Credit and financial crises in the long run

Moritz Schularick and Alan Taylor have written a working paper looking at long run trends in money, credit and financial crises. They summarize the paper here. Several of the papers referenced at the end are worth checking out as well.

20 replies on “Credit and financial crises in the long run”

@Kevin O’Rourke
This does seem hugely relevant in the Irish case. I believe I would be right in saying that it is now generally accepted by academics that there was an enormous credit bubble in Ireland and that it played a huge role in our downfall. But I wonder if it is accepted by policy makers and even more so by politicians and the staff of NAMA.

Take for instance NAMA’s chief valuer John Mulcahy.
“Mulcahy believes in the cyclical nature of economic cycles and property markets. Since 1971, he says, the markets have moved in seven-year cycles, and both commercial and residential property have recovered by almost 90 per cent from the bottoms of their respective cycles.”

So by early 2014 we should be back to 90% of the peak in early 2007. Take the case of these apartments in Newbridge that were sold recently at 66% down from peak. In the next four years NAMA’s chief valuer believes those apartments will rise from €110,000 to €290,000 – an increase of 164%. Now he is supposed to be valuing at about 50% of peak plus LTEV taking us to 57%? That is still way too high.

Here’s a starter question for the scholars: Is it dangerous when asset prices are dependent on credit?

Note: this is not to say that a high priced asset doesn’t require credit. For example, if I want to buy a passenger jet and I don’t have adequate cash, I’ll need a loan. However the price I pay for the jet will reflect the manufacture costs and a reasonable profit margin. In this case, I’d argue that the price isn’t dependent on credit. Alternatively, if I wanted to purchase a dry field in the midlands and enter a bidding war, the price the field achieves is likely to be dependent on credit. Obviously this is a great situation for the vendor as rival bids are pushing the price higher using a 3rd party’s resources. In this scenario, the asset price is dependent on credit.

It really does seem that no one really knows what’s going on.

“Long-run historical evidence therefore suggests that credit has an important role to play in central bank policy. Exactly how, remains open to debate. After their recent misjudgements, central banks should clearly pay some attention to credit aggregates and not confine themselves simply to following targeting rules based on output and inflation.”

I mean this is a fundamental attack on inflation targeting, an approach that commanded quite broad suppport both within CB’s and in the wider world.

was monetary policy a cause of the tech bubble? the housing bubble? and more importantly how and why was it a cause

@Ahura Mazda
I think the dangers of credit may be illustrated by this man’s tale:
Lenihan boasts about stability of Irish banking system.
Banks collapse.
Lenihan inexplicably and recklessly guarantees all bank liabilities.
Country almost collapses – saved by Germany.
Lenihan vows to clean up lenders.
Leaves lenders unchanged – credibility on bank reform collapses.
Let’s hope that the next thing to collapse is the government.
Otherwise the next event will be:
Lenihan costs country €40 Bn with NAMA.
Hopes and dreams of citizens collapse for many years.

Steve Randy Waldman at the Interfluidity blog has a fantastic post from a few weeks back called “Asset inflation, price inflation, and the great moderation” which gets into these issues in a very insightful way:

“Prior to the Great Moderation, central bankers had to provoke recessions in order to control inflation. Broad-based wage growth led to increases in nominal cashflows by “spenders” that could only be tempered by creating unemployment or other conditions under which workers would accept wage concessions. In the post-Reagan world, growth in the sticky component of disposable income shifted to the wealthy, who tend to save rather than spend their raises. The marginal dollar of consumer expenditure switched from wages to borrowed money. The great thing about consumption funded by credit expansion, from a central banker’s point of view, is that it is not sticky downward — no one who gets a loan today assumes that she will be able to expand her borrowing by the same amount every year. Credit-based consumption is susceptible to monetary policy with far less impact on employment than wage-based consumption. (One of Ben Bernanke’s many claims to fame is his characterization of the credit channel of monetary policy transmission.)”

So what’s the problem? First, in exchange for apparent stability, the central-bank-backstopped “great moderation” has rendered asset prices unreliable as guides to real investment. I think the United States has made terrible aggregate investment decisions over the last 30 years, and will continue to do so as long as a “ride the bubble then hide in banks” strategy pays off. Under the moderation dynamic, resource allocation is managed alternately by compromised capital markets and fiscal stimulators, neither of which make remotely good choices. Second, by relying on credit rather than wages to fund middle-class consumption, the moderation dynamic causes great harm in the form of stress from unwanted financial risk, loss of freedom to pursue nonremunerative activities, and unnecessary catastrophes for isolated families. Finally, maintaining the dynamic requires active use of policy instruments to sustain an inequitable distribution of wealth and income in a manner that I view as unjust. In “good times”, central bankers actively suppress the median wage (while applauding increases in the mean wages driven by the upper tail). During the reset phase, policymakers bail out creditors. There is nothing “natural” or “efficient” about these choices.

The great moderation made aggregate GDP and employment numbers look good, and central bankers sincerely believed they were doing a good job. They were wrong. We need to build a system where changes in asset prices reflect the quality of real economic decisions, and where the playing field isn’t tilted against the poor and disorganized in the name of promoting price stability.”


thanks as always for the link. I like the timeframe it takes. That is looking back as far as the second world war and uses that as the ‘hinge’ around which things started to change or transform.

In so much ‘popular’ discussion I have listened to in the past 12 months, it has been the rise of Thatcher and Regan to power, which people use as their ‘hinge’ around which they decide the transformation happened. But I suppose Thatcher and Regan administrations are within the living memory of many more people today. Whereas the WWII is that bit removed into the past.

Of course, in economic terms, WWII is possibly a ‘recent’ stage in events. Economics is still probably struggling to figure out what exactly has happened in more modern times, closer to us in living memory. I always liked reading Benoit Mandlebroit’s book about markets, because he seems to use the broad timescale in his analysis too, to understand chaos in markets.

Could someone clear up a few points for me. Credit IS money – yes? What is debt? – negative-money? Is debt really virtual future income? If I spend part of my next year’s income today, might that be a problem for me?

Debt is certainly a legal contract – so what happens when you run out of Real Money, aka that cash stuff? Crank up the spreadsheets and delete lots of zeros? Or will some CB print us out of trouble?

Interesting times indeed!

B Peter

@ BP Woods,

the trouble with our current system, is that it cannot ‘create’ enough money to sustain everyone associated with the money system, without the creation of debt. So in other words, in the current system, creation of money is synonymous with the creation of debt. They are almost one and the same thing. We have worked ourselves into a situation where we cannot create one without the other.

My understanding is that in the Arabian countries they are able to work a different angle. That is, where they already know that they have barrels and barrels of ‘wealth’ available to them under the ground. They have established some kind of system, whereby money is created which depends on the tangible asset or resource they have under the ground.

The asset has to be managed over the extended period, and parts of it may be traded or exchanged in ways between different parties who want out or it. The big problem with debt based finance, as opposed to asset based finance – is the debt is paid down over time. In other words, money that used to be there gradually erodes away.

It cannot be replaced again, unless more debt is created. If more debt is not created then we get a tightening of money supply. We have to look at new ways in which we can create money. But ‘money’ isn’t the proper term for it. Rather it should be wealth that is tied back to some renewable long term resource such as a building. That wealth could be exchanged within the ‘group’ of people who have decided to come together to manage the resource.

As I understand it, asset based finance happens a lot in making of movies. Where the members of the ‘team’ making the movie can barter their relative ‘shares’ of the movie project. In other words, they trade services for the duration of the project and it decides who reams the reward in the end. It seems to work for movies, because each new movie is like a whole new project, a whole new little economy of services and exchanges in its own right.

@ BP Woods,

to get back to your point, everyone today talks about a short age of credit. But what we really mean, is there is a shortage of debt. People are not taking on debt, so there is nothing to lend against on the other end.

In Britain, they encourage citizens of the country NOT to pay down debts such as credit cards, overdrafts, loans etc too quickly. Otherwise the ‘economy’ contracts too fast and we have a tightening of money supply to the system.

There it is, the more debt we create the more liquid we make the whole system. The entire financial services industry is devoted to taking all kinds of debt and exposing it back to the market as some form of liquidity, which is used to finance almost everything else.

Ironically, the more debt we can create the more we can spend! It accelerates and it accelerates and you witness a consumer spending boom. The same in the reverse, it contracts just as quickly.

Someone today said to me, you are hit with a penalty if you pay down all your debts too quickly, because the institution suffers a loss of interest earnings. This may be true. But only in so far, as the institution has used your future interest payments as a mechanism to create more liquidity in the system. But the big chunk is the principal payment I think. If you pay that down, that liquidity has more or less vanished out of the financial system and cannot be ‘used’ by the institution in any way.

Apologises, one last piece of nonsense on my behalf. The above may shed some light on the reason why so many Irish ‘borrowers’ get away interest-only payments. Indeed, in a lot of cases, the interest being rolled up also.

The fact the banks seem very much attuned to is, as long as the debt in total is there on their books, it is still considered to be some kind of liquidity they can use and manage and work with. All that Irish banks tried to do over the course of the Celtic Tiger was fill up their barns full of this ‘debt’, because it really is their fodder for the winter so to speak. In that respect, they could be compared to farmers.

Too much money (credit is bank money) means inflation in asset prices. Investment decisions made on this basis are mal investments. As the asset prices correct, the investments lose capital value. This destroys money even more and we have a deflationary spiral.

No sensible business decisions may be taken as the economic landscape changes so much people get confused as to where to invest. So pay down of debt or bankruptcy removes more money! Spiral!

No bank lending. No multiplier. Less and less econ activity. Reduced gov payments less econ activity. Failure of more private sector businesses.

In the long term an over correction now will be good for Ireland. And not just because it may mean sensible politicians are elected. Just that things really are worse than they seem!

@ Pat Donnelly

Coincidentally, I read Keen’s piece today and was moved to write to him for his assessment on the choices facing Ireland currently. I respect all the august economists on this site, but I think the crisis proved that mainstream economics was using the wrong macro-models on the way up, so my faith that they are best placed to advise on policy for the way down is somewhat shaken. I’ll let you know if I get a response.

I don’t know what the Irish credit growth figures going back 5 decades are like. My own aha moment on the unsustainable credit boom came as a TCD undergrad in late 2000 / early 2001 with a series of David McWilliam’s columns in the SBP drawing attention to the growth in personal credit and the potential consequences. Worth noting that commentators now claim the “real Celtic Tiger boom” continued until 2003 when the construction / real estate bubble phase took over. As Keen persuasively argues, the reality is that the credit economy was growing for much longer than 5 years.

Key to understanding why this happened in Anglo-Saxon economies which tend to borrow over the shorter-term than continental economies interest rates is I think the Steve Randy Waldman argument I excerpted from above on my previous post. I would love to hear some of the academic economists pitch in on their take on this argument, especially how it might apply in the Irish and European economies.

Ok, no one has (yet) given a response to: Is credit money? This IS NOT a trivial question.

This also bothers me: Whence the credit? Who ‘begatted’ the credit? How was it done? Is the credit ‘real’ or ‘virtual’?. Because Ms Credit’s very ugly sister Ms Debt IS VERY REAL! – and a legally binding contract to boot.

Just examine that smooth, upward exponential plot-line of debt. Now please explain how this might be dealt with. Credit expansion, AGAIN!? Or what?

B Peter

@ BP Woods,

I think credit has a lot to do with things like ‘reputation’, trust and cooperation. I guess if one were to study wikipedia and the way ‘expertise’ is being handled in that kind of very artificial environment, one could argue there is a sort of currency exchange going on. Whereby a person earns a reputation and that buys them certain priveleges. I guess a credit rating is like that in financial terms. That is, you gain a reputation for re-paying your credit at some stage in the future. Or visa versa, you can gain a ‘reputation’ for just the opposite, in which case you can wander all over the place and find credit nowhere. That is a bit like Ireland in the context of the globe as of now.

The important point to bear in mind is, we don’t understand much about the processes of human cooperation. All we know is that at some point in the dim and misty past, humans somehow decided to cooperate successfully on a large organised scale in order to hunt large game like mamoths. That provided the ‘community’ with a surplus of protein, which in turn enabled some members of that community to engage in activities beyond merely hunting and gathering. In other words, at some stage in the dim and misty past, people released they could create wealth through cooperation and going after bigger game.

How is that so different from building a large office block which intends to capture large blocks of rental income, which in turn can be put to use. Like in the olden days, when large game was skinned and boiled and stretched. All sorts of industries spun out of the fact that a large carcass of meat had been successfully tamed and killed by the community. I mean, if we go back to this neolithic man some form of ‘credit’ must have existed between them. To enable the tribe to set up the hunting party and supply them with tools and weapons etc. Indeed to supply the entire chain with tools, facilities and such to process the large carcass when it was captured. What we are doing today is not so different.

In the newspaper today I learned from Pat McArdle’s article about this €4.0 billion the government intends to save. I could not help from reading the article, there is something nebulous called ‘trust’ involved here. What I mean is, a form of trust that is exchanged between different generations across time. In other words, future generations in Ireland will thank us today in 2009, if we achieve all of the savings and competitive re-adjustment which is needed in the economy. But the question also remains, how will the future generation in Ireland thank us for our efforts today? I mean, we could work very hard today to scrimp and save, to do right by those future generations. But we have no power with which to stop future generations from enjoying a crazy, daft credit splurge further down the line. Having spent our own lives trying to clean up the mess, so that they don’t have to deal with it. On the other hand, we could leave the mess there and allow a future generation to deal with it. Maybe that future generation would then accuse us today of being irresponsible. Maybe that future generation would display strength and fortitude and clean up the mess for us, down the road. Or maybe they would not. I don’t know.

What is clear though, is sometimes credit is useful today. If building and investment needs to happen today in Ireland and we don’t have the money, then we need to employ credit in order to make the progress required for tomorrow’s generation. What I am talking about is the sort of flip side of what I referred to above. In some circumstances, future generations will curse the hell out of us for not taking enough initiative today and using credit in order to harness opportunity only available today. One thing that springs to mind is the on-shore wind industry. The technology and the market for turbines to supply the on-shore wind industry was ‘corner-ed’ effectively by the Danish and the Germans 30 odd years ago. That was an opportunity they took advantage of. But the Danish and Germans of yesterday did not benefit. The generation of today do benefit. It is unfair in a way. This is what I mean by inter-generation-al trust relationships. Another example is the quay wall structures in Cork city which fell in the recent floods. They were built by British people in the nineteenth century. The British of the 19th century didn’t have the money – they must have used credit to do that work. But the fact is, the quay wall fell into the flood last week. Why? Because the Irish State has depended heavily on infrastructure provided to us by an earlier generation. We have no way now of sue-ing the early British engineers for building an insufficient flood defense in Cork. Nor have the British a way to charge the Irish today for the use of that flood defense for most of the 20th century.

People talk a lot about credit being extended across space. For instance, China providing the rest of the world with credit to buy Chinese products. However, I find it much more interesting to think about credit as it exists as a form of agreement between different generations in time.

Supposing that primitive peoples had not developed arrow heads and spears, techniques that were suitable for hunting large game. As a species we might still depend on hunting of rabbits today for meat. If the first farmers had developed the first ploughs to scrap away at a bit of soil and convert it into arable land, then we might still depend on the seasons and wild vegetation for food today. If earlier generations had not worked to domesticate certain plants and animals, we could not expand in our population to occupy so much of the globe. Human beings in some ‘form’ might be restricted to a small part of the globe in territory like many other species are.

The point is, we inherit a lot more things from previous generations that flood walls and physical infrastructure. We also inherit technological ideas and forms of organisation. We inherit processes. Processes take much time and energy to develop. I once read a book about Bob Noyce, one of the founders at Intel. When he started in the business of semi-conductors the tools and equipment needed did not exist. He had to develop skills in glass blowing and furnace building in order to make the tools he required. The first products he produced were very crude indeed. But he managed to sell enough single and twin transistor primitive silicon products to the market to gain more sophistication. Lets face it, the first man to devote his entire afternoon to dragging a piece of timber after an animal to dig up dirt must have felt pretty stupid. You can imagine the comments the locals must have made of that guy. But the point is, someone at some time had to make the effort to develop the first plough instrument. It probably wasn’t up to much. But later generations benefitted enormously from techniques tried and tested at great expense by earlier generations. The guy who tried to make the first plough could just as easily have gone and enjoyed a day’s fishing.

When I think about credit exchange agreements between different generations in a population or nation – I tend to think a lot less about one generation spending what belongs to another – I tend to think more about the currrent generation NOT investing sufficiently in the form of credit to harsh natural forces, technology and innovation to give the following generation a better start.

B P Woods
Credit is money. It exists if it is accepted by most people as valid. Once banks all became systemic, wheever that was, they all could create as much credit as they liked, subject to CB control. This moeny once out of the bank appears in paper form. It can then be burnt or buried, but usually ends up in another bank which is then allowed by the CB or encouraged, to lend out more credit as a multiple of what was deposited with them.

Debt does not exist if you skip or claim bankruptcy. Ms Debt is not a one night stand. Marry and go the whole nione yards. That is the only way or burn.

All the motive forces as harnessed in adverts, aim to get folks to spend. As they have no capital, they borrow. That creates new capital! Great, yes?

I can give more explanation, but you may exasperate the more recondite?

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