Arnold Kling  

Nick Rowe Asks About Debt Growth

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He writes,


I'm talking about the debt of households and firms. And I'm talking long run, not just the last few years. Over the last several decades, the ratio of debt to GDP has increased a lot. Not just in Canada, but in most rich countries, as far as I know. Why?

He proposes some answers, and I lean toward a combination of his (3) and (4), meaning more efficient financial intermediation and also excess growth of the financial sector. My line is that the nonfinancial sector wants to issue long-term, risky liabilities and to hold short-term, riskless assets. The financial sector accomodates by doing the reverse.

The financial sector can have a balance sheet consisting of risky, long-term assets and riskless, short-term liabilities by doing three things: diversifying risk, managing risk (screening out the worst projects, leaning on borrowers to behave), and "faking it" by using signals (ranging from plush lobbies to signs on the door that say "FDIC insured" to winks that suggest "too big to fail") and counting on creditors to maintain their confidence.

I think that the financial sector has gotten better at all three techniques over the last few decades. But they became particularly good at faking it. That is the story I would tell for the growth of financial intermediation and hence for the growth in private debt. It is a story that is unlikely to have a happy ending.


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COMMENTS (11 to date)
Jason writes:

Why didn't you end the post with "Have a nice day."?

mark writes:

There are a lot of reasons and I put a comment on his blog with some. One I didn't mention, but came to me afterwards, is simply this: the nations he is including in the sample have, for the first time in history, stopped trying to kill each other.

E. Barandiaran writes:

The answer to Rowe's question is this from your previous post:

"In most of the world [during the past 1,000 years], government and banking tend to be highly entangled. I read Niall Ferguson [and Charles Kindleberger] as saying that this entanglement historically came about because governments were financing wars. One of the dubious achievements of the Progressive movement was convincing Americans that such entanglement is necessary in a modern economy that did not need to finance wars [although it needs to finance the large expansion of the welfare state]."

plus a good understanding of the changes in the financing of government between 1930 and 1970s, including how financial systems changed in the late 1970s to recycle petrodollars.

Bill Shoe writes:

I think the answer is related to his "Not an explanation #1" (borrowing and spending too much). The only difference is that he talks in terms of incomes (flows of money), but I think the problem exists in assets (stockpiles of money).

I think overlending has slowly created a situation where two parties are both effectively booking the same asset. This overlending does not require balanced flows/incomes.

Naive lender A lends money to undisciplined borrower B. Then B blows the money on bad investments. B has effectively used up that asset and A ain't gettin' it back. A still has it on his books as an asset that will be paid back, due to bad information or reluctance to realistically price the likelihood of payback. A and B have both either blown the money or booked it as future income. They can't both be right.

Nick Rowe emphasizes the answer must describe very long-term economies. However, I think this asset double-booking is consistent with this. Housing and pension issues can in fact build for decades before they become impossible to continue.

I think my answer is similar to Tyler Cowen's concept of "We are not as wealthy as we thought we were".

Seth writes:

Because debt to GDP doesn't tell us much.

Seems like debt to total asset value would be a better ratio to look at.

brian writes:

Look, man has struggled with debt/credit for millenia. It's why usury laws are a mark of early civilization and why the Hebrews had their Jubilee. Debt is like a drug which in appropriate doses is great, but which human nature cannot resist over-consuming. So we have these generational cycles (not Austrian business cycle) ending in panic. Those who experienced the 30's hated debt, but when their influence waned, we abused structured finance.

It's interesting to me that no one has been able to put this issue into a post-modern framework so that it can be discussed in mixed company without the stigma of "morality."

I used to think that disallowing interest expense as a tax deduction for business as one of the stupidest ideas I had ever heard. Now I am not so sure.

Bill Shoe writes:

@brian, yea I think debt itself is the problem. Over the last 3 years everyone has blamed banks, currencies, government regulation (or lack of it), fed policies, etc. Nobody ever stands up and says "oh, debt doesn't work well".

Arnold says we need to seek systems that are easy to repair rather than systems that never fail. If firms (and governments) were funded with equity instead of debt then failure would be acceptable. The existence of debt is what makes failure so bad that it can't be tolerated.

Foobarista writes:

A few other points:

1. Technology. Technology advances have made it much cheaper and easier to package and quickly approve loans than previous times, so consumer debt is far more widely available (and used). Add to this wide availability and instant electronic access to FICA scores, credit reports, etc, so debt is much easier to access than it once was, for both buyers and sellers. The machinery for processing a loan for a car, washing machine, or flatscreen TV takes just a few minutes.

2. The "financial sector" isn't just banks. Given technological advances, loans are originated at nearly any retail establishment - theoretically, any place that accepts credit cards.

R Richard Schweitzer writes:

Simple:

Graph the rate of inflation vs. the increase in the various forms of private (non-governmental) debt.

Governmental debts contribute to inflation because they are pure consumption or distributional costs.

Gary Rogers writes:

Let me sum it up: STIMULUS!

The definition of economic stimulus is to find ways to encourage people to spend instead of save. Economic stimulus can run the gamut from giving away money by mailing government checks to borrow and spend programs to create jobs to the Fed pushing interest rates down. On the one hand we see some kind of stimulus each time a recession even looks possible but when was the last time either the government or the Fed promoted savings?

The factor in this case that I think requires the most scrutiny is low interest rates. When the Fed pushes interest rates lower it directly affects lending and savings rates. Consider that if I get less than 1% interest on my savings account and can get an extremely low interest mortgage, I am more likely to go out and buy a big house than I am to grow my savings. Isn't the best way to move up the economic ladder founnd in the ability to accumulate capital through savings? Low interest rates discourage savings. But, we all know the Fed cannot keep interest rates low for long without triggering inflation don't we? Evidently they can.

I suggest that there are other things going on in our complex economic puzzle that have made it possible for the Fed to continue pushing low interest rates for years. Several responders recognized what exporting countries are doing by loaning back the dollars we spend on their products and our money hungry government is a willing participant in the transaction. Demand to purchase debt drives bond rates down. Second, and a factor that I do not hear very often, is the wave of retirement money in the IRA and 401K accounts of all the boomers that are rapidly approaching retirement. This money is seeking a safe but significant rate of return which tends to move toward investments that are packaged to look safe but still yield a decent return. All of this excess money looking for an investment helps push down interest rates. Third, something that I almost never hear, is the deflationary effect of borrowing money. We know that the Fed has been doing Quantitative easing by buying up bonds and inserting cash into the economy. So, wouldn't the opposite happen when the government borrows $1.5 trillion a year from the economy? This by itself probably needs more explanation but I am convinced it is significant and real. Congress deflates on the one hand while the Fed is frantically trying to inflate on the other. No wonder the bankers are getting rich on the inflationary side while the rest of us are getting poorer on the deflationary end of the transaction. It is not the bankers but an insane economic policy that we should be fighting.

With the complexity of the economy I am sure there are other things going on, but from my view this explains a lot.

Charles R. Williams writes:

My household's debt is about 150% of my household share of GDP. I could pay off my mortgage tomorrow taking 150% down to 0%. There are two reasons I don't. First, my mortgage is the only protection I have against inflation wiping out a fixed income stream. Second, my savings are tied up in tax sheltered accounts and I face a lower tax rate in the future. Effectively, I have borrowed a huge sum of money from myself. The primary significance is that somebody else is making a lot of money - I estimate about 5% of my total income.

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