An Explanation Of How Credit Facilitates The Business Cycle!

If you have read The Great Recession Conspiracy, you know the Business Cycle is driven by consumer expectations, i.e., "If things are going to get worse, they will, If things are going to get better, they will, " for awhile.

But the thing that facilitates, enables, the Business Cycle is credit.  When the Business Cycle is expanding, credit is easy to get, when it is contracting, credit is hard to get.

This piece called Buttonwood from the July 7, 2012 issue of the Economist explains this function nicely.  Read on............

Buttonwood

Duncan dough notes

A thought-provoking analysis of the debt crisis

Jul 7th 2012 | from the print edition

FEW can claim to have predicted the scale of the financial meltdown of the past few years, but Richard Duncan, an economist with a career in finance, made a good attempt. His book “The Dollar Crisis”, published in 2002, argued that the post-Bretton Woods financial system had led to huge global imbalances and a credit bubble that would end in collapse.

Mr Duncan erred in thinking that the crisis would be prompted by a dollar implosion. But his analysis, again highlighted in his latest book, “The New Depression”*, still seems acute. Ending the Bretton Woods system of fixed exchange rates, and the dollar’s link to gold, enabled countries to finance persistent current-account deficits. This in turn sparked huge and occasionally destabilising flows of cross-border capital and a massive burst of credit creation. Total credit in the American economy passed $1 trillion in 1964; by 2007, it had exceeded $50 trillion.

This debt explosion showed up not in consumer prices but in asset prices, notably in property. The cycle was self-reinforcing: banks lent money to people to buy property, causing prices to rise, making banks more willing to lend, and so on.

To explain the process, Mr Duncan outlines his “quantity theory of credit”—adapting Irving Fisher’s equation on the relationship between money supply and prices. Instead of MV=PT (the money supply times the velocity of circulation equals the price level times the number of transactions), he suggests CV=PT. The C stands for the total credit in the economy, while V is the turnover of credit. More credit, extended more often, means higher asset prices.

This bit of the book needs more detail, and some data on how his theory is supposed to have worked. The Fisher equation is a truism: the amount of money spent equals the value of goods bought. It is not intuitively obvious that the Duncan equation meets the same standard. Some debt is used to buy consumer goods, some to buy financial assets such as shares, some to buy real assets such as property. It is not clear how these should be aggregated, or indeed how to treat those assets and goods that are not bought with credit.
Still, Mr Duncan has surely grasped a wider truth. During the boom, policymakers ignored rising asset prices—and indeed welcomed them as evidence that all was well—and disregarded accompanying private-sector credit growth. But when asset prices collapsed, and the banks got into trouble, some of that private-sector debt ended up on the public balance-sheet, leading to the current phase of the crisis.

At this point, you might expect Mr Duncan to call for a return to the gold standard. Far from it. The debt deflation that would be necessary to return the credit supply to a level commensurate with the gold standard “would destroy the world as we know it”, he writes.

Nor does Mr Duncan have much truck with the demands of the tea-party types. He thinks the American government should run big fiscal deficits for the foreseeable future to counteract the lack of private-sector demand for credit. Japan has been able to finance a much higher government debt (in relation to its GDP) without difficulty. But he thinks this spending should be used to improve the economy’s long-run potential. He calls for a programme, costing perhaps $1 trillion over ten years, to invest in solar energy. This might cut the cost of energy by 90%, he claims, delivering a huge productivity gain.

Sadly for Mr Duncan, there is no real prospect of such a project receiving political approval in America. And the massive fiscal stimulus which he thinks “the most probable scenario” for 2013 is unlikely to occur even if there is a Democratic sweep in November’s elections.

That may leave the economy reliant on the Federal Reserve, and more quantitative easing (QE), a policy which Mr Duncan believes is having diminishing returns. A third round of QE will have a short-term wealth impact (via the stockmarket) but will quickly lead to higher inflation. Much more apocalyptic scenarios may unfold.

If some of Mr Duncan’s predictions look unlikely, the book is well worth reading for its analysis. Policymakers interfere heavily in the modern economy, not just via tax-and-spend policies but also through monetary policy, manipulating the level of interest rates to boost demand. This is not capitalism, he suggests, but “creditism”. It is this system which has broken down, and unless you understand it, you will not be able to fix it.

* “The New Depression: The Breakdown of the Paper Money Economy”, published by John Wiley.

Economist.com/blogs/buttonwood