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.
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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