To Infinity and Beyond!
For those unacquainted with it, the Quantity theory of Credit describes the mechanism by which bank credit creation affects the economy. In short, banks create new purchasing power when they make loans, and this either used for productive investment, or financial transactions. The former raises real GDP, the latter raises only nominal GDP (ie, creates inflation). It’s main proponent and inventor, Professor Richard Werner of the Southampton business school, took to twitter to defend one of its key premises (that banks can create new money by making loans at will) last night. In so doing he entered into a long and fascinating conversation with Frances Coppola on the subject of credit markets, which I thoroughly enjoyed and will summarise and reflect on in this post. Richard (http://en.wikipedia.org/wiki/Richard_Werner) and Frances (http://coppolacomment.blogspot.fr/), are both very insightful on and commendably obsessed with banking – so despite a few brief lapses into inevitable trolling and twitter baiting, their argument contained many important ideas!
The main initial thrust of the argument related to the small matter of the causes of the Eurozone crisis! Richard claims that the ECB is to blame – by creating a regime where credit growth boomed in some countries inappropriately, and contracted in others. Frances claims that the ECB is not entirely to blame, although it’s one size fits all monetary policy certainly exacerbated underlying structural issues. For Richard, the argument turns on the fact that Central banks ultimately rule the macroeconomic roost by influencing the overall supply of credit. As evidence for this he cites the fact that under Bundesbank supervision, German credit growth was robust in the 90’s but totally stopped in the 2000’s.
The chart shows private sector credit as a % of GDP. In the 90’s it expands, and in the 2000’s, sure enough, it contracts. Richard contends this is because credit demand is infinite, there will always be borrowers at the prevailing price.
The break in supervisory regime from 2002 onwards shows clearly that lower credit growth is the ECB’s doing. Frances contends that demand is at least part of the problem:
Of course these are mutually contradictory positions. Richard says demand is infinite. Frances says it is limited – and that limited demand can be a problem in balance sheet recessions. From the perspective of a guy working on a bank dealing floor, Frances’s position has intuitive merit. Banks are desparately keen to borrow money and invest in safe assets – and there just aren’t enough of them. Good borrowers don’t want to borrow any more – and those that do are shut out of the ‘well functioning’ parts of the market, ie, the bond market which is ticking over just fine – the problems are in the market for household and small business credit. A central part of the Quantity theory of credit is that credit can be used for either productive or unproductive things, and that the division between the two determines growth. Credit used for productive things (investment in real physical capital) generates economic growth – the newly created purchasing power is matched by increased production of goods and services to be purchased. Credit used for unproductive things (buying financial assets or land) simply raises inflation, either of consumer prices if the wealth effect (consumers feel richer because their assets are appreciating, so go out and spend) or asset prices if the wealth effect is small. The division between the two explains the difference of opinion between Frances and Richard. They are talking about very different things:
Frances is living in the real world. Not just the world of real GDP, but the world of actual possibilities. Richard is living in the nominal world – and correctly asserting, in essence, that money printing for unproductive purposes can easily cause inflation – ie nominal GDP growth – without regard for the consequences. As Frances says:
Which is wholly fair – but Richard quite rightly asserts that it is possible that we can live in this world. Episodes of hyperinflation are known to happen – even if they are nowhere near as common as one would believe listening to financial pundits who believe that any expansion of the money supply will tip us into Weimar Germany in spite of decades of experience of steady credit growth and no such problems. However, this is a bit of a red herring… Richard was seeking to support his main argument that Credit supply is always rationed and thus, credit supply is the only determinant of nominal GDP growth, and Frances was pointing out that in extremis, this wouldn’t be true – ie if credit supply was ramped up to extreme level, nominal GDP growth must also stop as the volume of transactions would collapse due to the system collapsing! Furthermore – clearly there would be no ‘Demand’ for credit at this point – not in any meaningful sense. Sure you could borrow money, but as I pointed out this is meaningless in the limit:
Talking about this extreme is useless. We need to understand the constraints on economic growth right now. What does this have to do with the original argument, about the ECB and its role? Well taking Richard’s position, you’d say the ECB was entirely at fault. Credit demand is infinite, so the ECB’s policies on credit creation must, by definition, be responsible for any imbalances or distortions. But is this fair? If you look at efforts the ECB has made to encourage credit creation, banks have hardly co-operated. The ECB’s TLTRO is as clear a signal as possible that European banks are supposed to lend some money to small businesses and households, but as I and Frances both point out…
The TLTRO takeup is disappointing. Banks are seemingly actively getting in the way of the ECB’s stated goal. Now Richard, I’m sure he won’t mind me saying, has some fairly strong prior beliefs about what the true objectives and powers of central banks are, namely that they can control credit creation if they want to, and they do want to, in order to engender structural changes in the economy that suit their beliefs about what constitutes a good economic system. This may be true – but the arguments he uses to support it are mainly of the form ‘Central bank policies seem to be trashing small banks and undermining politicians – so they must be trying to push their own agenda!’. This is fair – they may well be – but I think Frances and hopefully you, dear reader, would agree with me that things are rarely that simple. The ECB is hidebound by a variety of restrictive treaties – and constantly feels the need to make reference to how it is limited by them. In addition, it’s not certain that even the governing council of the ECB knows what it wants – witness the spectacle of Mario Draghi, former Goldman Sachs enforcer and all round playmaker having to admit that he couldn’t even get unanimous agreement for the language change in his latest press conference, in his own words, with some embellishment by the FT:
“There were major decisions where there was no unanimity,” the ECB president said, adding that policy makers were “not politicians” and had to stick to their mandate of keeping inflation on track. Not to do so would be “illegal”.
Certainly this could all be a ruse to give the appearance of due process whilst they get on with doing exactly as they please, but it’s a weird way to communicate with financial markets – which deprived of the threat of QE could easily create a rapidly accelerating crisis for the periphery. It’s certainly not what I would do if I were really in control. Of course I’m not, and I don’t know how it really works, but my point is more that I don’t think anyone does. What I know from the markets is that banks are seeking to do high quality business with their preferred customers – but when one of my strategists opined to the chairman of my major investment banks board that the ECB might ‘force banks to lend’ by buying their assets, he was told in no uncertain terms that we would be forced to do no such thing. Banks are very powerful entities. Institutions and hierarchies matter. The ECB is certainly failing to reflate the Eurozone’s troubled economy but is it doing it maliciously or out of incompetence? Everything I know about the world indicates that when people say they’re going to do something but fail, it’s because they’re unable to do it but think they can bluff it out.
This is by no means the end of the argument. We need more evidence. The fact that we even have to have this conversation is a shocking indictment of the ECB’s lack of accountability. They should clearly and unambiguously state their intentions, and should have the democratic legitimacy to actually control the economy as they are supposed to do. I’m sure Frances and Richard would both agree that this is the overriding concern – and if the dust ever settles on this crisis the need for reform is pressing. If it doesn’t – then regardless of whether it was deliberate, the ECB will be largely responsible for the Eurozone’s decline.
Anyway, here’s the whole thing for your edification and enjoyment. Warning: Long.