{"id":31221,"date":"2015-06-24T08:47:28","date_gmt":"2015-06-23T22:47:28","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=31221"},"modified":"2015-06-24T08:47:28","modified_gmt":"2015-06-23T22:47:28","slug":"too-much-private-credit-is-undermines-growth-and-increases-inequality","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=31221","title":{"rendered":"Too much private credit undermines growth and increases inequality"},"content":{"rendered":"

\t\t\t\tThe OECD has just published a new Economic Policy Paper (June 2015) – Finance and Inclusive Growth<\/a> – 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!
\n<\/p>\n

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<\/a>.<\/p>\n

I discussed the current fiscal strategies of the Australian government in this blog – Australian fiscal statement 2015-16 – cynical and venal<\/a> – and the strategies of the British government in this blog – British fiscal statement – continues the lie about austerity<\/a>.<\/p>\n

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.<\/p>\n

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!<\/a> – for more discussion on this point.<\/p>\n

Both governments are pushing their economies in the same direction as before the crisis – growth becomes reliant on private debt buildup.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

The OECD research reinforces that conclusion even though that was not their aim nor did they put it in those terms.<\/p>\n

What they have found is as follows.<\/p>\n

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”.<\/p>\n

The questions they ask are:<\/p>\n

1. What are the implications of this credit expansion for economic growth? The mainstream presumption is that it is a positive force.<\/p>\n

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?<\/p>\n

The starting point is the literature on the impact of financial expansion on economic development. In general, that literature demostrates that:<\/p>\n

Economies gain a lot from moving from a small financial sector to a more developed one.’<\/p><\/blockquote>\n

So one of the elements of an economic development strategy is to ensure businesses can get access to finance to build working capital.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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”.<\/p>\n

There is mixed evidence available as to whether the benefits outweigh the costs, but generally the conclusions falls in favour of net benefits.<\/p>\n

The question then is whether “there can be too much finance”?<\/p>\n

That is the issue the OECD research sought to examine. They studied 50 years of data and found that:<\/p>\n

… 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.<\/p><\/blockquote>\n

They establish that result using an array of measures of financial activity within the economy (direct and indirect).<\/p>\n

So beyond some threshold, which varies across different countries, more private sector credit undermines economic growth.<\/p>\n

Firther, different forms of private credit provision have different negative impacts.<\/p>\n

Credit to households has the largest negative impact.<\/p>\n

Why is that the case?<\/p>\n

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:<\/p>\n

1. Misallocation of capital<\/p>\n

2. “large implicit subsidies to too-big-to-fail banks create incentives to lend excessively”.<\/p>\n

3. Overlending as a result of “opacity about underlying credit risk”.<\/p>\n

The other negative effects noted above then reinforce the poor pattern of investment.<\/p>\n

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).<\/p>\n

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).<\/p>\n

Second, the vulnerability of the over-stretched banks has occurred because of “Too-big-to-fail guarantees by the public authorities”.<\/p>\n

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”.<\/p>\n

There is the famous 2013 interview with the President of Iceland \u00d3lafur Ragnar Gr\u00edmsson who was explaining how Iceland recovered so quickly from the GFC and its bank crash (Source<\/a>):<\/p>\n

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.<\/p><\/blockquote>\n

Third, they found “A higher quantity of credit is likely to go together with a lower credit quality”.<\/p>\n

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.<\/p>\n

Fourth, too much credit went to households which ended up in unproductive outlets (homeovercapitalisation etc).<\/p>\n

The second part of the study sought to study the impact of credit on income distribution.<\/p>\n

They juxtapose two alternative possibilities:<\/p>\n

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

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.”<\/p>\n

They find that:<\/p>\n

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”.<\/p>\n

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.<\/p>\n

3. “People with higher income benefit more than poorer ones from credit-financed investment opportunities.”<\/p>\n

5. Further, there is a wage mechansim that increases income inequality as a result of the growth of the financial sector:<\/p>\n

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.<\/p><\/blockquote>\n

Overall, they concluded that “The long-term costs from credit overexpansion fall disproportionately on the socially vulnerable”.<\/p>\n

On the policy front, they suggest that governments should introduce frameworks to prevent “credit overexpansion”.<\/p>\n

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.<\/p>\n

Please read my blog – Lending is capital- not reserve-constrained<\/a> – for more discussion on this point.<\/p>\n

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.”<\/p>\n

The alternative is to force these institutions to allocated buffers to insure against failure.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

If private spending is to be moderated as credit is reduced, then the public sector will have to take up the spending slack.<\/p>\n

It isn’t rocket science. But Groupthink oblivion is just that!<\/p>\n

Conclusion<\/strong><\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

That is enough for today!<\/p>\n

(c) Copyright 2015 William Mitchell. All Rights Reserved.\t\t<\/p>\n","protected":false},"excerpt":{"rendered":"

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