Noah Smith wrote a piece on Tuesday rejecting the idea that credit enables economic growth. His position can be summed up in the following quotes:
“If I borrow, I can get a nice big TV and a new car, but eventually I’ll have to skimp to pay it back. In a way, the consumption-fueled borrowing binge is an illusion of wealth — after all, borrowing doesn’t increase my salary. Pleasure today means pain tomorrow.
It seems like the only people who don’t instinctively believe in credit-fueled growth are academic economists.
The academics have good reason for being skeptical. After all, production isn’t the same as consumption. In the example of me borrowing to buy a TV and car, my debt binge doesn’t make my salary — my production – go up at all. But in an economic boom, a country’s total production really does rise — that’s what fast growth means. In other words, if credit fuels economic booms, then it must do it in a fundamentally different way than the way it fuels a personal consumption binge.
If taking on debt lets a borrower increase his consumption, why doesn’t making that loan force the lender to decrease his consumption?”
This is an outright rejection of endogenous money and an embracing of loanable funds based thinking. The comment that lenders must “decrease” consumption is an obvious misunderstanding of banking. A bank does not have to decrease its consumption when it makes a loan. Loans create deposits from thin air. A well capitalized bank does not borrow reserves and multiply them or reach into its grab bag of deposits to make new loans. It endogenously expands its balance sheet to create the new loan and new deposit.
This money creation is indeed from thin air not unlike the way a corporation can create stock (a different form of financial asset) from “thin air”. All the bank needs is sufficient capital to meet capital requirements and the demand for the loan. If there is a reserve requirement then the Fed must necessarily ensure that there are sufficient reserves for the banks to meet its requirements. This is, for all practical purposes, an ex-post requirement and not the result of banks borrowing reserves or multiplying reserves before the loan takes place. Banks lend first and find reserves later if they must.
Importantly, a monetary economy is essentially constructed as a series of records of accounts to track how we make claims on goods and services. This system of records is a creation of the human mind from nothing. The entire monetary system is created from “thin air” and loans/deposits are just one form of asset/liability that is created within the monetary system. The money supply is no more fixed than my ability to conjure emotions from thin air. In essence, all of the financial assets/liabilities that we have created from thin air are simply accounting relationships that enable our ability to record how we interact within the monetary system. Bank deposits and loans are just one type of way we account for these interactions though they’re a particularly important type of interaction because they represent the primary medium of exchange in the system.
It should also be noted that loans don’t really get paid back in the aggregate. There is no aggregate “pain tomorrow” in the long-term. The financial system does not have a start and stop date like you or I do. Noah makes a fallacy of composition in claiming that an individual must repay loans. That is true at the individual level and false at the aggregate level. For instance, look at private sector credit trends and tell me where the stop date is:
(“Pain tomorrow”? Only in neoclassical economic fantasyland)
Of course, none of this means there can’t be short-term pain. Debt can increase at such a rapid pace coupled with unproductive output that it could cause an economic shock. That is essentially what we’re living through right now. Aggregate demand has been weak for several years, in part, because consumers have not been tapping credit to expand their purchasing power. Much of the housing boom was built on leveraged production and consumption that created a short-term disaggregation of credit. So we shouldn’t downplay the destructive potential of debt expansion.
Further, it should be obvious that much of private investment is funded with borrowed money. While debt does not create aggregate saving it can indeed finance investment as well as the consumption that fuels that investment. This funding of investment not only adds to saving indirectly, but drives the engine of the economy by increasing purchasing power and improving the net worth of the private sector when credit is used in a productive manner. If company XYZ builds a widget by borrowing money which a bank endogenously creates and then that widget is purchased by someone who also borrowed funds then it should be obvious that debt enables growth. The credit is the tool which enables the process of investment and production in this instance. Thus, in this sense, credit is an important enabler of economic growth.
I don’t know why academic economists can’t understand endogenous money. And I also don’t know why mainstream academic economists feel the need to brush off everything that isn’t orthodoxy – as if they’ve already discovered how everything in the world works. But we’re all worse off because of this closed-minded approach to economics.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.