Saturday, May 3, 2008

A nation of debtors

As savings rate goes down.......

.....the stock of debt goes up.


  1. Great graphs... I see them as the prelude to a fascinating story.

    Conventional wisdom is that because money is the debt of another/others that debt and deposits should match. Your graphs clearly show this to be fallacious. To many it is entirely counter intuitive that money borrowed by one and paid to another can somehow 'disappear' from the system.

    It is my opinion that the explanation is securitisation of debt; mortgage backed securities; credit card debts (both running balances and month-on-month spending; commercial paper - and (likely) other exotic instruments with which I'm not properly familiar. I think that the answer to the crucial question "What has happened to the money" is that "time preferences have changed." Money has been tied up such that it is only available in the future.

    I'd love to establish and quantify what has been going on. I think that these linear quantities (such as M4; sectoral debt etc. etc.) while interesting only present a very narrow view of the current situation. In abstract terms, I want to establish a trend graph for availability of money over time... since this will define both inflation and asset prices in the future. I'm not sure how to go about doing this, but the crucial difference to what I've seen here (and the best of what I've seen elsewhere) is that we need to consider time.. we need to ask how liquid non-cash assets are now, and how this is expected to change in the future. I think we need to establish exactly the same for debt... It matters, for example, if mortgages have massive early repayment penalties.

    I'd be very interested to discover your thoughts on this - and, of course, any concrete evidence that helps to estimate the temporal effects on debt and savings.

  2. asteve,

    I like your comments and some of your theorising is very thought provoking.

    On this point, I'm keen to separate the words "money" and "debt". Debt can be defaulted on, money can't.

    In the credit bubble the question "where did all that money come from" is the other side to the credit crunch question of "where did all the money go to"

    The answer is that it's not money, it's debt. It get's created out of nothing and evaporates into nothing. The money remains.


  3. asteve,

    Money is the counterpart of debt.

    Today, two types of institutions create money; central banks and a subset of banks called monetary financial institutions.

    When a central bank creates money, it is a liability on its balance sheet. The counterpart asset is either government debt or foreign assets. Both, naturally are debts.

    Turning to commercial banks, they create money when they make a loan. The increase in money supply is a book-keeping entry on the liabilities side of their balance sheet. On the assets side, there is a loan, which is a debt.

    So, all money is backed up by debt. In fact, debt is the cornerstone of our financial system. Without an increase in debt, there can be no increase in the money supply.


  4. asteve,

    The relationship between time and money is a point well worth discussing.

    Alice, given that money is merely a medium of exchange, debt is not necessary to create money - I simply have to work for it. Money measures the number of hours work completed. And when I have money then I can require others to work for me.

    Debt arises when I am unable to work long enough, say, to raise the money to buy a house. In this case I must commit some part of my future labour to repay the debt.

    But has the debt created money, or built a house ?

    The "debt money" has gone into mortgaging our future labour, and what needs to be known is not the size of the debt, but the time it will take to repay.

    This is the metric we should be controlling.

    Mike O.

  5. I think you arue all missing the point. Money is not credit. All transactions are ultimatley settled in money, even if they are parked in credit.

    A shop only accepts your debit card because it expects the remittance to it's bank account to be redeemable in cash (money) should it need it.

    Most of the time they are happy with the bank showing them a number on a bank statement. But that's just credit - a checking account is basically a ultra-short term bond issued by the bank.

    When you go to the ATM to withdraw you convert that credit to money. Banks never have enough money to stand large scale withdrawals, which is why they can go to the BoE to convert reserves into money.


    That's the point of why we had a credit expansion and now a credit crunch. People were happy with the numbers on the pieces of paper their banks and brokers gave them and didn't look to convert any of it into money.


  6. Why should anyone save when interest rates are so low?

  7. :-) Nick, I think you need to be careful - some of your terminology makes your comment sound rather close to the "Money as Debt" crowd and their bonkers tangents. (I hope you don't consider that too rude... I'm not contradicting what you say - just questioning how interpretations might be extrapolated...)

    Alice, I agree that debt underwrites out financial system... What I think is interesting and relevant is that there is more debt than money - when a naive observer might have assumed balance. For example, when I borrow £10K and spend it, I merely transfer the M4L money to someone else. The "Money as debt" crowd say that this is because some mythical system is sucking dry the system by charging interest - which (and here they do voodoo hand-waving) can't be repaid. The MAD crowd are deluded because they think that the interest payments are somehow outside out monetary system - and they are not. Having debunked the conspiracy theory, one might be forgiven for thinking that debt and savings should be equal. (OK, I realise that your charts are only for households... but I remain to be convinced that there are massively wealthy non-household participants who are hoarding all the money. I think that what is happening is that money is being invested in credit outside the M4-realm (for want of a better name) and that this is where both the money and wealth are residing. Perhaps investment bonds are being sold in such a way as not to influence savings figures but to influence debt figures? If they are, then it would be a good idea to work out when these bonds mature.

  8. asteve,

    I'm happy to hear your rebuttal to this, but for me to accept it it'll have to address the issue directly.

    To summarise main conclusions:
    1. Money and credit are two different things;
    2. Only the BoE can create money;
    3. Banks can create official credit, primarily through fractional reserve lending;
    4. Anyone who enters into a contract to be paid later for a service provided now can create unofficial credit. The shadow banking system did alot of this;
    5. Both money and credit provide purchasing power so long as the vendor accepts money or credit;
    6. In a bubble, money and credit look like the same thing and push prices higher;
    7. Credit must be repaid in money or new credit;
    8. In a credit crunch, the new credit is not forthcoming and the old credit disappears because it gets defaulted on;
    9. Because at the end of the cycle there is not enough money to settle all the credit transactions.

    I'm not interested in "debt as money" theories. The hard fact of modern banking is they loan out money they don't have through fractional reserve lending. When everybody tries to convert their bank balances into money they find out it's not all there. This is why current accounts are really just a short term bond with an instant recall option attached. Not money.

    I'm interested to hear your thoughts. At the end of the day I just want to get this right. If I'm wrong now, I'm quite happy to hear what right is.

    At the moment the commentators on this blog are all pretty much in the M3 / M4 is money camp, and also the inflation = CPI camp. I'm keeping the Austrian line in here because I think that's the right one.


  9. Nick, A response, if not a rebuttal...

    1. Money and credit are highly inter-related - the boundary is often blurred.

    2. Talking about "creating money" is unhelpful because it has no formal definition - commercial banks expand M4 when they choose to lend... this is independent of the central bank. Banks are, mostly, constrained by Basel and other regulations imposed by governments. In any case, for "really real" money (Treasuries) these are created not by the central bank but by the Treasury... Treasuries are used to buy notes and coins from the royal mint too... and there's nothing more money-like than coins you can use to buy beer during a power cut.

    3. Anyone can create credit - not just banks. When I agree to be paid late by a customer, I create credit. It's nothing special. Banks do a lot more than this when they lend.

    4/5. This 'unofficial credit' is rather different to M4 - since the creditor can't spend it until it is paid (excluding the sale of debts to debt collection agencies, I suppose.)

    6. The similarities and differences between credit and money (however we define that) are extremely similar in a bubble as outside a bubble.

    7. Credit can be defaulted.

    8/9. It is unhelpful to think about there being "enough money to settle debts" - because that's not now debt settlement works. You need to take account of the term-structure of the debt. Maturity dates are critical when assessing the risk of debt.

    I disagree that fractional reserve lending is "lending out money they[banks] don't have". We likely agree about how fractional reserve lending works... I argue only that an understanding of fractional reserve results in a refined definition of money... and for this refined definition - money (well, M4) is defined. There are lots of different types of money-like stuff... and M4 is only one definition of many. All manner of contracts outside M4 have value - and it is only by convention that we do not include these. Every contract has some risk attached... the idea that there is one notion of money is flawed... What distinguishes financial assets is maturity; liquidity and default risk. Measuring these is something of a nightmare.

    I'm far from opposed to the Austrian line - I think that it is extremely astute... however, because the practical systems we experience have been defined (on the whole) by non-Austrian school economists... Their metrics are not really what we need. What is an even bigger problem is that it is not entirely obvious that completely appropriate metrics could be defined.

    I despise both the terms "money" and "inflation" since they're so wishy-washy that they prevent analysis in any meaningful way. For money we might be talking about M0; M4; central bank liquidity; bond and asset valuations; credit; bartered goods - etc. With inflation, we might be talking about RPI; RPIX; CPI (and each of those subject to a different annually adjusted set of weights); core-inflation; non-core inflation; wage-inflation; cost of living; asset-specific inflations (HPI, for example) - etc. All of these are utterly different.

  10. asteve,

    Thanks for the detailed and focused response. I'll be thinking those points through.

    In case you haven't picked it up from my comments, my entire interest in this (aside from intellectual) is I'm trying to reach an answer on the deflation/inflation question so I can position myself to protect my family's assets through the crisis.


  11. IMHO, the inflation/deflation debate will take an unexpected turn - just as it did in the 1970s when the economy returned the "theoretically impossible" stagflation. This time, of course, it won't be stagflation - that is what many people expect.

    Inflation in the very long term is inevitable. In the short to medium term, I see biflation (rising commodities; stagnant production & wages; falling asset prices). I can't be more accurate - but that's the forecast I'm assuming. I'm not trying to play the commodities markets - that is a spectacularly risky hobby. My choice, for now, is a safe liquid position - and I anticipate opportunities aplenty in 1 to 3 years time.

    I hope that your reference to "protecting" your assets does not indicate a "me(n)talist" approach involving burying supposedly precious objects. I think that the best way you can position yourself is to stay informed and to recognise that much advice, professional or otherwise, is baseless.

  12. asteve,

    I've got a diversified portfolio: 50% canned goods, 50% ammunition.

    Only joking. I'm in the deflation camp right now and I too think stagflation won't happen. Not because it's theoretically impossible (I'm neither Keynesian nor do I call rising prices "inflation"), but because I think banks won't lend, consumers won't borrow, and global wage arbitrage will prevent the wage-price spiral. I think the collapse of credit will outpace the creation of new money, like it did in Japan.

    But this is still a provisional position and I'm alert to changes. The good thing is that indicators of serious inflation or deflation happen with plenty of warning (if you are liquid enough to respond).

    In any competitive activity, you are not competing against nature you are competing against rivals. I liken it to the difference between, say, javelin throwing and boxing.

    So my primary strategy is:
    1) Divest all assets and hold cash, because liquidity is crucial;
    2) Spead that cash around to minimise counterparty risk;
    3) Have few ties to a location so I can leave the country (political risk) or move to a new job (economic risk);
    4) Stay one step ahead of the mass of the population. I'm not too bothered about staying a step ahead of traders.

    I'm with you on biflation but being Austrian I wouldn't call it that. I see tumbling asset prices as the deflationary collapse of credit and I see rising commodities as the inflationary expansion of money and normal supply-demand issues due to peak oil, low fertiliser, commodity bubbles and increased global demand.

    For a middle-income earner like me, biflation is great. All the important high costs come down (housing, healthcare, education) while the things that go up are a tiny part of my take home pay. I think the important goods are socially stratified and therefore the key is to do better than my rivals