Tuesday, March 10, 2009

Do We Need To "Get Credit Moving Again"?

It sounds like a reasonable enough proposition. But is it?

Some good work has been done on this subject by a few of my preferred sources, Kevin Depew at Minyanville.com and Mike Shedlock of Global Economic Analysis. Let's take a look:

Depew writes:

These are heady times we are living in. Collectively, our national intoxication runs deep and fierce. From moment to moment no one really knows whether to laugh, cry, or do both at the same time, and so the air on the street is juiced with a mildly psychotic hum. I enjoy it, but not everyone is built to handle this kind of environment. This is, after all, the Age of Self Evidence. Don't even think about attempting to verify the facts behind that assertion. It's as right as rain and as true as a tree stump. It is... self evident.

For example, consider the assertion - made almost daily by politicians and monetary policy figures - that all we need to do to end this economic crisis is “kick start” lending and that credit is the “lifeblood of the economy.” These baseless assertions infect news article after news article and are repeated by the vast majority of economists and market pundits over and over again as “self-evident” truths. The Age of Self Evidence.

The reality, however, as noted on Minyanville recently in the article, “Deflation Redux,” is that these assertions are non-sequiturs. “Credit is the lifeblood of the economy.” This sounds reasonable, which is why it’s so easy to value it as self evident.

But think about it for a moment. Lending is actually a function of productivity, and productivity is a function of price. Lending to create productive assets is done by savers who want a decent return. They stopped lending a long time ago, long before this “debt crisis” erupted, because the return for risk wasn’t there.

In place of these lenders, however, there was the Federal Reserve, which has the unique ability to make credit available (i.e. print money) whenever they like, and essentially out of thin air. Fed credit availability, unlike the lending normally made available by savers, is not backed by savings. And so this credit made available by the Fed went to create assets such as houses, strip malls and office buildings that aren't productive. The net result of this has been a massive debt buildup that is now being liquidated, or deflated. When will this debt deflation end? When savers, once again, see a reasonable return for the risk. Unfortunately, this requires prices to come down - a lot.

(emphasis mine)

Depew hits the nail on the head with this analysis. "Credit" is not what creates wealth. Production creates wealth. Credit is a claim on future profits from production. That is what this crisis is all about. We have realized, essentially, that there is not nearly enough production to justify the amount of credit in the economy. For a decade, the most useful way of generating wealth we could think of was to devise new ways in which to create credit based upon a declining amount of production. It had to end sometime.

Mike Shedlock sheds some light on the same topic:

Like Kevin, I had to laugh the first I heard “Credit is the Lifeblood of the Economy”. After it was repeated 20 times then espoused by Congress, the Treasury, and the Fed, and indeed even President Obama, it became more scary than funny.

This is why:
The flip side of credit is debt. Is debt the lifeblood of the economy?

Surely not! It’s not that debt is bad in and of itself. Debt is fine as long as it is going to productive uses or as long as the lending is backed up by savings somewhere. No one can argue that savings should not be lent.

However, the problem is that credit has been extended without savings backing it up to those who had no possible means of paying it back, with leverage, and with “no money down”.

Were it not for fractional reserve lending, this could never have occurred.

Clearly debt is not the lifeblood of the economy. By extension, credit is not the lifeblood of the economy either. Rather it is savings that is the lifeblood of the economy, because without adequate savings, extending credit is nothing but a pyramid scheme that eventually implodes, which is of course what happened.

Amazingly, the “solution” in Congress is to encourage more reckless lending even though there is no savings to lend. This Ponzi financing scheme can’t possibly work, which by definition means it won’t.

(emphasis mine)

These should not be groundbreaking developments. It should be "self-evident" that borrowing ourselves out of this mess is not going to work. Yet this fallacy that we need to "unfreeze the credit markets" is such an entrenched belief among our policy makers that all I can do is shake my head. Or write. Take these examples:

Timothy Geithner, Feb 25th, 2009 in a radio interview with NPR:

...we issued a very powerful statement by the secretary of the Treasury, the chairman of the Fed, the chairman of the FDIC on Monday, and the president has said this consistently. And it's really important for people to understand, which is again, to get the credit necessary for recovery to be firmly established, we need to make sure that we strengthen the system and that these institutions have the ability to provide this critical function. I mean, credit is the lifeblood of the economy. Economies don't work without it, and the necessary path to recovery is to make sure that there is enough confidence in these institutions and they have the resources to play that critical role.

Geithner essentially says that without more debt, the economy cannot work. This is patently absurd.

Think the idiocy is concentrated on the US? Think again. Canadian Prime Minister Stephen Harper suggested the same in a press conference today announcing more billions in "stimulus." A few excerpts:

And let me be clear to you as my fellow citizens:

We will not turn the corner on this global recession until the American financial sector is

Our stimulus plan will help us to sustain economic activity and make transitions but it
cannot fix the problem of the global financial system.

Harper proves here that he has no idea where economic activity is rooted. Building a factory has nothing to do with the American financial sector.

Finally, the Economic Action Plan contains a large number of important measures to
improve the availability of credit in the Canadian economy.

In spite of the strength of Canadian banks, the availability and cost of credit here is being
affected by the international financial crisis.

I will not go into the details.

Thank goodness.

Seriously though. What possible good will making credit more available do if there are no economic means with which to use it?

We need to start making things again. Having credit to do so does not help make the production of goods economic. What is required are lower overhead levels in conducting business. If widgets are being made in China at X price and Y quality, then there are two ways in which to return that production here: Improve the quality and/or lower the price. But there is no way to compete with the Chinese if we need to pay 5x too much for land to put the factory on, 5x too much for building the factory, and way too much on labour. All of the governments actions thus far serve to prop up the costs of business overhead, thereby making it impossible to make a product for a reasonable price. Even if the quality is far superior, the consumer will elect the cheaper product if the price differential is too great.

Asset prices need to be liquidated, and wages need to adjust to the new economic reality.

Having increased credit availability will not help to achieve either of these things.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.


Cody said...

The Feds aren't entirely wrong: credit HAS been the lifeblood of the economy since 1971, as evidenced by the constant inflation and repeated bubbles we've experienced since then. It seems our politicians have come to believe this is the only way growth will occur from now on, which may not be entirely wrong in the short term. Having moved so much of our productive capacity off-shore, what can we possibly produce and sell to the world that cannot be made more cheaply elsewhere, other than our raw resources?

We've shipped the primary components of our economic engine across the oceans; is it surprising that the engine has stalled?

mannfm11 said...

I think Cody misses the point. This has been true since day 1 almost. It is hard to paint a complex subject with a simple brush, as there is so much more. The only thing the Fed has done is allow for liquidity between players and the public, as the Fed is only about 2% of the debt in the system. The banking officials have been more complicit with their allowing of banks to operate on slimmer nad slimmer capital until a mild breeze can blow them over.

The only solution is bankruptcy with everyone taking a haircut. Problem is that those that have cannot afford to let those that don't have off the hook. You can't maintain the price structure and cut the pension assets by lets say 70%, but if you cut the price structure by 70% as well you end up with a GDP that is still a relative divisor of the debt.

What they don't want to admit is that they need more of the hair of the dog that bit them to get them drunk one more time. This means we need a new form of subprime mortgages, a new form of subprime auto financing, a new form of giving credit cards to idiots and a new group of derivatives to make it all possible.

If there wasn't a central bank, the party would have to end much earlier. I think deposit insurance, as great an invention as it has been, is also the culprit in this matter. WE are looking at a tragedy in the making much worse than the great depession with the only potential saving grace that actions to support the unfortunate are not so taboo. This is the only result other than more debt and credit to pile it up higher for next time.

Namke von Federlein said...

@ mannfm11 - here a few of the "new forms of derivatives to make it all happen" - so far! It's about new Swaps at the CME - http://www.notesforinvestors.com/CA_Mar_09_09-01.html

@ cody - Credit is never the "lifeblood of the economy"? Perhaps you mean it to say that it was the drug of the economy since 1971?

As Matt points out : "Credit is a claim on future profits from production." In other words, I will lend you my potatoes if I think that you can use them to produce even more potatoes (for instance, you have invented crop rotation). Later, you give me back a fresh batch of potatoes and then we will split the surplus.

Real-world examples from early Canada:
The rural Quebec French population did not do crop rotation. The English did do crop rotation. The English were more successful.
Same thing with trading. The English set up trading posts and created little market towns. The French sent out French "trappers" into the woods (monopoly). The English could trade more efficiently - they had more efficient seasonal price discovery, less overhead for getting the goods and less dependency on one supplier (ie less risk).

And I am very happy to see Matt mention the importance of pricing to productivity. Perhaps this is a poorly understood area of economics? In late 2007, I was commenting that the core problem coming up was a pricing problem. In late 2007, I put it this way : the world is pricing commodities in a currency that is technically worth zero. Why? Because nobody knows how many USD are in circulation in the world. Not even the legit currency (they stopped publishing the M3). And certainly not the amount of counterfeit USD (which, thanks to off-shore fractional reserve lending) could be trillions of dollars *leveraged* into the system. In late 2008, I suggested that something absolutely incredible had happened - due to the insolvency and illiquidity of the USD positions of the banks of the world, the world's commodities are now priced in a currency which is worth *less* than nothing?

Perhaps this pricing issue is an overlooked point by both the inflationists and the deflationists?

Before we can put a price on something, we need a stable baseline. Everybody is fixated on the liquidity and the solvency of the USD and the US.

The current theory seems to be think that inflating nominal asset values (by inflation or by using the absolute act of desperation called 'mark to whatever market price puts you in your happy space'
accounting) to get the credit market contracts up from under water. But the original contract prices were not based in any way, shape or form on a fair *production* price. Option A : build a house from scratch for $200,000. Option B : buy the same house for $560,000. In the bubble, buyers went for option B. Why? Nothing down, no payments for 6 months, live in the house for 6 months, sell if for a 5% list price profit - free rent and free money.

So, it isn't hard to determine how far prices will fall? You just look at the production price plus a sales mark-up and you have your price. How low will home prices go? Today's cost-to-build + 40 %?

I also like Matt's point about deflation as a motor of productivity.

The way I like to think of it : in a deflationary environment people will not produce something until there is a buyer, and a buyer will not buy anything until they *need* it. Deflation makes price discovery and productivity simple. Inflation does the exactly the opposite. However, the best case is 0 % inflation? I know some of the arguments for a low inflation rate. The only arguments that I have heard are good for the lenders and bad for the buyers.

Where are we now? There is a ton of inventory of all types in US attics, garages, closets, warehouses, schools, libraries, stores, etc. It will take at least a couple of years to wear all this stuff out.

Last point (while I'm at it) - They are not "consumers", they're people. Cancer is a consumer.

Anyway, a long comment. I'm just relieved to see the word productivity used on an econo-blog!

Thanks for the nice blog post!

Matt Stiles said...

Thanks Namke,

I will disagree with you on determining price as a function of the cost of productivity. In other words "the labour theory of value."

I believe value is determined as a preference by individuals to part with something else in an exchange. Ie. they are willing to exchange X hours of labour for Y good/service. This is the "preference theory of value."

If we were to believe the "labour theory" we would have to conclude that selling anything at a loss is impossible. In reality, "people" or prospective consumers really don't care what it costs to make a product. The price they are willing to pay is a function of their time preference.

My major concern is that the domestic cost of production is so artificially high (due to the availability of credit) that the average person would be foolish not to choose a foreign made good at a far cheaper price. Now that the credit that these prices were based upon has collapsed, the prices must also. Employment/growth/productivity will not return until it has done so. Attempting to stop this process is foolish and destructive.

Indeed, deflation will be the biggest motor of productivity we have seen since the postwar period.



View My Stats