Credit only where it’s due
What does credit do after it has finished the job it was designed for? The supply of credit ought to stop at funding productive activity. But the reality is different. Surplus credit fuels dangerous asset price inflation and funds profligate governments. As leverage increases, so too does the risk of crisis and recession.
Credit, otherwise known as debt or loans, is not necessarily monstrous. It can be a most helpful economic beast of burden, carrying resources to the places where they can be best used. Loans from households to businesses fund helpful investments, and loans from rich older households to poor younger ones help spread property, especially houses and cars, more equitably. Even loans to governments can be a useful alternative to taxes.
However, credit too easily goes astray and there is no natural force to rein it in. Without firm regulatory guidance, credit seems to expand indefinitely, until the financial system explodes. That has been the pattern since the end of the Second World War.
Academics Moritz Schularick and Alan M. Taylor showed in a 2012 paper that the ratio of bank credit to GDP in developed economies fell during the Great Depression and then expanded steadily and rapidly. Combining the 14 countries studied, the ratio surpassed the previous pre-Depression peak of about one by 1970, and started the 2008 crisis at just below two.
Their work does not directly include government debt, but that has also increased, from 60 percent of GDP in the G7 countries in 1990 to 83 percent just before the crisis, according to the International Monetary Fund, and 122 percent this year.
Economies typically become more credit-intensive as they become richer. But excessive credit growth is dangerous. In another paper, Schularick, Taylor and Òscar Jordà point out a consistent pattern in developed economies: a “stronger increase in financial leverage … in the prior boom tends to correlate with a deeper subsequent downturn.”
Little of the new credit created in the last few decades has served the overall economy. Schularick and Paul Wachtel recently ran the numbers for the United States. They show that the business sector has not borrowed from the rest of the economy since 1960. The pattern is similar in other developed countries. In other words, business profits were high enough to fund all desired investments.
Instead of funding growth, the proceeds of new private debt were mostly used to buy existing property, commodities, collectibles and financial assets. That pushed up asset prices but did not add much economic value.
Some new credit seems to have gone into consumer loans which pumped up the spending by poor Americans, although the use of mortgages as sources of cash complicates the analysis. Such lending for consumption is a bad substitute for what is sometimes called “pre-distribution” – making incomes more equal in the first place.
Then there is the increase in government debt. The proceeds of new loans were mostly used to avoid levying unpopular taxes. In a better run political system, that would not happen. More recently, the proceeds of debt have mitigated the effects of the financial crisis. In a better run economy, that would not be necessary.
Credit grew to an unhealthy size and then wreaked havoc. It remains too large and out of control – the ratio of total non-financial debt to GDP is higher now than before the crisis. Yet central bankers and politicians do not seem to have registered the risk of too much credit.
Yes, central bankers are talking more about macroprudential regulation, and governments continue to promise balanced budgets or even surpluses whenever economic conditions allow. However, there is almost no hard analysis of the mix of productive and unproductive debt, and no sign of any effort to change attitudes or practices.
The key change needed is psychological: the recognition that the value of an asset should only increase when the asset produces more of value to society. If that principle was accepted, the practical moves to stop unproductive lending would come almost naturally.
Regulation would play a big role. Supervisors of banks and other financial intermediaries would classify loans by use as well as by safety. Loans to support investment would be strongly favoured. Carefully controlled residential mortgages are fine – they convert rental expenditure into helpful purchasing power.
The tax system could help. The old idea of a punitive tax on unearned capital gains on land should be revived. Speculation becomes less attractive if the government takes virtually all of the gains.
Finally, fiscal arrangements need a rethink. Government deficits may sometimes be required to keep demand up. But if there really is unused capacity in the economy, it can be put to work just as effectively by the government printing money instead of borrowing it.
Right now, these plans are unpalatable to voters and many economists. But unproductive credit is a dangerous creature. Unless it is tightly controlled, it will surely ravage the economy once again.