The Credit Boom-Bust Cycle
August 12, 2007
It is very important to distinguish between monetary inflation and a credit boom, or, contrarily, monetary deflation and a credit bust. They are completely different. We looked into this issue in the past, but it is worth mentioning again here, especially as it appears we have just turned the corner from a credit boom to a credit bust.
Monetary inflation and deflation and purely monetary effects — meaning, in essence, that they result from changes in the value of currencies. The easiest and most reliable way to measure changes in currency value is to compare the value of the currency to gold. There are other indicators as well, for those who want confirmation.
Thus, if there was no change in currency value, there was no inflation, and no deflation.
The credit boom we are also all-too-familiar with now. “Easy credit” — meaning primarily low lending standards and high volumes of credit creation — tends to create economic activity and also probably increases in asset prices. This often has a “reflexive” character, such that, as more credit is provided, economic conditions get sunnier and sunnier and asset prices get higher and higher. Typically, at some point, many loans will be made to low-quality credits or against assets at unsustainable valuations. Then there is a credit bust, as losses to lenders causes a change in lending conditions. This also tends to have a “reflexive” character, as a restriction in credit causes a depression in economic activity and typically lower asset prices, which makes existing credits harder to service and lowers recoveries on busted debt, all of which in turn leads to still further caution on lending.
It should be immediately apparent that this credit cycle (and often a corresponding asset-price cycle) can occur in an environment of stable, gold-linked currencies. Take, for example, the Florida real-estate boom and bust of the 1920s. It took place in its entirety while the dollar was linked to gold at $20.67/oz. No inflation and no deflation.
It seems to be very tempting for people to associate the boom period with monetary inflation, and the bust period with monetary deflation. This is the “Austrian theory of the trade cycle” in a nutshell, and at times it has validity. Accompanying this idea is the notion that “banks are creating money from nothing” during the credit expansion, which today is wholly untrue. Banks don’t create money. They are intermediaries who borrow from certain parties and lend that money to others. This is apparent in their financial statements, but should be obvious to anyone who has NOT ever found a dollar bill printed by Bank of America or Citicorp. However, in the nineteenth century banks did create money, literally printing paper bills. Often this money creation happened alongside lending, so a bank would literally print money from nothing and lend it out. The bills were redeemable for gold, which kept things from getting out of hand as long as the redeemability was reliable. Sometimes the redeemability wasn’t too reliable, and indeed banks created both a monetary inflation and credit expansion simultaneously, in a single act.
I hope we can recognize how much of today’s rhetoric, especially “Austrian” rhetoric, reflects the 19th-century environment it was developed in, even if those conditions haven’t existed for several generations. Unfortunately, a great many people have become adept at repeating the rhetoric at what they feel are appropriate times, without ever understanding the theory (correct or incorrect) that lay behind the rhetoric many decades ago.
Now, typically at this point there is an exhausting discussion about whether M2 or M3 or MZM or god-knows-what constitutes “money”, and whether thus a credit expansion (these are essentially credit measures) is equivalent to a “monetary” expansion, and whether this credit/monetary expansion constitutes inflation, and so on and so forth. These discussions are all pitfalls of using a quantity theory of money. We value theory guys simply look at the value, and if the value hasn’t changed, then there has been no significant change in monetary (as opposed to credit) conditions. Actually, the only money is base money, which is something like a manufactured good. All credit has a counterparty — someone who has to make good on a legal contract. Money — paper bills essentially — doesn’t have that quality. When you hold a $20 bill, nobody is legally liable for anything. You can’t go to court and say “you have to give me…”, well, what exactly? In essence, you “bought” the bill by trading something valuable for it (typically employment labor or some other asset), and you are stuck with it just the same as if you bought a toaster.
The quantity-theory guys typically think they are very sophisticated in all of their endless discussions of various forms of credit, but the fact that these discussions have gone around and around for about a hundred and fifty years with no conclusion should provide some hint that they are ultimately a dead end. The picture is very clear for the value theorists, allowing them to come to a definitive (and correct) conclusion without much effort.
Did the value of money change? Well, there’s your answer.
The inability to distinguish between credit conditions and monetary conditions (which stems from the inability to distinguish between money and credit to being with), leads to all sorts of odd conclusions. There was certainly a credit boom during the 1920s, for example, but there is no evidence whatsoever of monetary inflation (falling currency value) of any real significance. The dollar was comfortably pegged to gold, and indeed many dollars were made out of gold, in the form of $20 bullion coins.
This confusion between monetary inflation and credit expansion leads to another problem. Certain “Austrian” types have taken up the traditional classical/libertarian focus on monetary stability, which is all well and good. In practice, this means a gold standard. The libertarian approach to markets is basically hands-off, and thus if borrowers and lenders want to destroy each other with silly credit, the libertarian allows them to do so, and perhaps looks for a way to profit from the situation. However, by confusing money and credit, many of today’s self-proclaimed “Austrians” in effect have taken up a focus on “stable credit,” whatever that may mean, instead of stable money. This is not necessarily a bad thing, as credit busts can be very painful. However, this is a traditionally mercantilist focus, and is a accomplished through what amounts to government coercion.
Let’s take a specific example. A great many people today blame two recent asset-price bubbles on Alan Greenspan. The first was the TMT bubble of 1998-2000. Did the Fed cause people to pay too much money for equities of TMT companies? Or to finance kooky ideas that never went anywhere? Or to lend awesome sums for infotech buildout that didn’t produce cashflow? Certainly not. What people blame the Fed for is not stopping this behavior. In short, people blame the Fed for not exercising its powers of government coercion/manipulation! Oddly enough, these Fed-blamers are often the same ones who want to make the Fed disappear! Well, if the Fed didn’t exist, then who would exercise the powers of government coercion/manipulation? At the time, Alan Greenspan argued that the Fed’s proper role is to manage the money, i.e. avoid inflation and deflation. What people did with the money, such as lend it to loser ventures or use it to buy overpriced equities, was their own damn fault.
I agree with Alan — at least in principle. In practice, Greenspan didn’t really have the tools to do what he wanted to do, and the dollar’s value did rise to an uncomfortably deflationary level during that period.
The second period was of course the 2002-present period, corresponding to the real-estate bubble in the US and also just about everywhere else as well. This is more complicated, as the Fed was trying to do something about both the recession and monetary deflation of 2001-2002, resulting in a very low policy rate target. And indeed the value of money did change, going from deflationary to reflationary to mildly inflationary to significantly inflationary. I won’t get into the heavy analysis of the period, but certainly nobody forced banks to make silly loans to borrowers, and nobody forced borrowers to take them., and nobody forced anyone to pay vastly more for properties than was justified by any cashflow metric. Certainly not the Fed. In that aspect, it wasn’t much different than the Florida boom/bust of the 1920s.
There are some consequences to paying too much attention to credit booms and busts. Sometimes a credit bust is really a reflection of economic bust. In new economic conditions, such as a recession caused by higher taxes, credits that would have been fine turn into bad credits. Thus, we should focus on the new element, the higher taxes, rather than credit per se. It is all to easy to assume that the reason that credit goes bad is because it was made in the first place. That, in other words, the cause of a credit bust was an unsustainable credit “bubble” preceding. This simplistic analysis thus serves as a replacement for finding out what was really going on. For example, it seems to me that most of the commercial lending in the 1920s period was probably pretty sound, and the reason much of it eventually went bust was the dramatic change in economic conditions caused by tax hikes worldwide, followed by monetary instability in late 1931. Sometimes credit booms are just a natural phenomenon of a growing economy. A conclusion from putting too much focus on credit, and blaming everything under the sun on credit, is that one becomes very concerned about managing credit, thus the tendency for certain “Austrian” types to lapse into mercantilist credit-management arguments.
In practice, I find that a credit boom/bust can indeed cause a recession, but these tend to be relatively mild recessions within a context of a longer-term course of economic improvement. There were several minor recessions in the 1950s and 1960s, for example, but these are remembered only by economic historians. We remember the two decade period as one of general economic health. Korea recently experienced a recession corresponding to a boom and bust in consumer credit-card lending. It’s over now, and nobody was too much hurt by the situation. The century-class economic disasters like the Great Depression, the inflation of the 1970s, the Asia Crisis, the disasters of Latin America in the 1980s, and so forth, usually have taxes or monetary instability at their root.
That is why I haven’t jumped up and down about the boom and bust in US real estate and credit broadly speaking (including private equity, structured finance, credit-related derivatives, commercial real estate lending, new rules on margin for investment funds, etc), even though it is certainly the mother of all credit/asset bubbles — probably the biggest in all of US history in its extremity and extent — and hardly anyone is more bearish on the sector than me. The natural result would be a recession, probably a very long and nasty one, but not a century-class disaster of the 1930s/1970s variety. The real danger that I see now is monetary inflation, which is already well on its way, and likely to get worse as appetite for “hawkish,” anti-inflationary policies will pretty much disappear going forward. There doesn’t seem to be too much danger of dramatic tax hikes, although things are likely headed toward higher taxes in the US as the Democrats become more influential.
I would say that most commercial lending in the 1980s in Japan was probably OK as well. There was certainly a credit bubble related to property, but so what. Even if this had been followed by a bust, the losses suffered by banks and the economy as a whole would have been much, much less and much, much shorter in duration if a) there hadn’t been probably the most intense monetary deflation ever experienced in human history, and b) the government hadn’t raised taxes on real estate to silly levels, such as a 90% capital gains tax on property in 1991, which persisted until 1998, or a tenfold increase in effective property tax rates. (Yes, sometimes people are that stupid. In fact, I would say that they are pretty much that stupid all the time, with some exceptions.)
A second aspect of confusing money and credit is that one becomes unable to understand the virtue and value of a gold standard, which is to create stable money (money that is stable in value). On the one hand, we have the Austrians, who blame the Great Depression on “inflation,” by which they seem to mean too much credit in the 1920s. On the other hand, we have the Monetarists, who blame the Great Depression on “deflation,” by which they seem to mean too little credit in the early 1930s. Both blame the Fed. The problem with both approaches is that their followers tend to conclude that the gold standard didn’t work, as it caused either “inflation” or “deflation,” i.e. too much or too little credit, depending on which side of the bed you get up that morning.
The gold standard did work, of course. Money was stable in value. The problem wasn’t unstable money. Even if the problem was “too much” or “too little” credit — which it wasn’t, in my opinion — there was nothing a gold standard could do about it. Take out a gold coin. Do you see it making loans? It just sits there … inert … stable.
The “Austrians” and the Monetarists, between them, commanded most “conservative “economic thinking over the past sixty or so years. The “Austrian” approach to their conundrum, over the years, has been to recommend all sorts of bizarre and exotic systems which they call a “gold standard.” Their fear of the consequences of credit busts are so intense that, from time to time, they want to outlaw banking altogether! Apparently all lending is tainted with sin in their opinion. (They don’t do this as much now, it seems.) “Never a borrower nor a lender be” said Shakespeare, and historically that opinion has held quite a bit of weight, whether in the form of the Christian edicts against usury that prevented lending from the third to fourteenth centuries AD in Europe, or Islamic banking rules today. Nevertheless, don’t be surprised if people think you’re a super-kook today, if you go on about that “fractional-reserve” banking stuff! The Monetarist approach has been to ignore gold altogether — the Monetarists advocated the end of the gold standard in 1971 — and instead follow their bizarre and exotic monetary-quantity models. After the failed Monetarist experiment of the early 1980s, nobody takes those models too seriously anymore, so Monetarism has devolved into little more than a theory of the Great Depression (still popular) and some libertarian homilies about free markets, free trade and so forth.
I like to focus on the Bretton Woods gold standard of the 1950s and 1960s. It was a world not much different than today’s, except that their money was pegged to gold and they enjoyed a level of broad-based prosperity and improvement that has eluded Americans since … since we went off the gold standard in 1971.
It may seem like I quibble about credit and money, but I see people having struggled with this matter for lo about eighty years now. The solution is actually quite simple, and I hope by now that it seems so to you too.