Sunday, May 13, 2012

Pitfalls of Credit Induced Growth - My Article in Hindu Business Line

Date: May 2, 2012


With the operation twist coming to an end in June, the world is all ears to any hints dropped by the Federal Reserve of what may come next. Whether we agree with their existing policy or not it's important that we view the world from their co-ordinates and in particular the role that credit has played in our economy in the past 4 decades; because its only then we would realise that this exercise of bond buying  every year coupled by large government deficits is an exercise that would continue as far as one can see because the moment this stops the natural deleveraging cycle would take over and taking with it years of growth created on the foundations of credit.
 In the era of commodity based money, it was the savings that used to drive credit and thus growth. So people used to save their money in banks and banks used to lend that money to entrepreneurs and corporates. Ever since the dawn of fiat money it is really the credit that drives both savings and growth.
Since 5 centuries it is well known that an increase in credit is accompanied by an increase in growth rate. So post 1970 when the Central Bankers received an almost omnipotent control of the nation’s monetary policy they have used this relationship extensively; hence whenever the economy used to take a breather in order to unwind the malinvestments in the form of lower equity and bond prices particularly of the financial institutions, the Central Bankers always used to come in and artificially reduce the interest rates thus performing two critical actions: 1) Saving the financial institutions equity and bondholders from losses and 2) Reigniting the growth of credit which would then boost the GDP growth
However as a result of these interventions and the supposed transcendence of the period of “The Great Moderation” the malinvestments that would have unwound with some losses to equity and bondholders have become even bigger and now threaten to take down even the savings of the masses if a system wide deleveraging were ever to happen. Post 2008 with the financial and the household sector deleveraging (excluding the massive uptick in student loans) the increase in government debt is avoiding precisely such a scenario.
Now as we understand from preliminary economics an increase in government deficit is equivalent to an increase in private sector savings. So the government deficit is not just providing that marginal growth in credit but also allowing the private sector to de-lever.
Just so that the annual trillion dollar additional government debt doesn’t overwhelm the system, the Federal Reserve will constantly engage in its bond buying exercise and thus try to keep the bond and stock markets afloat.

Both these operations are justified under the garb of the fact that there still is a lot of slack in the economy which brings me to an important point associated with the credit growth of the past four decades. As can be observed from the graph, the impact of a dollar increase in credit on GDP has reduced significantly every decade. So much so that now the real GDP increases by just 8 cents for every dollar increase in credit.

The secret of the reducing efficacy of credit on GDP can be observed in the next graph. As one can see that even though the credit has been increasing over this time the financial sector of the economy has seen a massive growth while the credit growth in corporate sector has lagged behind, so much so that now the total credit in the financial sector overwhelms that of the productive corporate sector. Isn’t it ironic that a sector like financial which is supposed to be a facilitator or tertiary to the main economy is now infact the leader as far as its contribution to total credit is concerned. This is precisely due to the irresponsible policies of the Central Bankers that didn’t allow the unwinding of the bad debts of this sector and letting the bondholders and equity holders be wiped out. So with every single intervention these debts instead of getting unwound have only ballooned. As a result of this each of the recoveries since 2001 has produced fewer jobs.
Post 2008 with the overall credit in the financial sector reaching its zenith, what the policy makers are now hoping is that the corporate sector slowly picks up this debt that the financial sector unwinds and during this transitory phase the government carries the baton helped ofcourse by the Federal Reserve. However this is the same misguided hope that has led the world into the current mess. The government expenditure accompanied by the Federal Reserve’s bond buying programs is nothing more than a transfer of wealth, the same phenomena that has been happening for the last 40 years in the fiat money regime i.e. from people who earn their money from labour to holders of assets thus widening the income gap.
So meanwhile our policy makers wait for the corporate sector to takeover the credit creation baton, the misallocation and thus destruction of the resources in the real economy continue thus ensuring that the next fall would be even bigger.

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