Private credit overhangs and the business cycle

This is an abbreviated post from our subscription series at Credit Writedowns Pro.

Back in 2012, three economists published a paper via the San Francisco Fed that looked at nearly every advanced economy business cycle from 1870 forward with the object of understanding the role of credit in the business cycle. And a post yesterday by Matthew Klein at the Financial Times alerted me to the paper.

Now, what the economists found, not surprisingly, was that “financial-crisis recessions are more costly than normal recessions in terms of lost output; and for both types of recession, more credit-intensive expansions tend to be followed by deeper recessions and slower recoveries”. I want to discuss this both in terms of endogenous money and in terms of its implications for the present recovery and proposed recovery solutions.

Endogenous Money

Let’s put this out here from the start. The reason that credit has such an overriding impact on business cycles is because money is endogenous. And by that I mean that credit is created out of thin air to fuel economic activity, independent of base money created by government. Traditionally, the creation process has gone through banks as financial intermediaries. But the reality is that any economic actor can create credit to another actor endogenously. In recent years, shadow banks have been a key area driving credit creation in advanced economies. The key is whether that credit is fungible and transformable or exchangeable freely within the economic system.

For example, in the United States, during the housing bubble, private-label mortgage securitization was a significant part of the credit structure used to fuel the credit bubble. Financial institutions would originate mortgages that ended up being often of dubious quality because the mortgage originators knew they could package the loans into private-label mortgage-backed securities and offload the risk. But, during the bubble, these securities were considered high quality assets, freely tradeable on the open market, rated AAA by the ratings agencies and usable in lieu of government-backed assets as collateral in rehypothecation chains to create even more credit. In short, private-label mortgages were money created out of thin air, but freely traded and transformable into government-backed assets.

Now, in our credit system, the currency of account is the only legal tender in a central bank’s economic domain. The government is the only economic agent able to create this money. And in a fiat currency world, the government can create money in infinite quantities because the currency of account is simply a government IOU. As the British five pound notes say, “I promise to pay the bearer on demand the sum of five pounds”. This government base money, exactly because it is backed by the government, which is the only entity that has coercive taxing power, is considered the risk free and most desirable safe asset in the economy. But government money is only a fraction of the credit structure in any economy. All other money is created by private sector actors and is not of equivalent desirability because of the solvency risk of those private actors. Hence, private-label mortgage-backed securities are not government money. Rather they are private money which was accepted for a time as nearly as safe as government money.

I expect the creditor-centric model to continue to predominate and for policy to be oriented toward boosting the ability of debtors to repay. My longer-term forecasts are predicated in large part on what we are seeing on the wage front. You cannot have high growth rates without a credit accelerator. And you can’t get substantial household credit growth without an increase in income to support it. Given the lack of policy accommodation, we are very late in this cycle and will see other indicators weaken, particularly corporate earnings. That’s bearish for stocks and for risk assets like high yield that are dependent on companies with more levered capital structures having higher earnings and cash flows. Despite the recent backup in government bond yields due to the Fed’s intention to raise rates in 2015, I think the environment is favorable for government bonds.

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Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.