Credit and financial crises in the long run

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.

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

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.”

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,

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.

http://www.debtdeflation.com/blogs/2009/12/01/debtwatch-no-41-december-2009-4-years-of-calling-the-gfc/

What are the equivalent Irish figures? Can they be as bad, given that Keen traces the rises over five decades in Australia and the USA?

@ 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.

@ 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.

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.

Credit is dispensed by those who pretend to have capital and works until those involved disbelieve them.