Monday, September 19, 2016

The Credit Economy

Credit Growth Drives Economic Growth, Until it Doesn’t

The single most important thing to understand about economics in the age of paper money is that credit growth drives economic growth.

Before the breakdown of the Bretton Woods international monetary system in 1971, there was a difference between money and credit. There no longer is.

Paper dollars and US treasury bonds denominated in paper dollars are just different types of government IOUs. When gold was money, the increase in the Money Supply (M1 and M2) had an extraordinary impact on the economy. Today, what matters is the increase in the total supply of credit.

The best source of information about credit and credit growth in the United States is the Flow of Funds, published quarterly on the website of the Federal Reserve. Every serious analyst of the US economy should be familiar with the Fed’s Flow of Funds. Google it.

At the end of 2010, $52.6 trillion of credit was outstanding in the United States. In 1971, the ratio of total credit to GDP was 150%. Now it is 354%. In other words, credit has been growing much more rapidly than the economy for the past four decades.

It is easy to understand how rapid credit growth facilitates economic growth. When credit is expanding, consumers can borrow and spend more and businesses can borrow and invest more. Increasing consumption and investment creates jobs and expands income and profits. Moreover, the expansion of credit tends to cause the price of assets such as stocks and property to increase, thereby boosting the net worth of the public.

Rising asset prices give the owners of assets more wealth (i.e. collateral) against which they can borrow still more. This cycle of expanding credit leading to increased spending, investment, job creation and wealth, followed by still more borrowing produces a happy upward spiral of prosperity….so long as it continues. Eventually, however, every credit-induced economic boom comes to an end when one or more important sector of the economy becomes incapable of repaying the interest on its debt.

The Flow of Funds breaks down the US credit market into three main categories: the domestic non-financial sector (69% of total debt), the domestic financial sector (27%) and the rest of the world (4%). The non-financial sector is comprised primarily of the household sector, the corporate sector and the federal government. The financial sector is comprised primarily of the Government Sponsored
Enterprises (GSEs) such as Fannie Mae and Freddie Mac, the mortgage pools that the GSEs guarantee, the issuers of asset backed securities and commercial banks.

In recent decades, the financial sector has expanded its debt much more rapidly than the non-financial sector, and therefore has played the more important role in creating economic growth. In 1971, the debt of the financial sector was equivalent to 12% of GDP. It hit 100% of GDP in 2005, peaked at 121% of GDP (or roughly $17 trillion) in 2008 and is now 96% of GDP. The sharp reduction in the sector’s debt after the crisis began in 2008 was made possible by the first round of Quantitative Easing, during which the Fed printed $1.7 trillion and used it primarily to buy assets from the financial sector, thereby allowing the financial sector to reduce its leverage.

The surge in the debt of the financial sector between 1971 and 2008 was driven by two subsectors: 1) the GSEs and the mortgage pools they guaranteed and 2) the issuers of asset backed securities (ABS). The debt of the former group expanded from 4% of GDP in 1971 to a peak of 58% of GDP (or $8.1 trillion) in 2009. It has subsequently fallen to 51% of GDP. The debt of the latter group expanded from zero in 1971 to a peak of 32% of GDP (or $4.6 trillion) in 2007. It has subsequently fallen to 17% of GDP.http://ads.agorafinancial.com/www/delivery/lg.php?bannerid=5371&campaignid=319&zoneid=225&loc=1&referer=http%3A%2F%2Fdailyreckoning.com%2Fcredit-growth-drives-economic-growth-until-it-doesn%25E2%2580%2599t%2F&cb=54a2700692

The GSEs and ABS issuers increased their debt by selling bonds. They used the cash they received from issuing bonds to buy mortgages (and, in the case of the ABS issuers, to also buy a smaller amount of credit card loans, auto loans, etc). By buying trillions of dollars worth of mortgages, they financed and fueled the US property bubble. Inflating home prices allowed the American public to treat their homes as ATM machines, from which they “withdrew” equity.

Between 1971 and 2009, household sector debt increase from 43% of GDP to 98% of GDP (or to $13.9 trillion).

Borrowing and spending by US households drove the US economy; and, as imports into the US exploded and the US trade deficit blew out to a previously unimaginable level, it also drove the global economy. Like every credit bubble, this one was fun while it lasted. However, when large numbers of American home owners could no longer service the interest on their mortgages in 2008, Fannie and Freddie had to be nationalized and most of the issuers of asset backed securities failed.

Over the last two years, the debt of the financial sector has contracted by $2.9 trillion (to $14.2 trillion) and the debt of the household sector has contracted by $443 billion (to $13.4 trillion). Offsetting that has been a $3 trillion increase in the debt of the federal government (to $9.4 trillion).

Overall, total credit in the US increased by 0.4% or $203 billion (to $52.6 trillion). Like credit, economic growth in the United States has been essentially flat, increasingly by only 0.1% or by $19 billion between 2008 and 2010.

The $3 trillion increase in US government debt prevented a global depression over the last two years, but what sector of the economy will take on additional debt and drive the economy over the years immediately ahead?

Will it be the household sector? The corporate sector? State and local government? Will Fannie and Freddie or the ABS issuers come back from the dead? No, no, no and no.

The only sector of the US economy that can finance significant amounts of new debt is the federal government. Economic growth in the United States (and therefore, to a very significant extent, the world) will be determined by how much more the US government borrows and spends. Those who wish to slash government spending should bear that in mind.

To read more details on US debt, please see The Corruption of Capitalism, Chapter 10: “America Doesn’t Work.”

http://dailyreckoning.com/credit-growth-drives-economic-growth-until-it-doesn%E2%80%99t/

Comments

Credit economy spending causes everything to cost double what it’s worth. The inflation of the 1960s and 1970s taught everybody to buy a house.  We also needed cars to get to work and function.  So, we all took out home mortgages and auto loans because we didn’t have the cash. We had some savings in retirement plans, but not much.

By the 1980s, the prices of everything doubled and whatever the government subsidized quadrupled.  We had 401K plans, so we saved quite a bit.  We had most of it in fixed income that paid around 10% per year, but after 1985, the stock market started moving and the fixed income began to fall.  I refinanced the house with a 15 year mortgage.  I always believed that paying off the house and the cars was the best investment I could make. We love the convenience of using our credit card, but we have always paid it off in full every month, so we never paid any interest.

By the 1990s, stocks were the place to be and that remains the case.  Fixed income is down to 1% per year.  By 2000, my generation was paying off their home mortgages and had a bundle in retirement accounts in stock. In 2008, stocks dropped by 50%, but bounced back with a lot of money printing.

The Generation X folks started buying houses in the 1990s, but were looser with their money, so they were less inclined to make paying off their mortgages much of a priority.  They had credit card debt that we never really had.  They didn’t toss their extra money into home equity like we did.  They still have car loans

The Millennials took out $1 trillion in student loans, but the jobs weren’t there and so they’re stuck. Most live with parents or rent and have car payments and nothing going into savings.

The Generation X and Millennials can take the prize for taking our debt to GDP from 150% to 354%. If we can get our economy back, it will fall to them to dig our economy out of its hole. Let’s hope we can give them that opportunity.


Norb Leahy, Dunwoody GA Tea Party Leader

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