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Unlimited Credit

This post from November 2015 is becoming more important as the federal deficit ratchets up and private credit is turning back up.  I am leaving in the references to Sanders and progressive counters because they may well be current again.

If you’re like most people, you probably think that you can never have too much access to credit. After all, you never know what might go horribly wrong or when an opportunity to really follow your dream might come up. A little scratch ready in the background might be the difference between the good life and something much less.

Then again, a lot of credit has a corrosive effect. In a world saturated with borrowing everything is judged against the expected return if the money was simply loaned out at market rates. It seems reasonable that where a little credit is a good thing a lot of credit, defining everything in the world, is the biggest enemy of both long-term thinking and a society looking to maximize happiness and human potential.

Logic says that where a little credit is good a lot could be bad, meaning there is an optimal point. Where is that? Where are we with respect to a good level of credit? It turns out that train left the station a very long time ago – and this may explain a lot of the problems in this economy.

Roger Bootle is always looking out for new perspectives.

Roger Bootle is always looking out for new perspectives.

It’s important to define the terms before we get to the data. The issue at hand isn’t borrowing but available credit – whether it’s used or not. The term for it is “financial capacity” or the ability to finance everything in the world. The concern is that simply having credit available is the main force creating a world where everything is defined in terms of its monetary value, right now, rather than any social or satisfaction.

The root of this perspective comes from looking at the economic world as a dichotomy of sorts – those actions that produce goods or services which are new and those actions that merely distribute what is already know. Economist Roger Bootle, one of the most esteemed economists in London and frequent contributor to the Daily Telegraph, separates the two this way:

The whole of economic life is a mixture of creative and distributive activities. Some of what we ‘‘earn’’ derives from what is created out of nothing and adds to the total available for all to enjoy. But some of it merely takes what would otherwise be available to others and therefore comes at their expense.

Successful societies maximize the creative and minimize the distributive. Societies where everyone can achieve gains only at the expense of others are by definition impoverished. They are also usually intensely violent.

Much of what goes on in financial markets belongs at the distributive end.

Workers of the World, Unite!

Workers of the World, Unite!

In other words, financial people don’t actually make anything. The more we use them as our yardstick and the more we consume their services the more we become a world of a well defined pie – all gains come at the expense of someone else.

His warning, that this is the root of a violent society, is especially chilling.

Bootle is far from a political progressive, too. His point is the rather conservative (small “c”) one that the financial world may be necessary but at some point it actually contributes to instability and short-sightedness because its contribution to the “product” of society is ultimately nill.

Barataria has written about this problem from many other perspectives in the past, the most important being that of resiliency – the ability to weather storms on a personal and social level. But this has come to the presidential campaign in a speech by Hillary Clinton decrying “Quarterly Capitalism” which deserves far more attention.

"You're money's not here ... it's in your house, and yours!"

“You’re money’s not here … it’s in your house, and yours!”

All this is well and good, but can we define a point where there is an optimal level of credit available to grease the skids and allow us to realize the good life without becoming slaves to the financial industry? According to a 2012 paper written by International Monetary Fund (IMF) economists Jean-Louis Arcand, Enrico Berkes and Ugo Panizza we can empirically define a such a place.

Leafing through both a history of thought on this topic and national economies over the last century, they were able to come up with a reasonable answer. It turns out that when available credit to the private sector hits between 80-100% of Gross Domestic Product (GDP) the effects of having more credit are actually a net negative for growth.

The financial world starts to dominate and the bean-counters take control from the entrepreneurs, engineers, and artists – as well as the workers and doers. Too much credit means the unproductive, distributive world makes slaves of the productive world. How is that? Give the authors the first word:

This result is surprisingly consistent across different types of estimators (simple cross-sectional and panel regressions as well as semi-parametric estimators) and data (country-level and industry-level). The threshold at which we find that financial depth starts having a negative effect on growth is similar to the threshold at which Easterly, Islam, and Stiglitz (2000) find that financial depth starts having a positive effect on volatility. This finding is consistent with the literature on the relationship between volatility and growth (Ramey and Ramey, 1995).

In shorter words, the higher the reliance on finance the more there are “bubbles” which mis-allocated resources and increase volatility – as we saw in the many bubbles that defined the 2000s.

Given this rough gauge, where is the US now? Where have we been? Financial Capacity is easy to calculate and graph – and the results tell us something amazing:

Financial Capacity, defined as available private credit as a share of GDP, since 1952.  Data from the St Louis Federal Reserve.

Financial Capacity, defined as available private credit as a share of GDP, since 1952. Data from the St Louis Federal Reserve.

Despite a recent pull-back, Financial Capacity has been expanding rather continuously since the end of WWII – and currently stands about double that magic optimal range estimated by the IMF. More interesting, the mid-point of their estimated optimal maximum, 90%, was hit sometime around 1974.

There's always a fight.  This one is more interesting.

There’s always a fight. This one is more interesting.

If you lived through the 1970s you may have a strong opinion about what exactly went wrong. Acceptable answers include Nixon, hairspray, polyester, disco, and cocaine. It’s pretty rare to find someone who will tell you there wasn’t something terribly wrong throughout that decade.

Barataria has written before on the broken social contract between labor and capital that used to divide the fruits of the economy 50/50. That unwritten agreement was broken about 1974, with the split now 57/43 in favor of capital. The difference is far from trivial – about a trillion dollars a year or $9,000 per household.

What exactly happened in 1974 to change the relationship? In the past we’ve offered a few suggestions centering on labor markets, globalization, and increasingly cheap capital. Add to that list a very subtle effect that makes that year an important turning point – it was the year that finance started to become a net drag on the economy, the year when the financial operators took control and started to define everything in our lives on their terms.

Feel the Bern?  That flame has to last if he's gonna do it.

Feel the Bern? That flame has to last if he’s gonna do it.

If this is the case, how do we get rid of them? The answer doesn’t come from politics, although your opinion about the decline of workers over the last 40 years probably informs your opinion of Sen Bernie Sanders, at the very least. The answer comes from our own choices about how we rely on credit, as individuals and as a society – and how that makes slaves of our thinking and ultimately changes our choices.

What will it take to return control to those who, in the words of Roger Bootle, are “creators, not distributors”? There is a chance that a few laws here and there might make access to credit more difficult, but that misses the point.

Easy access to a lot of credit is more of a social value than anything else. Change that and we may just change the world – and free the creators, the makers and doers, to have a good life once again.  And let’s not forget Bootle’s observation that societies which fail to understand this are “usually intensely violent” – something that constantly gets our attention in today’s America.

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