OECD: Credit is Bad for Your Economy

by Dr Constantin Gurdgiev, Adjunct Assistant Professor of Finance with Trinity College, Dublin

In many jurisdictions around the world, policymakers and economic analysts are keen on promoting the virtues of credit systems as drivers for growth. Even in more conservative, boom-and-bust weary economies, conventional view of financial services is that the investment and savings facilitation provided through credit systems to the real economy is a good thing. Thus, ever since the onset of the Global Financial Crisis, euro area and other advanced economies’ policy makers have repeatedly stressed the need to ‘get credit flowing’, ‘reduce financial barriers to investment’ and ‘restore lending’ as key policy priorities. Over the same period of time, global competition for developing and expanding international financial services accelerated, spurred by the broadly-based belief that more financial sector investments equals higher domestic growth.

The problem with credit

The problem with this view of the financial economy is two-fold. Firstly, it is based on deep mis-conceptions about the role of financial services in the real economy. Secondly, it ignores variations in the effective links between real growth and different areas of finance.

This month’s research paper published by the OECD, titled “Finance and Inclusive Growth”, sheds some light on these two issues1.

At the top, the study finds that since the 1970s, a large scale expansion of the financial sector in the OECD economies has resulted in a three-fold credit and stock markets expansions relative to GDP. Thus, in simple terms, expansion of financial services has not resulted in a similar growth in the real economy. Instead, a rapid rate of the financial flows outpacing real economic growth signals severe mis-allocations of financial sector funding to unproductive activities.

Ever politically correct, the OECD mutes some of the key conclusions arising from the data. Per OECD study, “The empirical evidence in this study underlines that the financial sector is an important ingredient of growth. Economies gain a lot from moving from a small financial sector to a more developed one. However, there can be too much finance. When the financial sector is well developed, as has been the case in OECD economies for some time, further increases in its size usually slow long-term growth. Prior OECD studies concluded that excesses in credit extension also make economies more vulnerable to crises.”

In reality, the OECD data is nothing short of damning. take a look at the following chart, reproduced from the study results.

Different forms of financial expansion have contrasting effects on growth at the margin Percentage point change in real GDP per capita growth
Source: OECD (2015) Figure 5
Note: The figure shows point estimates surrounded by 90% confidence intervals

To quote the study: “Estimations based on the entire dataset for OECD countries show that, for the average country, an increase in financial sector value added or intermediated credit from their previous values is associated with slower growth (Chart above). In contrast, stock market expansion is associated with higher growth (Figure 5). Extending the dataset to include the G20 countries yields the same findings that an increase in intermediated credit is associated with slower growth and a stock market expansion with higher growth. The results are symmetric: reductions in financial sector value added or intermediated credit are linked with higher growth, and stock market contractions with slower growth.”

In other words, across all OECD economies, a 10% expansion in private sector credit, relative to GDP, on average implies 0.26 percentage point drop in long-term GDP per capita growth rate and with 90% probability, the effect of credit expansion falls between -0.05 percentage points contraction in real per capita GDP and -0.47 percentage points decline. When the stock of credit grows by 10 percent of GDP, the effect is even more dramatic, resulting in a reduction of 0.3 percentage points in GDP per capita.

The chart also highlights the other side of the OECD findings: both the target and the source of finance matters. As shown above, credit expansion via lending to households represents the most damaging source of financial sector growth, leading to a drop of 0.65 percent in long term growth rate. Credit by banks is the worst contributor to decline in GDP per capita growth by source, resulting in an average decline in growth rates of 0.5 percentage points. Credit created by non-banks is more benign. Only equity results in growth rates that are positive, albeit hardly significant: a 10% of GDP expansion in stock markets valuations leads to a GDP per capita growth rate uplift of 0.18 percentage points.

Dynamically, however, financial sector expansion effects on growth in the real economy depend on the starting point from which credit expansion begins. OECD study shows two comparatives, one for banks credit and one for stock markets capitalisation, reproduced in the following two charts.


Estimated change in per capita GDP growth when credit intermediation increases by 10% of GDP
Source: OECD (2015) Figure 4b


Estimated change in per capita GDP growth when stock markets expand by 10% of GDP
Source: OECD (2015) Figure 4c

Once again, looking at the charts, credit creation via intermediaries, e.g. banks, starts to generate negative returns in terms of real GDP growth whenever it takes place in the environment where credit system exceeds 60 percent of GDP. Positive growth effects of the banking sector-led credit expansions are highly sensitive to the degree of financial system development, with economic effects dropping precipitously when credit expands from around 30% of GDP to 40% of GDP. It is worth noting here that, currently, not a single euro area economy operates in the environment where credit to GDP ratio stands below 100 percent.

While the effects of stock markets expansions are more benign than debt expansions, once stock market capitalisation exceeds 60 percent of GDP, economic growth effects of further equity valuations uplifts also become negative. However, this effect is non-linear, with a small positive growth effects arising forms tock markets around the point where stocks capitalisation reaches 80 percent of GDP.

This evidence on the relationship between credit / debt creation and stock markets equity valuations and long-term growth puts into serious questions the European Union’s latest structural policy innovations summarised within the European Capital Markets Union proposal2. The CMU focuses excessively on credit creation via traditional intermediation channels (the very channels that have been exposed by the OECD researchers as the most damaging to long-term real growth) and is predicated on an implicit assumption that higher credit and equity markets growth should lead to higher growth in real GDP (the very assumption challenged by the OECD data)3.

Beyond growth effects, OECD (2015) also presents evidence that “…economic inequalities widen when finance expands: 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. …The distribution of credit can be an additional source of income dispersion if it implies that low income people cannot finance the opportunities they identify to the same extent as their better-off counterparts.”

What do the OECD findings propose?

The main policy dilemma that arises from the OECD findings is what can be done to address the negative effects of credit expansions that push economies beyond the point where new debt results in slower growth. The OECD advances a series of proposals that can be summarised as follows:

1) Increase capital buffers on the banks and incentivise the banking system to more pro-actively manage its risks4 ;
2) Decouple sovereign balance sheets from too-big-to-fail banks risks5 ;
3) Increase supervisory pressures on banks and financial intermediaries6 ; and
4) From opting for better balance in the sources of finance available in the economy7.

But the OECD has a major problem in the fact it fails to admit in its research in explicit terms, while attempting to deal with it indirectly. The problem is that much of the current glut of credit outstanding in the advanced economies is based on massive increase in recent decades in savings. Yes, you heard me right: over the last 2-3 decades, global savings glut became massive, driven primarily by two factors:

1. Demographic ageing in the advanced economies that generated large surplus of savings in the form of deposits and longer-maturity instruments; and
2. Growth trends in the emerging economies that generated rapid increases in income and, correspondingly, aggregate savings.

The OECD can’t quite come around to declaring the need to curb the savings behaviour of households, but it can recommend such curbs, dressed up as the tool for ‘improving’ the quality of financial funding sources. Thus, the organisation recommends:

1. Higher and new taxes on savings (extending VAT on household deposits);
2. Taxing mortgages to reduce incentives for saving via owner-occupied property purchases; and
3. Introducing direct restrictions on credit availability to households and home ownership.

Never mind the core point that it is the imbalance of debt that impedes financial sector contribution to real growth, let’s just tax households some more.

References

1. OECD (2015): “Finance and Inclusive Growth“, by Boris Cournède, Oliver Denk, and Peter Hoeller. OECD Economic Policy Paper June 2015, Number 14.

2. Gurdgiev, c. (2015): “Summary of Comments on the European Commission Green Paper ‘Building a Capital Markets Union‘” (March 31, 2015). Presented to the Oireachtas Joint Committee on Finance, Public Expenditure and Reform, Ireland.
The topic of CMU has been covered in depth also in the following posts: Three Strikes of the New Financial Regulation: Part 3 – The Capital Markets Union and Three Strikes of the New Financial Regulation: Part 4: CMU or Not CMU?

3. See more on the topic of debt v equity in funding investment.

4. See more on this aspect of recent EU reforms here:Three Strikes of the New Financial Regulation – Part 6: Banking Dis-Union

5. See more on the sovereign-banks risk loops here in the context of the euro area: Geography of the Euro Area Debt Flows as well as some links and discussion concerning the Basel III approach to dealing with the sovereign-banks contagion: Banking Reforms : recent links and Shortages of Safe Assets & Banks Recaps – troubled waters of Basel III.

6. You can follow our recent coverage European innovation in financial services regulation and supervision from the posts linked here: The New Financial Regulation: Part 10: Legal v Operational Logistics.

7. See discussion of this here: Gurdgiev, c. (2015): “Summary of Comments on the European Commission Green Paper ‘Building a Capital Markets Union‘” (March 31, 2015). Presented to the Oireachtas Joint Committee on Finance, Public Expenditure and Reform, Ireland

 
AndyLouis:
from NYT No Extra Credit by Joe Nocera
What if the Obama jobs plan, the coming deliberations of the supercommittee, the debate over taxing millionaires — what if none of it is likely to make a whit of positive difference for the economy? What if the only thing that matters is something Congress and the president rarely mention, and can do nothing about?

I’ve come to believe this is the case. What is killing the economy is lack of credit. In the aftermath of an asset bubble, invariably the result of too-loose credit, banks don’t just tighten their standards; they practically shut down.

This was true during the Great Depression, and it’s been true during the Great Recession. And until normal credit standards return, economic growth will continue to be stunted. “Overreaction to the credit bubble is now the knee on the throat of the economy,” says my friend Lou Barnes, a mortgage banker at Premier Mortgage Group in Colorado.

I'm not an economist, but I think I agree with this. But can it really just be that simple?

No, it's actually a rather stupid analysis on behalf of the NYT, but then what else would you expect...

 

Lots of companies run their operations based on debt, credit lines from banks. Banks stop lending money, the cash flow dries up, reduced operations.

The previous economy was the equivalent of living off 12 credit cards (ironically how it started), and then suddenly you've maxed them. Your servants, luxury stuff, holidays and whatever spending all contributed to the economy, making it artificially high.

Now we're seeing the bills being paid. It's unlikely we'll see that level of temporary circulation, until time forgets (LTCM dudes are employed so maybe)

 
trazer985:
Lots of companies run their operations based on debt, credit lines from banks. Banks stop lending money, the cash flow dries up, reduced operations.

The previous economy was the equivalent of living off 12 credit cards (ironically how it started), and then suddenly you've maxed them. Your servants, luxury stuff, holidays and whatever spending all contributed to the economy, making it artificially high.

Now we're seeing the bills being paid. It's unlikely we'll see that level of temporary circulation, until time forgets (LTCM dudes are employed so maybe)

^^^This

The economy artificially expanded way beyond where it should have been

"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger
 

Yes, exactly. Lack of credit really blows.

The economy is a function of aggregate supply and aggregate demand. In times of loose cedit (right before the Great D and pre-2007), credit throws supply and demand out of whack - too much demand and too much supply...essentially creating a clusterfuck of how the economy allocates economic resources. With loose credit we can buy a $20,000 car that we only use for about an hour a day, or a power drill that will only be used 2-3 mins in its total lifetime - complete and total economic waste.

When credit tightens, we have to buy stuff with real money. Suddenly, we cant take out a loan for that car or get a credit card to buy a power drill. Agg supply and agg demand re-adjust in the short-term, which is painful and destroys productivity.

The POTUS doesn't have any control over this, niether does congress. Only the Fed directly influences credit policy.

And too be clear: lack of credit is not the issue, too much credit was.

Man made money, money never made the man
 
RE Capital Markets:
Yes, exactly. Lack of credit really blows.

The economy is a function of aggregate supply and aggregate demand. In times of loose cedit (right before the Great D and pre-2007), credit throws supply and demand out of whack - too much demand and too much supply...essentially creating a clusterfuck of how the economy allocates economic resources. With loose credit we can buy a $20,000 car that we only use for about an hour a day, or a power drill that will only be used 2-3 mins in its total lifetime - complete and total economic waste.

When credit tightens, we have to buy stuff with real money. Suddenly, we cant take out a loan for that car or get a credit card to buy a power drill. Agg supply and agg demand re-adjust in the short-term, which is painful and destroys productivity.

The POTUS doesn't have any control over this, niether does congress. Only the Fed directly influences credit policy.

And too be clear: lack of credit is not the issue, too much credit was.

Nail meet head, amazing that people think the cure is more credit

 

Lack of credit is not the issue right now. It is the lack of aggregate demand. Borrowers don't want new loans, and lenders don't want to lend. No one wants money because they want to hunker down and get rid of all the debt they've built up. This has caused AD to plummet, and in turn results in layoffs, further AD decreases, etc.

RECM is spot on. Available credit needs to be used more efficiently. In other words, every dollar of money in circulation needs to pump out more units of GDP, this will get the economy moving again.

looking for that pick-me-up to power through an all-nighter?
 

doesnt help that we have sticky prices in certain RE markets that are holding prices up and not allowing the common consumer to jump into the action.. i still think NYC are has a good chunk to go down still esp in certain locations... anyone seen the NYC rent to buy's ratio?

but yes before we have RE buyers we also need jobs n solid economies for the buyers

 

aftermath of an asset bubble? bubble aint even popped yet.....in the absence of gov intervention, this bubble will pop soon and it wont look nice. but im sure fed will run to the "rescue" by printing for decades to come and we will be japan. All they have to do to avoid this is let asset prices revert to true fair value as deemed by market participants. This will be very painful for a number of years, but it is a MUST. Regardless of what asshole PhDs say, this isnt rocket science. Markets are very dynamic, they will keep trying to collapse in the absence of interventional liquidity, making each attempt worse and worse. Then what finally happens when they decide to not print money anymore? KABOOM

 

I completely disagree with people who say that there's a lack of credit. There may be a lack of credit to unqualified buyers, but it is completely false to say that money isn't being lent.

I am nothing special, but have always been pretty responsible with money. I've been married for just over a year to a girl with very little credit history. In the past year we've gotten very favorable mortgage rates with little down, very favorable car loan with zero down and new credit cards with a high limit.

I am in finance at a F500 and my wife is a teacher, we are not wealthy. We obtained all this credit with absolutely no hassles whatsoever. I am sure that we could go out and buy her a new car tomorrow and have no issue with getting a loan to make the purchase.

twitter: @CorpFin_Guy
 
accountingbyday:
I am nothing special, but have always been pretty responsible with money.

Actually, you are special. Most people were irresponsible with credit.

Banks still offer competitve financing to borrowers with good credit because the very nature of modern financing is hyper-competitive. Banks are fighting to earn your business, you win when you get the most competitive rate.

Man made money, money never made the man
 

It's 110% lack of credit, or, to be put differently, lack of credit in the context of the last 10 years. The housing market directly or indirectly affects 20% or so of the economy. Credit standards are so much higher than they were even 5 years ago that it's breathtaking. Subprime lenders were the rage until 3 years ago. Now there isn't a single genuine subprime lender left in the United States. To exacerbate the loss of subprime lending is the vast tightening of conforming loan products. Where once someone could obtain a loan with a 580 credit score he or she must now have a 640 credit score--bare minimum. Those 60 points are devastating to a lender's typical pool of borrowers.

Where once one could cash-out a second home or could cash out a primary residence to 90% LTV a borrower can no longer cash out a second home and can only cash out to 85% max, 80% conventional. Where one could obtain a mortgage a year after bankruptcy that person now must wait 2 years at least. Where one once had 30% equity in his house one now has -25%--good-bye HELOCs. Where one could find a lender willing to issue a construction loan one is now running into a brick wall. Where one could purchase a house with some repair issues one is now running into brick wall with the FHA. I could go on for pages and pages about just the little things that make is difficult to obtain home financing.

The point is, the housing market is a critical component of the economy and tight credit has caused the persistence of the housing depression. The only solution is time.

Array
 

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