Too much private credit undermines growth and increases inequality

The OECD has just published a new Economic Policy Paper (June 2015) – Finance and Inclusive Growth – which challenges the notion that the financial market deregulation in the period prior to the GFC, which led to a rapid increase in the absolute and relative size of the financial sector, was beneficial. It argues that in the aftermath of the credit binge, with the private sector overladened with debt, further credit “expansion is likely to slow rather than boost growth”, particularly if taken up by households. The research also shows that “Financial expansion fuels greater income inequality” and that government needs to reform the sector to stabilise growth and reduce inequality. What the paper doesn’t say (it is the OECD after all) is that their research also undermines arguments that it is better to base growth on private debt accumulation rather than public debt accumulation which matches deficits. Thus strategies in place in Australia, the UK and the Eurozone for governments to pursue surpluses which then require the private sector to increase debt to drive consumption are fraught and will ultimately fail. Again!

You can see a shorter version of the paper as a Policy Note No. 27 – How to restore a healthy financial sector that supports long-lasting growth.

I discussed the current fiscal strategies of the Australian government in this blog – Australian fiscal statement 2015-16 – cynical and venal – and the strategies of the British government in this blog – British fiscal statement – continues the lie about austerity.

While there are differences in circumstances and detail, the overriding similarity, common in the advanced world with these strategies is that both governments expect the private domestic sector to maintain the growth in the economy by increasing its indebtedness while the fiscal balance contracts towards surplus as quickly as possible.

The British Chancellor has pushed the envelope a bit harder since the March fiscal statement with his recent Mansion House speech where he indicated they will basically ban fiscal deficits. Please read my blog – George needs a bowl of Cornflakes! Colloquially speaking that is! – for more discussion on this point.

Both governments are pushing their economies in the same direction as before the crisis – growth becomes reliant on private debt buildup.

The advanced world is transfixed on fears that the government debt in Australia is too high – courtesy of all the scaremongering that has been going on. But nary a word gets mentioned about the dangerous private debt levels.

But the reality is that the debt levels and the growth in them means that consumer spending is likely to remain fairly subdued overall. It is unlikely we will see a return to the pre-crisis period when debt grew much faster than disposable income and the resulting spending maintained stronger economic growth.

Which means that given the external deficits in Australia and Britain, the national government will have to run continuous deficits to maintain a balanced growth strategy.

The OECD research reinforces that conclusion even though that was not their aim nor did they put it in those terms.

What they have found is as follows.

With the dramatic expansion of the financial sector in most OECD nations since the neo-liberal period of financial deregulation and reduced prudential oversight began in the 1970s (variously in different nations), the growth of private bank credit is now “more than three times … relative to GDP as half a century ago”.

The questions they ask are:

1. What are the implications of this credit expansion for economic growth? The mainstream presumption is that it is a positive force.

2. How has this credit expansion impacted on the income distribution? Is it an equitable impact or has it increased inequality and, if so, how?

The starting point is the literature on the impact of financial expansion on economic development. In general, that literature demostrates that:

Economies gain a lot from moving from a small financial sector to a more developed one.’

So one of the elements of an economic development strategy is to ensure businesses can get access to finance to build working capital.

There are many other advantages of a functioning financial system for economic development cited in the full Report, which are just distilled from the vast research literature on the topic.

While the area is not without controversy (for example, where are the gains from development going?) that topic is not the issue dealt with in this blog.

The literature also points to negative effects of expanding finance in developing nations. Some of these impacts include “drawing highly talented workers away from sectors with greater productive potential”, “generating boom-and-bust financial cycles that slow long-term growth”, “heightening the risks of regulatory capture”, and “exacerbating income inequality”.

There is mixed evidence available as to whether the benefits outweigh the costs, but generally the conclusions falls in favour of net benefits.

The question then is whether “there can be too much finance”?

That is the issue the OECD research sought to examine. They studied 50 years of data and found that:

… that more finance is linked to sharply higher growth at low levels of financial development but that, above a certain point and at the margin, further financial expansion is associated with slower growth.

They establish that result using an array of measures of financial activity within the economy (direct and indirect).

So beyond some threshold, which varies across different countries, more private sector credit undermines economic growth.

Firther, different forms of private credit provision have different negative impacts.

Credit to households has the largest negative impact.

Why is that the case?

First, the neo-liberal period has been accompanied by what the OECD call “excessive financial deregulation”. This relaxation resulted in the “weakening economic fundamentals” which has led to:

1. Misallocation of capital

2. “large implicit subsidies to too-big-to-fail banks create incentives to lend excessively”.

3. Overlending as a result of “opacity about underlying credit risk”.

The other negative effects noted above then reinforce the poor pattern of investment.

It is clear that the obsession with investment in financial assets rather than productive capital (real assets) reduces potential growth and adds nothing to the current capacity of the economy to generate sufficient sales to maintain employment levels (except in the financial markets).

Remember that financial market activity is largely wealth shuffling. Only a very small percentage of all financial market transactions aid the real economy (around 2-3 per cent).

Second, the vulnerability of the over-stretched banks has occurred because of “Too-big-to-fail guarantees by the public authorities”.

The OECD found that “the link between credit and growth is not as negative in OECD countries where creditors incurred losses due to bank failures as in those where they incurred no such losses”.

There is the famous 2013 interview with the President of Iceland Ólafur Ragnar Grímsson who was explaining how Iceland recovered so quickly from the GFC and its bank crash (Source):

We decided to let the banks fail … They were private banks … Why are somehow banks the holy churches of the modern economy … We went against the orthodoxfinancial view prevailing in the United States and Europe .. we actually managed to create a recovery that was quite remarkable … These were private companies … rewarding the bankers and the shareholders so when they failed why should ordinary people pay the price, bear the burden.

Third, they found “A higher quantity of credit is likely to go together with a lower credit quality”.

A higher the quality of financial intermediation (resulting in lower non-performing loans) the lower is the negative impact on growth. Further, the more effective (sound) is the banking regulatory framework, the lower is the negative impact on growth.

Fourth, too much credit went to households which ended up in unproductive outlets (homeovercapitalisation etc).

The second part of the study sought to study the impact of credit on income distribution.

They juxtapose two alternative possibilities:

1. “Financial deepening can benefit the poor disproportionately if it relaxes credit constraints that affect them more than the better-off”.

2. “Conversely, greater financial depth can widen income gaps if it enables the better-off to obtain more or cheaper funding for the profitable projects that they can identify, compared with lower income people who would lack access to credit.”

They find that:

1. “There seems to be no systematic link between the depth of credit intermediation and the share of credit going to the fifth of households with the lowest income levels, or to the next fifth of the income distribution”.

2. “The data indicate that, even relative to disposable income, low income households do not have as much credit as higher income households.” Higher income earners borrow more and exploit greater personal investment returns.

3. “People with higher income benefit more than poorer ones from credit-financed investment opportunities.”

5. Further, there is a wage mechansim that increases income inequality as a result of the growth of the financial sector:

The high level of pay in the financial sector is an important factor behind this link and has fuelled public questioning about the role of the financial sector. Evidence provided in this study shows that the financial sector generally pays its employees more than what workers with similar profiles get elsewhere. This premium increases more than proportionately with remuneration levels and becomes very large at the top. Moreover, male financial sector workers earn a substantial wage premium over female financial sector workers, especially at the top.

Overall, they concluded that “The long-term costs from credit overexpansion fall disproportionately on the socially vulnerable”.

On the policy front, they suggest that governments should introduce frameworks to prevent “credit overexpansion”.

Forcing increased capital requirements on banks (that is, improving the asset side of the banking system rather than trying to regulate the liability side) might help.

Please read my blog – Lending is capital- not reserve-constrained – for more discussion on this point.

They also suggest splitting big banks that might be considered ‘too-big-to-fail’ “into entities sufficiently small that they could go bankrupt without creating systemic risk.”

The alternative is to force these institutions to allocated buffers to insure against failure.

They avoid discussing other options such as eliminating the majority of financial transactions (derivative trading etc) which add nothing to the well-being of the majority.

They also do not consider the creation of public banks, which is the logical way to ensure that credit provision enhances collective well-being and underpins job creation.

The are oblivious to the bigger picture also relating to the implications for fiscal policy. The research runs counter to what other parts of the OECD are recommending with respect to the desirability of fiscal surpluses.

It is a schizoid organisation. The whole organisation should attempt to understand that non-government deficits are equal to the penny the government surplus and vice versa.

So if there is a desire to rein in the over-expansion of private credit (particularly in the case of household debt) then the national accounting logic that Modern Monetary Theory (MMT) demonstrates will lead to the conclusion that a growth strategy based on fiscal austerity will be damaging to prosperity.

If private spending is to be moderated as credit is reduced, then the public sector will have to take up the spending slack.

It isn’t rocket science. But Groupthink oblivion is just that!


The OECD report has implications for the way we understand what is going on in Greece at present as the Troika bears down on the Greek government and increasingly forces its into a position of surrender.

The reality is that very little if any of the ‘bailout funds’ provided by the Troika actually went to stimulate spending in the Greek economy. I have written about this extensively and will return to the theme soon as I gather more evidence.

While austerity impacts severely on the Greek people, the banks that loaned the economy the money seemingly walk away relatively unscathed. More later on that topic.

That is enough for today!

(c) Copyright 2015 William Mitchell. All Rights Reserved.

This Post Has 22 Comments

  1. “The whole organisation should attempt to understand that non-government deficits are equal to the penny the government deficit and vice versa.”

    Shouldn’t that be: “non-government deficits are equal to the penny the government surplus and vice versa.”

  2. Dear Allan (2015/06/24 at 18:08)

    Thanks, fixed. Others had also E-mailed about that typo. I appreciate your scrutiny.

    best wishes

  3. Beginning to question the real difference between ” productive ” and financial assets.

    The fact is “productive assets” add to costs and financial assets under the present system of banking control of the Commons are used to capture the surplus created if any.
    However they are now planning a solar farm in west cork of all places.
    The west coast of Ireland has perhaps the lowest solar flux in Northern Europe given its latitude and cloudy climate.
    I have become convinced yee mobilization guys are simply taking the piss on a global level.
    The planet has become a bad joke – with no peasant commonsense to temper this madness.
    Sorry Bill but Growth is not needed for most people.
    Growth has become a capitalistic absurdity.

  4. To provide jobs to access purchasing power people are forced into projects which sabotage the Industrial surplus (see above) or are engaged in sales etc etc.
    The fact both Ireland and Iberia engaged in the biggest “productive” drive ever seen per capita with major road and rail investment respectively
    In reality this has led to a real decline in the quality of life as the costs of the now continual maintaince of these “assets” are subtracted from the populace..

    Typically what you witness this year in SW Ireland is a major increase in tourist activity as in particular yanks (as a result of the strong $) race around in ever increasing circles.
    The mission of the resident residual peasant population should they choose to accept it is to somehow capture any $ crumbs not captured by the corporate sector ( airline , car rental , chain hotels etc etc)
    In truth Keynesian growth destroys all local exchange as it refuses to account for the real costs of capitalistic centralization.
    If you destroy local exchange you destroy civilization.

  5. Bill,

    I have a minor quibble. You say “What the paper doesn’t say (it is the OECD after all) is that their research also undermines arguments that it is better to base growth on private debt accumulation rather than public debt accumulation which matches deficits.”

    That implies that the choice is between private debt and public debt. I’d dispute that and on the grounds that it’s very debatable as to whether public so called “debt” is actually debt at all. The latter is certainly very “un-debt-like” where that so called debt is near maturity or where only a low rate of interest is paid on it.

    As Martin Wolf put it, “Central-bank money can also be thought of as non-interest-bearing, irredeemable government debt. But 10-year Japanese Government Bonds yield less than 0.5 per cent. So the difference between the two forms of government “debt” is tiny…” See:

    Moreover, it is debatable as to whether government debt (which pays interest) makes any sense at all. Certainly Milton Friedman and Warren Mosler argued that the only liability the state should issue should be zero interest yielding base money.

    Thus it can well be argued that the choice is not between more private debt and more public debt. The choice is between more private debt and having the state spend more base money into the economy. Given the problems associated with debt, it strikes me the base money option is far better.

  6. Just a quick question……

    Denmark has better public services than the UK.

    The common perception is that this is because taxes in Denmark are higher. Thanks to this blog, I can see that this isn’t true…..

    Nevertheless, isn’t it still the case that the price of better public services (government expenditure) is higher taxes?

    ie although the taxes aren’t actually funding anything, the government still needs to confiscate private money to off-set the inflationary impact of its spending

    Therefore, albeit in a roundabout way, aren’t people right in assuming that high taxes are needed for good public services?

  7. “Nevertheless, isn’t it still the case that the price of better public services (government expenditure) is higher taxes?”

    Not necessarily. The price of better public services is more people working in the public services. So the question you have to ask is what are they doing at the moment that is so much more important?

    If that is working in the finance industry, then you can strip those people out of that industry by regulating what they are currently doing out of existence. Those people are then (transitively) redeployed in the public services where they can do something of benefit.

    The result is less pointless work being done moving numerical entries on a computer around ever faster and more useful real work being done that actually benefits society – all within the existing real capacity of the economy.

    The main lesson of MMT is to think in real terms – particularly when it comes to government policy.

    And it is also how you challenge those who believe you can’t have better public services. Ask them specifically: “What are people doing that is so much more important than looking after the nation’s health/educating the population/maintaining the national infrastructure.

  8. Thanks Neil Wilson,

    I understand what you’re saying……

    However, if we look at Europe, there is a clear trend whereby high tax countries have better public services than lower tax ones….

    In the minds of the public, this is because the government is generating revenue via tax and spending it on public services.

    Obviously this isn’t how things work. Nevertheless, there is a direct link between the quality of public services and amount of tax – albeit in a more round about way (ie taxes are raised to fend of the inflationary impact of public expenditure, not to generate income)

    Or that’s at least the way I see it.

    So basically, at the end of the day, are the public not right when equating good public services with higher taxes, albeit for a different reason than they suppose?

    Or am I getting this all wrong?

  9. Hi Barzini,

    It is not really true when you look at these countries they don’t pay that much more tax in reality when all of the taxes are lumped together.

    What you must remember is there is more than one way to take currency out of the system than just tax.

    Every time you raise a fiscal or monetary lever you take currency out of the system. In the same way as when you cut any of these levers they add currency to the system.

    Interest rates, national insurance contributions, VAT etc, etc,

    It’s what choices these countries make to take currency out of the system and what they see as the most effective way of doing it.

    Are they regressive or progressive measures ? and who are they trying to take the spending power away from when they do ?

  10. The UK might cut taxes, raise VAT, raise interest rates and raise national insurance and cut some duties.

    The Scandanavian countries might leave everything else alone and just raise taxes. They also might just raise VAT on luxury goods for example to try and take spending power away from the rich.

    There’s more than one way to skin a cat.

  11. Thanks Derek,

    So why in your opinion are public services far better in Denmark than in the UK?

    Is it simply because the political will exists in Denmark to invest more in the public sphere? Or is it because a greater percentage of the wealth of the UK is being siphoned off by malevolent forces?

  12. Denmark is no model economy / society .
    Like all the others it runs under severe corporate control.

    Their wind farm escapade is a classic case of Industrial sabotage.
    Its apparently work for works sake.
    The Doozer economy of he Fraggle Rock type using absurd memes to mobilize the society / justify extraction of purchasing power in the interests of wealth concentration.

  13. There is a unholy alliance once again building between Fabian socialists and Jesuitical elements in the Catholic church.

    The notorious Irish socialist / feminist Mary Robinson was talking on Irish state radio the other day.
    She said and I kid you not.
    “such a powerful moral voice (The Pope ) has validated the (climate) science”………!!!!!!!!! ……this is the most unscientific statement one can make and goes completely against the scientific method.
    The fact that such a stupid statement was not challenged on radio is unfortunately a normal conversation today.

    I am questioning Bills very basis for mobilization and simply asking what’s the point of this activity other then to sustain or increase this pointless wealth disparity.

  14. Barzini. I’m unfamiliar with European idiomatic phrases. Does that stand for “dead horse who must be flogged?”

  15. Hi Bill, looking forward to hearing more thoughts about Greece. Thinking more about Greece made me wonder about the cost of hosting the Olympics and how much that may have contributed to issues. Eg Google returned this article:

    It’s madness that the Olympics can enable countries to massively spend on sports infrastructure that’s generally wasted but can’t massively spend on projects that can greatly improve a countries future growth. We almost need a really good world development fund that can just identify projects countries should do like the NBN so that it can be bipartisan or something?

  16. One other thing I’ve been thinking about is how much of the modern worlds benefits don’t feed into GDP. Examples like Wikipedia being an essentially free mega-encyclopaedia in real-time that is all done by volunteers and the other amazing blogs like yours as well as any other volunteer work that actually benefits society like homeless shelters, drug and alcohol work etc. these volunteered hours don’t get fed into GDP.

    What I see is eithera job guarantee should pay these people for their time and hence add to GDP or else we need a better measurement of societal benefits other than GDP? Maybe the former is easier although they both face challenged obviously.

    I may be missing something obvious so hope so would appreciate feedback if so. 🙂

  17. Hi Willy,

    I have a simple question, the answer to which I don’t yet understand

    Why does Denmark have better social services than the UK?

    Like everyone else, I previously believed the answer was ‘higher taxes’

    Now thanks to this blog and others like it I understand that governments do not raise revenue via taxes. Also I now understand that there is more than one way to take currency out the system to prevent inflation (ie not just income tax).

    My current understanding is that the reason services in Denmark are better is because Denmark spends a higher percentage of GDP on the public sphere and that to off-set the inflationary nature of this spending, the government charges higher taxes.

    As a result, are the public correct to a certain degree when they associate high taxes with high quality public services – albeit for a different reason than the one they suppose?

    I am starting to talk about these topics with friends and this is the type of question which is coming up.

    If you perceive this line of enquiry to be beneath you then I apologize, but I would have thought that this blog would encourage questions from people who are interested in this subject and approach it with an open mind and good faith.

  18. “Like everyone else, I previously believed the answer was ‘higher taxes'”
    It should be noted Denmark is on a currency peg and if it acts to defend that peg it is similar to borrowing in foreign currency (Euros.)

  19. Hi Barzini


    In my view not only has our democracy been taken over by vested interests but so has the money creation process.

  20. Barzini

    There is nothing wrong with your line of questioning. I’ve seen statements similar to yours by Cambridge old Keynesians. Tax theory is a very poorly developed subject. Post Keynesian tax theory began with Kalecki when he showed that taxes on income and profits could increase income, profits and employment. Classical theory sees tax as a reduction of profits at a micro level and then uses the fallacy of composition to extend from a micro to macro level so the reduction of profits at the macro level is inferred. Post Keynesian economics uses both micro and macro foundations. Post Keynesian tax theory tends to be in the Kaleckian tradition. The effects of higher tax that have been described at a national level include increased investment, faster technical progress, reduced demand leakage, increased profits, increased national income and greater equality.

    At first glance this suggests hope for troubled regional authorities, however regional authorities tend to exist within free trade areas and capital tends to move to low tax areas while at the same time exploiting markets in high tax areas. One example is the city of Detroit where manufacturing moved outside of the city boundaries to pay lower taxes, yet at the same time exploited the infrastructure provided by the city. An obvious response to this is to abandon free trade but regional authorities do not usually have the legal power to do this.

    As far as I know, MMT hasn’t done much work on tax theory. To be fair on MMT, other Post Keynesians haven’t done a lot of work on tax theory either.

  21. “However, if we look at Europe,”

    If everybody ties a leg up and hobbles across the street would you base the maximum speed of moment based solely upon those that are hobbling – some of which would hobble faster than others.

    Or would you theorise what could happen if you remove the tied leg and walked or ran across the street?

    Europe is in a straitjacket of thinking. Caught in a faulty frame of reference. We’re talking here about what happens when you take the straitjacket off.

    For example where are the conservative parties looking to rein in bank lending so they can slash taxes? Once you understand MMT and start looking at things in real terms you realise there are a lot more policy options available than the ones currently in use.

    In the early 19th century there was a widespread belief that you would suffocate if you travelled faster than 30mph. That nearly derailed the advent of the trains!

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