velocity?

Mattyoung writes:

Now you have me reading the anthropology of money.

I would guess that money, in its primitive derivation, is command authority from the village chief, the chief lending the crown jewels to warriors charging them with the authority to confiscate goods and labor.

Separately, I would expect that during times when a money economy contracts, we regress to the earlier, more primitive functions of money.

What we witness is the rebellion of digital money against the greenback, and the royalists are manning the ramparts.

AJ writes:

Arnold, I love this analogy (as well as others by you). In this example, you show the complete link between money and credit - a continuum of instruments in real life.


Mike Sproul writes:


"the creation of fiat money happens in t-tables on balance sheets, it does not happen through reams of green paper coming of printing presses.

Does that give you any insight into the distinction between money and credit, and how real that distinction might be?"

AMEN! Federal reserve notes are the liability of the Fed, which issued them. Dollars in a checking account are the liability of the private bank that issued them, credit card dollars are the liability of the company that issued them, and a walmart gift certificate is the liability of walmart. Only a highly-trained macroeconomist would be foolish enough to aggregate all of those things together and ask pointless questions about which of them qualify as money.

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