“Screwed-up” logic

In Fitting some pieces together my “offensive” (that´s because he called me “bogus”) friend writes:

Come to think of it…

I’ve been saying since forever that excessive debt hinders growth.

Some time back I looked into the erosion of debt by inflation.

Lately, I’ve been noticing that real GDP growth was consistently better during the Great Inflation than at any other period in the data FRED provides.

Now I’m thinking it was the erosion of debt during the Great Inflation that enabled the superior economic growth.

What this would mean is that, already during the Great Inflation, debt was excessive.

What it means for you is that if we want good growth without inflation, policy has to help you get your debt down to a very low minimum.

Something you always wanted.

It´s a great piece of “screwed-up” logic!

These are the relevant charts. In what sort of world would you prefer to live? Also, in what sort of world would you expect debt ratios to be higher?

In the first charts we see the combination of real growth, inflation and unemployment during the “Great Inflation”. Between 1968 and 1981, real growth averaged 3.06% with a standard deviation of 2.6. Unemployment was on a rising trend as was inflation (gauged by the core PCE).

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Now look at the same combination during the “Great Moderation”. Between 1987 and 2007, real growth averaged 3.02% with a standard deviation of just 1.35. Unemployment was on a downtrend and inflation persistently low. The charts are on the same scale to make comparison easy.

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To him, debt is the driver of the process. Increase debt, generate inflation to erode the value of the debt and come out with “superior” growth!

He forgets that debt is endogenous. Why did the debt ratio rise during the “Great Moderation?” Maybe for the same reason that after being flat (in nominal terms) all through the “Great Inflation”), stock prices trended up for seventeen straight years between 1982 and 1999.

Would that be associated with a more “friendly” (less “risky”) macroeconomic environment (low macro volatility)?

When you look at household debt, you see that the lion´s share of the increase in the household debt ratio came from the increase in mortgage debt. Did the several incentives given to “homeownership” distort decisions? Quite likely, but that´s an altogether different question.

His “logic” closes with the recommendation to keep debt at a very “low minimum”. The lowest minimum is zero. Maybe the “best performing” economy would have “zero debt” (and assets)!

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5 thoughts on ““Screwed-up” logic

  1. Marcus,
    Things are often not clear for me unless expressed at an offensive intensity. I sincerely thank you for evaluating my work. A slow thinker, I will take some time with what you wrote. I will get back to you after that, assuming I have a useful thought. Meanwhile I have a few short notes.

    1. Please note that my objection is to “excessive” debt, not ANY at all. If you insist I point out a level, I point to the early 1960s… to the time BEFORE the 1966 end of the Golden Age as defined by Minsky. Let’s say less than 150% of GDP. Why we would need to have more credit-in-use than that, escapes me.

    2. Please, and this is very important: I am NOT calling for inflation. I am only TRYING TO EVALUATE the effects of inflation. So when you write:

    To him, debt is the driver of the process. Increase debt, generate inflation to erode the value of the debt and come out with “superior” growth!

    I must holler back NO THAT’S NOT RIGHT!
    Credit-use actually is the driver of growth. Debt is only the costly evidence of credit-use.
    In an economy with significant debt, AS IT HAPPENED the inflation of the 1965-1984± period significantly reduced the cost of that debt relative to income.
    BECAUSE the cost of that debt was significantly reduced, the economy was ABLE to continue growing well above trend as YOUR graph shows.

    I am not saying let’s have more inflation. FAR from it. I am saying, please try to understand the process as I see it. The thing that hinders growth is COST — in our case, the cost of debt. NOTE that I write: “if we want good growth without inflation, policy has to help you get your debt down”… I NOT say we should increase inflation.

    Hey, my ideas could be wrong. But you have to criticize what I’m really saying before you can convince me that I’m wrong.

    3. You remind me that debt is endogenous — meaning, generated within the private sector by borrowers and lenders (setting government debt aside, I guess). Close enough? Okay.
    But you also point out that household debt grew “quite likely” because of “the several incentives given to ‘homeownership’”

    Yes!
    THE GROWTH OF (ENDOGENOUS) DEBT WAS DRIVEN BY POLICY.
    BUT WE HAVE NO POLICY TO ENCOURAGE THE REPAYMENT OF DEBT.
    We have no policy that offsets the imbalance (excessive debt) created by policy.

    Thanks Marcus. Get on my case any time!
    Art

  2. First some data:

    http://research.stlouisfed.org/fred2/graph/?graph_id=104716&category_id=0

    http://research.stlouisfed.org/fred2/graph/?graph_id=104719&category_id=0

    http://research.stlouisfed.org/fred2/graph/?graph_id=104722&category_id=0

    1) The Great Inflation had its good times. During 1964-74 unemployment was almost always below the natural rate of unemployment. From 1963 to 1974 the real growth rate of actual GDP and potential real GDP was about 3.9%. Household sector leverage fell from 64% of disposable personal income in 1963 to 62% in 1974. But core PCE inflation rose from 1.3% in 1963 to 7.9% in 1974.
    2) The Great Moderation had its bad times. During 1990-97 unemployment was always above the natural rate of unemployment. From 1989 to 1997 the real growth rate of actual GDP and potential real GDP was about 2.8% and 3.0% respectively. Household sector leverage rose from 80% of disposable personal income in 1989 to 89% in 1997. But core PCE inflation fell from 4.1% in 1989 to 1.9% in 1997.
    3) The good times of the Great Inflation came at the price of an ever accelerating inflation rate that was unsustainable. The bad times of the Great Moderation were the result of a long period of persistent disinflation, which in NGDP level targeting is unlikely to happen.
    4) It’s possible that the high growth rates in potential GDP during the good part of the Great Inflation owe something to an economy that was persistently above potential, and the low growth rates in potential GDP during bad times of the Great Moderation owe something to an economy that was persistently below potential. But it’s more likely that the rate of growth in potential GDP is mostly determined by other factors.
    5) Mason and Jayadev (2012) showed that “Fisher dynamics” – the mechanical effects of changes in interest rates, growth rates and inflation rates on debt levels independent of borrowing – explain the evolution of household sector leverage very well:

    http://repec.umb.edu/RePEc/files/FisherDynamics.pdf

    They find that whereas the household sector more often borrowed than not during the 1964-74 period, the household sector ran a primary surplus throughout the 1990-97 period. Mason and Jayadev estimate the the effective interest rate on household sector debt as the weighted average of the rate of mortgage, installment and revolving debt. This lags the current market averages. They find that the real effective interest rate was only about 2% during 1964-74 but was about 5.5% during 1990-97.
    6) It’s likely that accelerating inflation and financial repression contributed to the low real effective interest rates of the Great Inflation, and that disinflation and financial liberalization contributed to the high real effective interest rates of the Great Moderation. But the primary contributing factor to rising household sector leverage is financial innovation and lax credit standards, neither of which can be blamed on monetary policy.

  3. Mark: “the primary contributing factor to rising household sector leverage is financial innovation and lax credit standards, neither of which can be blamed on monetary policy.

    What, then, is policy for???

    I’m sure Mason and Jayadev cover it, but the fall in “household sector leverage relative to disposable personal income” can be largely explained by inflation’s effect on disposable personal income. Inflation affects stocks and flows differently.

    Potential output and natural rates are calculated by working backward from actual conditions, and if conditions do not vary along the expected path, the calculations are revised for times past. The history of potential output changes as new data becomes available.
    Therefore, I am uncomfortable with an analysis that evaluates actual performance by comparison to potential output and natural rates.

    • “What, then, is policy for???”

      Monetary policy is the process by which the monetary authority of a country controls the supply of money (often targeting a rate of interest) for the purpose of promoting economic growth and stability. This has virtually nothing to do with credit policy.

      Credit policy can vary considerably within a monetary zone. For example the debt to income ratio increased substantially in Spain and Nevada but by little or even declined in Germany and Texas during the global housing bubbles. This occurred despite that fact that Spain and Germany, and Nevada and Texas, were subject to the exact same monetary policy. What was different was the credit policies within the respective countries and states within the monetary zones, over which the central banks had little to no control.

      “Inflation affects stocks and flows differently.”

      That was one of the whole points of my mentioning it. But constantly accelerating the inflation rate to hold the level of debt constant, or to decrease it, is surely not a sustainable process, is it?

      I mentioned potential GDP mainly for Marcus’ benefit. I think it is a useful concept, but the practice of NGDP level targeting would render it largely unnecessary for policy making purposes.

  4. Marcus, lets look at your RGDP Growth – 1987-07 graph:
    Since 2001 the growth was all slow. Set that part aside.
    Before 1992 the 1991 recession could easily swallow the 1988 peak. Growth in these early years was no better than the 3.02 average.
    This leaves us with about a decade of superior growth in the middle of the 1987-2007 period.

    What could have caused this superior growth?

    You would say NGDP growth was satisfactory. Okay.
    You might say that the spending in those years was satisfactory. Okay.
    You might even say that the quantity of money in those years was satisfactory. Okay.
    You’re almost there. Look at the components of the money (in red) overlaid on RGDP:

    http://research.stlouisfed.org/fred2/graph/?g=eUC

    Before 1991, total debt was increasing relative to the quantity of circulating money
    From 1991 through 1994, debt was decreasing relative to money.
    Since 1994, debt was again increasing relative to money.

    The 1991-94 decline of debt made it easier for debt to increase again later.
    The 1991-94 increase of circulating money gave us an alternative to borrowing.
    This combination of factors reduced financial cost and opened a door to growth.
    The result was the decade of superior growth shown on your graph.

    People say the good growth of those years came from improvements in Information Technology. You and I know better. The good growth worked itself out through improved IT, but the moving force behind it all was the money.
    Art

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