Wednesday, 10 June 2009

Why do economies grow?

There is a massive literature seeking an answer to this question, and I have no wish to provide a survey. However, I am struck by the disconnect between the academic literature on growth and the current economic policies pursued by the UK government and central bank.

The centerpiece of the current strategy is bank lending. It is almost universally agreed that the UK doesn't have enough credit growth at the moment and that every tool available must be directed towards increasing lending. Why is lending so important?

Basically, it's a demand-side argument; if credit contracts, consumption and investment fall, causing a decline in GDP. Falling demand leads to rising unemployment, which multiplies the negative impact of the initial credit contraction.

Like all dangerous arguments, it contains an element of plausibility. For example, it's not hard to see how a firm wishing to invest would be constrained by a sudden lack of bank credit. Let us ignore for a moment that banks are not the only source of capital. Firms can issue equity or use retained profits to finance investments. Let's concede the point and recognize that bank lending might influence growth through investment channel. More bank loans mean more capital which translates into a larger supply of goods.

However, this argument cannot apply to consumption. If an individual takes out a loan to finance a flat screen TV, demand increases today, but the individual now has a debt that must be repaid in the future. A personal loan transfers income from the tomorrow to the present. Debt cannot make a person richer; it makes them poorer because they have to pay interest.

The sad truth about the UK economy is that growth was temporarily boosted by a flood of cheap consumer credit, which allowed the household sector to transfer future expected income into the present. In turn, this led to rising household debt levels, with interest payments eating into a larger proportion of disposable income. Banks created this credit by massive leveraging and when default rates rose fractionally, it pushed the UK banking sector to the edge of total destruction. We all now understand this, however, few have fully acknowledged the implications of this new reality.

The lesson is both simple and unpalatable. The UK can no longer rely on an artificial boost to demand caused by reckless bank lending and the insatiable appetite of households for credit. Household balance sheets are stretched to the limit and a period of painful consolidation would be the best strategy.

However, UK policymakers think they have an answer to the financial crisis. It is to cut borrowing costs to a minimum and to the extent possible turn interest rates negative. The government replaces households and borrows huge amounts of money to keep demand high. The Bank of England plays its part by printing cash. If all goes well, inflation will rise and eat away at the nominal value of household sector debt.

In other words, the government intends to inflate the problem away, robbing savers in order to protect borrowers. It's a massive wealth redistribution scheme, which if we are honest, we would call theft.

However, let's leave moral indignation for another day and return to our original question. Will this strategy led to higher economic growth in the long run? Call me a cynic, but I am doubtful that we will be better off as a result of today's zero interest rates and huge government borrowing.


Jo said...

Q: Why must economies grow?

A: Mr Ponzi....please call your office.

Mark Wadsworth said...

1. Economies grow because people get cleverer over time.

2. Banks serve a useful function as middlemen between savers and borrowers - they 'oil the wheels' a little bit; they run stuff like direct debits, credit cards, standing orders, BACS payments and so on. That's about all they are good for - any more than that leads to chaos.

Stevie b. said...

"Call me a cynic, but I am doubtful that we will be better off as a result of today's zero interest rates and huge government borrowing."

You should not be doubtful & you are not being a cynic. You are a realist over anything beyond the short-term, which means until the day after the next general election. Propping up the un-propable-uppable will make us all worse-off longer term.

Anonymous said...

I like much of what you have written. However the big ticket spend for many individuals was on housing. Since eventually the properties will end up being owned by the borrowers, they ultimately don't pay rent, so their investment will reduce their outgoings, particularly in later, possibly pensionable years.

I am alarmed at the certain knowledge the state wants to devalue my savings through induced inflation, but am at least a little comforted that the next administration will be more financially astute. Either because they believe in sound money, or because the IMF imposes sound money upon them.

And I adore my big telly. Programs are rubbish, but the picture is lovely.

Anonymous said...

In other words, the government intends to inflate the problem away, robbing savers in order to protect borrowers. It's a massive wealth redistribution scheme, which if we are honest, we would call theft.

It has been obvious for many months that the only way of preventing millions of reckless borrowers going bankrupt is to devalue their debt. I am sure this is what the government want and I am afraid to say so will the next government, there is no other way of preventing massive debt defaults causing a domino effect. The prudent amonst us who saved for their old age will I am afraid suffer just as did the prudent in the 70's who saw their life savings vapourised in a few years. What message this gives to todays children I don't know but certainly it is not to save but borrow borrow borrow so the whole sorry mess will return in another 10 years or so.

TheFatBigot said...

The problem with their strategy of propping-up house prices and inflating away the resulting debt is that it can only work if they do it for ever.

Once this year's unaffordable credit has become affordable through inflation, perceived house values have to rise again next year to ensure there is sufficient mock equity to allow further loans to be secured.

It is tempting to think of it as a self-perpetuating and self-justifying inflation machine, but there is no such thing because inflation devalues assets as well as debts. Eventually the loss of value in other assets will have a detrimental effect far outweighing the temporarily attractive maintenance of spending power.

The whole thing is truly absurd. There is only one sound path and that is for people to live within their means. And the inescapable fact is that if you live within your means you actually have more money to spend because you are not spewing X% a year in interest.

Not for the first time, they have it upside-down.

electro-kevin said...

Credit is entirely at odds with environmentalism. It enables people to spend way beyond their entitlement and enables them to scrap perfectly serviceable gizmos for the latest thang - flat screen TVs being a great example. Credit magnifies superfluous consumption.

So here we have the Brownian economy - built on credit bingeing whilst ever more inventive ways to tax us are created in the name of environmentalism.

Anonymous said...

The economy grows when GDP gets bigger. This happens when products are made and services are provided.

GDP also grows when people buy goods and services they used to do for themselves, like child and elder care, growing some of their own food, or sharing unwanted clothes instead of buying new ones. Or when they buy second cars so both partners can work at jobs.

GDP grows when we pay to clean up after car crashes, floods, and people replace goods that are stolen. It goes up when people buy Prozac because they feel anxious.

In other words, growth isn't necessarily such a great thing. GDP will fall if we do more for ourselves. Such a terrible thought! lol!

DBC Reed said...

Quite a lot of otherwise sensible
commentators believe cheap credit for mortgages increases consumption
,most irritatingly Larry Elliott of the Guardian whose analyses always come undone at this point.As one of the Anonymice points out above, it only increases spending in shops by older people: the young whose purchases of big ticket items like white goods, furniture, cars should be keeping industries going are left without purchasing-power.Oldsters spend a lot of money abroad.This has been obvious for decades but the Homeowners Party wins all the elections.
Cheap credit can increase consumption by wage inflation but the Homeowners Party is organised to repeat"house price inflation good:wage inflation baa-baa baad"
Also the UK bubble analysis is predicated on the notion of the quantity of money where low interest rates/Keynesianism is more concerned with velocity.You could get a lot of economic activity from getting hoarded money into circulation ( not increasing the money supply by its broadest measure) and getting it to rattle round the system faster.

sobers said...

Going into debt to buy productive assets is reasonable, going into debt to consume is lunacy. Debt for consumption merely pulls forward the fruits of ones labour from the future to the present. You still have to do the extra labour at some point to repay the debt, plus your usual labour to live on. Plus you have to pay the interest (more labour).

Both public and private sectors have been drawing down on that future labour (sorry kids) and eventually the bills will have to be paid. Individuals can go bankrupt (but not all of them) and while States can, the result is not pretty, and to be avoided if at all possible.

There can be no more consumer credit boom, because we are all up to our ears collectively in debt. If you borrow to pay interest, that is a death spiral (take note Gordo).

Anonymous said...

I think Gordon understands how things work: and we live in a consumption society. It is all that matters and so getting it up and running again is all that matters. And it will work: it already is. Labour will win again and the party (Party) will carry on. As for the ground-level state of the UK, more squalid sqaulor, over-crowding, more binge drinking, drug taking, fighting, bigotry. Beautiful sight!

AC said...

Inflation is a tax that moves money from the poor to the rich.

Inflation is the way that governments squeeze the poor till the pips squeak !

AC said...