Credit Bubbles. Thought of the Day 90.0

creditbubble

At the macro-economic level of the gross statistics of money and loan supply to the economy, the reserve banking system creates a complex interplay between money, debt, supply and demand for goods, and the general price level. Rather than being constant, as implied by theoretical descriptions, money and loan supplies are constantly changing at a rate dependent on the average loan period, and a complex of details buried in the implementation and regulation of any given banking system.

Since the majority of loans are made for years at a time, the results of these interactions play out over a long enough time scale that gross monetary features of regulatory failure, such as continuous asset price inflation, have come to be regarded as normal, e.g. ”House prices always go up”. The price level however is not only dependent on purely monetary factors, but also on the supply and demand for goods and services, including financial assets such as shares, which requires that estimates of the real price level versus production be used. As a simplification, if constant demand for goods and services is assumed as shown in the table below, then there are two possible causes of price inflation, either the money supply available to purchase the good in question has increased, or the supply of the good has been reduced. Critically, the former is simply a mathematical effect, whilst the latter is a useful signal, providing economic information on relative supply and demand levels that can be used locally by consumers and producers to adapt their behaviour. Purely arbitrary changes in both the money and the loan supply that are induced by the mechanical operation of the banking system fail to provide any economic benefit, and by distorting the actual supply and demand signal can be actively harmful.

Untitled

Credit bubbles are often explained as a phenomena of irrational demand, and crowd behaviour. However, this explanation ignores the question of why they aren’t throttled by limits on the loan supply? An alternate explanation which can be offered is that their root cause is periodic failures in the regulation of the loan and money supply within the commercial banking system. The introduction of widespread securitized lending allows a rapid increase in the total amount of lending available from the banking system and an accompanying if somewhat smaller growth in the money supply. Channeled predominantly into property lending, the increased availability of money from lending sources, acted to increase house prices creating rational speculation on their increase, and over time a sizeable disruption in the market pricing mechanisms for all goods and services purchased through loans. Monetary statistics of this effect such as the Consumer Price Index (CPI) for example, are however at least partially masked by production deflation from the sizeable productivity increases over decades. Absent any limit on the total amount of credit being supplied, the only practical limit on borrowing is the availability of borrowers and their ability to sustain the capital and interest repayments demanded for their loans.

Owing to the asymmetric nature of long term debt flows there is a tendency for money to become concentrated in the lending centres, which then causes liquidity problems for the rest of the economy. Eventually repayment problems surface, especially if the practice of further borrowing to repay existing loans is allowed, since the underlying mathematical process is exponential. As general insolvency as well as a consequent debt deflation occurs, the money and loan supply contracts as the banking system removes loan capacity from the economy either from loan repayment, or as a result of bank failure. This leads to a domino effect as businesses that have become dependent on continuously rolling over debt fail and trigger further defaults. Monetary expansion and further lending is also constrained by the absence of qualified borrowers, and by the general unwillingness to either lend or borrow that results from the ensuing economic collapse. Further complications, as described by Ben Bernanke and Harold James, can occur when interactions between currencies are considered, in particular in conjunction with gold-based capital regulation, because of the difficulties in establishing the correct ratio of gold for each individual currency and maintaining it, in a system where lending and the associated money supply are continually fluctuating and gold is also being used at a national level for international debt repayments.

The debt to money imbalance created by the widespread, and global, sale of Asset Backed securities may be unique to this particular crisis. Although asset backed security issuance dropped considerably in 2008, as the resale markets were temporarily frozen, current stated policy in several countries, including the USA and the United Kingdom, is to encourage further securitization to assist the recovery of the banking sector. Unfortunately this appears to be succeeding.

Velocity of Money

Trump-ASX-Brexit-market-640x360

The most basic difference between the demand theory of money and exchange theory of money lies in the understanding of quantity equation

M . v = P . Y —– (1)

Here M is money supply, P is price and Y is real output; in addition, v is constant velocity of money. The demand theory understands that (1) reflects the needs of the economic individual for money, not only the meaning of exchange. Under the assumption of liquidity preference, the demand theory introduces nominal interest rate into demand function of money, thus exhibiting more economic pictures than traditional quantity theory does. Let us, however concentrate on the economic movement through linearization of exchange theory emphasizing exchange medium function of money.

Let us assume that the central bank provides a very small supply M of money, which implies that the value PY of products manufactured by the producer will be unable to be realized only through one transaction. The producer has to suspend the transaction until the purchasers possess money at hand again, which will elevate the transaction costs and even result in the bankruptcy of the producer. Then, will the producer do nothing and wait for the bankruptcy?

In reality, producers would rather adjust sales value through raising or lowering the price or amount of product to attempt the realization of a maximal sales value M than reserve the stock of products to subject the sale to the limit of velocity of money. In other words, producer would adjust price or real output to control the velocity of money, since the velocity of money can influence the realization of the product value.

Every time money changes hands, a transaction is completed; thus numerous turnovers of money for an individual during a given period of time constitute a macroeconomic exchange ∑ipiYi if the prices pi can be replaced by an average price P, then we can rewrite the value of exchange as ∑ipiYi = P . Y. In a real economy, the producer will manage to make P . Y close the money supply M as much as possible through adjusting the real output or its price.

For example, when a retailer comes to a strange community to sell her commodities, she always prefers to make a price through trial and error. If she finds that higher price can still promote the sales amount, then she will choose to continue raising the price until the sales amount less changes; on the other hand, if she confirms that lower price can create the more sales amount, then she will decrease the price of the commodity. Her strategy of pricing depends on price elasticity of demand for the commodity. However, the maximal value of the sales amount is determined by how much money the community can supply, thus the pricing of the retailer will make her sales close this maximal sale value, namely money for consumption of the community. This explains why the same commodity can always be sold at a higher price in the rich area.

Equation (1) is not an identical equation but an equilibrium state of exchange process in an economic system. Evidently, the difference M –  P . Y  between the supply of money and present sales value provides a vacancy for elevating sales value, in other words, the supply of money acts as the role of a carrying capacity for sales value. We assume that the vacancy is in direct proportion to velocity of increase of the sales value, and then derive a dynamical quantity equation

M(t) - P(t) . Y(t)  =  k . d[P(t) . Y(t)]/d(t) —– (2)

Here k is a positive constant and expresses a characteristic time with which the vacancy is filled. This is a speculated basic dynamical quantity equation of exchange by money. In reality, the money supply M(t) can usually be given; (2) is actually an evolution equation of sales value P(t)Y(t) , which can uniquely determine an evolving path of the price.

The role of money in (2) can be seen that money is only a medium of commodity exchange, just like the chopsticks for eating and the soap for washing. All needs for money are or will be order to carry out the commodity exchange. The behavior of holding money of the economic individuals implies a potential exchange in the future, whether for speculation or for the preservation of wealth, but it cannot directly determine the present price because every realistic price always comes from the commodity exchange, and no exchange and no price. In other words, what we are concerned with is not the reason of money generation, but form of money generation, namely we are concerned about money generation as a function of time rather than it as a function of income or interest rate. The potential needs for money which you can use various reasons to explain cannot contribute to price as long as the money does not participate in the exchange, thus the money supply not used to exchange will not occur in (2).

On the other hand, the change in money supply would result in a temporary vacancy of sales value, although sales value will also be achieved through exchanging with the new money supply at the next moment, since the price or sales volume may change. For example, a group of residents spend M(t) to buy houses of P(t)Y(t) through the loan at time t, evidently M(t) = P(t)Y(t). At time t+1, another group of residents spend M(t+1) to buy houses of P(t+1)Y(t+1) through the loan, and M(t+1) = P(t+1)Y(t+1). Thus, we can consider M(t+1) – M(t) as increase in money supply, and this increase can cause a temporary vacancy of sales value M(t+1) – P(t)Y(t). It is this vacancy that encourages sellers to try to maximize sales through adjusting the price by trial and error and also real estate developers to increase or decrease their housing production. Ultimately, new prices and production are produced and the exchange is completed at the level of M(t+1) = P(t+1)Y(t+1). In reality, the gap between M(t+1) and M(t) is often much smaller than the vacancy M(t+1) – P(t)Y(t), therefore we can approximately consider M(t+1) as M(t) if the money supply function M(t) is continuous and smooth.

However, it is necessary to emphasize that (2) is not a generation equation of demand function P(Y), which means (2) is a unique equation of determination of price (path), since, from the perspective of monetary exchange theory, the evolution of price depends only on money supply and production and arises from commodity exchange rather than relationship between supply and demand of products in the traditional economics where the meaning of the exchange is not obvious. In addition, velocity of money is not contained in this dynamical quantity equation, but its significance PY/M will be endogenously exhibited by the system.

Economics is the Science which Studies Human Behaviour as a Relationship Between Ends and Scarce Means which have Alternative Uses. Is Equilibrium a Choice? Note Quote.

What is the place of choice in equilibrium theory? Alfred Marshall and Leon Walras, who introduced competitive equilibrium theory, employed the theory of choice in terms of utility, analogously to the Austrian school. Enrico Barone and Karl Gustav Cassel (the latter introducing general equilibrium theory in the German speaking world. Walras-Cassel System) used demand and supply functions as starting data, disregarding the theory of choice. Pareto, on the one hand, argued that the two approaches are compatible. However, he discarded cardinal utility introducing the notion of preferences, i.e. ordinal utility, as sufficient foundations for the theory of choice, thus starting the modern analysis of choice. Pareto also suggested that these data can be derived directly from choices, so short-cutting the theory of choice (since choices are not to be explained) and anticipating the theory of revealed preferences. This theory is, perhaps, the point of maximal distance between equilibrium theory and the Austrian school. On the other hand, Pareto’s theory of economic efficiency, or Pareto-optimality, and all analysis connected with it (such as, for example, the theory of the core of an economy) requires at least individual preferences, an element which underlies choices and helps to explain them.

What was presented above is the present state of competitive equilibrium theory. Demand and supply functions are sufficient for determining prices and equilibrium allocations. These functions represent choices. In other words, theory of choice is not necessarily an integral element of competitive equilibrium theory, only a prerequisite. However, individual preferences and the theory of choice are required in order to define Pareto-optimal allocations and demonstrate the two theorems of welfare economics. Competitive equilibrium studies the compatibility of price-taking agents’ choices. Thus, it concerns choices without representing a theory about them. Nevertheless, such a theory is required if statements on Pareto-optimality and other relevant characteristics of competitive equilibrium are to be made.

In similar terms, the theory of choice is required by non-competitive equilibrium theory as well. For instance, game theory deeply analyzes strategic choices and in every non-competitive market equilibrium price-making agents’ choices have to be analyzed to a certain extent. However, this analysis differs from that given by the Austrian school. The difference lies in the aim of the two approaches. While the Austrian school is interested mainly in individual choices and their implications in as much as according to the famous Robbins’s definition, “economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses”, equilibrium theory, including game theory, is interested mainly in the compatibility of choices. That is, equilibrium theory is not so much a theory of intentional actions as a the theory of intentional interactions. The two approaches overlap but do not coincide, even if they share the same vision of society and main assumptions about the behavior of its components.

Maffeo Pantaleoni  did not accept Pareto’s new theory of choice. He continued to follow the Jevons-Menger-Walras hedonistic approach to utility and he identified economic theory with the theory of subjective value. Probably, there was a courious change of position beteween Pantaleoni and Pareto about the political significance of economic theory. On the hand, Pareto was initially reluctant to accept Walras’s economic theory (introduced to him by Pantaleoni) because he was too liberal for sharing Walras’s socialism. In fact, he accepted Walras’s economic theory, not at all Walras’s political and philosophical view. On the other hand, Pantaleoni seems to have refuted Pareto’s new theory also because of its focus on equilibrium instead of individual choice. This would limit the liberal doctrine he envisaged strictly connected to economics as the theory of the individual choice.

For instance, let us take into consideration the theory of non-cooperative games. Its focus is on strategic interdependence, i.e. those situations in which each agent chooses their action knowing the result also depends on the actions of other individuals and that those actions as well generally depend on theirs. Individual action (for better clarity, plan of actions, or strategy) is not simply determined selecting the option that maximizes one’s utility from the set of actions available to each agent. The agent under consideration knows that other agents actions could prevent him from performing their optimal action and reaching the desired result. Individual equilibrium actions are determined simultaneously, i.e. we can generally determine the choice of an individual only by determining also the choices of all other individuals. Both the Austrian school and (competitive) equilibrium theory isolate the individual agent’s choice. However, while the Austrian school does not analyze the compatibility of the actions chosen by individuals (compatibility is presumed), competitive equilibrium theory analyzes interactions, although those among price-taking agents are rather weak. Interaction is predominant in strategic situations, where choices cannot be analyzed without taking interdependence explicitly into account.

How Permanent Income Hypothesis/Buffer Stock Model of Milton Friedman Got Nailed?

Milton Friedman and his gang at Chicago, including the ‘boys’ that went back and put their ‘free market’ wrecking ball through Chile under the butcher Pinochet, have really left a mess of confusion and lies behind in the hallowed halls of the academy, which in the 1970s seeped out, like slime, into the central banks and the treasury departments of the world. The overall intent of the literature they developed was to force governments to abandon so-called fiscal activism (the discretionary use of government spending and taxation policy to fine-tune total spending so as to achieve full employment), and, instead, empower central banks to disregard mass unemployment and fight inflation first. Wow!, Billy, these aren’t the usual contretemps and are wittily vitriolic. Several strands of their work – the Monetarist claim that aggregate policy should be reduced to a focus on the central bank controlling the money supply to control inflation (the market would deliver the rest (high employment and economic growth, etc); the promotion of a ‘natural rate of unemployment’ such that governments who tried to reduce the unemployment rate would only accelerate inflation; and the so-called Permanent Income Hypothesis (households ignored short-term movements in income when determining consumption spending), and others – were woven together to form a anti-government phalanx. Later, absurd notions such as rational expectations and real business cycles were added to the litany of Monetarist myths, which indoctrinated graduate students (who became policy makers) even further in the cause. Over time, his damaging legacy has been eroded by researchers and empirical facts but like all tight Groupthink communities the inner sanctum remain faithful and so the research findings haven’t permeated into major shifts in the academy. It will come – but these paradigm shifts take time.

Recently, another of Milton’s legacy bit the dust, thanks to a couple of Harvard economists, Peter Ganong and Pascal Noel, who with their paper “How does unemployment affect consumer spending?” smashed to smithereens the idea that households would not take consumption decisions with discretion, which the Chicagoan held to be a pivot of his active fiscal policy. Time traveling back to John Maynard Keynes, who outlined in his 1936 The General Theory of Employment, Interest and Money a view that household consumption was dependent on disposable income, and, that in times of economic downturn, the government could stimulate employment and income growth using fiscal policy, which would boost consumption.

In Chapter 3 The Principle of Effective Demand, Keynes wrote:

When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income …

The relationship between the community’s income and what it can be expected to spend on consumption, designated by D1, will depend on the psychological characteristic of the community, which we shall call its propensity to consume. That is to say, consumption will depend on the level of aggregate income and, therefore, on the level of employment N, except when there is some change in the propensity to consume.

Keynes later (in Chapter 6 The Definition of Income, Saving and Investment) considered factors that might influence the decision to consume and talked about “how much windfall gain or loss he is making on capital account”.

He elaborated further in Chapter 8 The Propensity to Consume … and wrote:

The amount that the community spends on consumption obviously depends (i) partly on the amount of its income, (ii) partly on the other objective attendant circumstances, and (iii) partly on the subjective needs and the psychological propensities and habits of the individuals composing it and the principles on which the income is divided between them (which may suffer modification as output is increased).

And concluded that:

1. An increase in the real wage (and hence real income at each employment level) will “change in the same proportion”.

2. A rise in the difference between income and net income will influence consumption spending.

3. “Windfall changes in capital-values not allowed for in calculating net income. These are of much more importance in modifying the propensity to consume, since they will bear no stable or regular relationship to the amount of income.” So, wealth changes will impact positively on consumption (up and down).

Later, as he was reflecting in Chapter 24 on the “Social Philosophy towards which the General Theory might lead” he wrote:

… therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.

For if effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him …

It was thus clear – that active fiscal policy was the “only practicable means of avoiding the destruction” of recession brought about by shifts in consumption and/or investment. That view dominated macroeconomics for several decades.

Then in 1957, Milton Friedman advocated the idea of Permanent income hypothesis. The central idea of the permanent-income hypothesis, proposed by Milton Friedman in 1957, is simple: people base consumption on what they consider their “normal” income. In doing this, they attempt to maintain a fairly constant standard of living even though their incomes may vary considerably from month to month or from year to year. As a result, increases and decreases in income that people see as temporary have little effect on their consumption spending. The idea behind the permanent-income hypothesis is that consumption depends on what people expect to earn over a considerable period of time. As in the life-cycle hypothesis, people smooth out fluctuations in income so that they save during periods of unusually high income and dissave during periods of unusually low income. Thus, a pre-med student should have a higher level of consumption than a graduate student in history if both have the same current income. The pre-med student looks ahead to a much higher future income, and consumes accordingly.Both the permanent-income and life-cycle hypotheses loosen the relationship between consumption and income so that an exogenous change in investment may not have a constant multiplier effect. This is more clearly seen in the permanent-income hypothesis, which suggests that people will try to decide whether or not a change of income is temporary. If they decide that it is, it has a small effect on their spending. Only when they become convinced that it is permanent will consumption change by a sizable amount. As is the case with all economic theory, this theory does not describe any particular household, but only what happens on the average.The life-cycle hypothesis introduced assets into the consumption function, and thereby gave a role to the stock market. A rise in stock prices increases wealth and thus should increase consumption while a fall should reduce consumption. Hence, financial markets matter for consumption as well as for investment. The permanent-income hypothesis introduces lags into the consumption function. An increase in income should not immediately increase consumption spending by very much, but with time it should have a greater and greater effect. Behavior that introduces a lag into the relationship between income and consumption will generate the sort of momentum that business-cycle theories saw. A change in spending changes income, but people only slowly adjust to it. As they do, their extra spending changes income further. An initial increase in spending tends to have effects that take a long time to completely unfold. The existence of lags also makes government attempts to control the economy more difficult. A change of policy does not have its full effect immediately, but only gradually. By the time it has its full effect, the problem that it was designed to attack may have disappeared. Finally, though the life-cycle and permanent-income hypotheses have greatly increased our understanding of consumption behavior, data from the economy does not always fit theory as well as it should, which means they do not provide a complete explanation for consumption behavior.

The idea of a propensity to consume, which had been formalised in textbooks as the Marginal propensity to consume (MPC) – which described the extra consumption that would follow a $ of extra disposable income, was thrown out by Friedman.

The MPC concept – that households consume only a proportion of each extra $1 in disposable income received – formed the basis of the expenditure multiplier. Accordingly, if government deficit spending of, say $100 million, was introduced into a recessed economy, firms would respond by increasing output and incomes by that same amount $100 million. But the extra incomes paid out ($100 m) would stimulate ‘induced consumption’ spending equal to the MPC times $100m. If the MPC was, say, 0.80 (meaning 80 cents of each extra dollar received as disposable income would be spent) then the ‘second-round’ effect of the stimulus would be an additional $80 million in consumption spending (assuming that disposable and total income were the same – that is, assuming away the tax effect for simplicity). In turn, firms would respond and produce an additional $80 million in output and incomes, which would then create further induced consumption effects. Each additional increment, smaller than the last, because the MPC of 0.80 would mean some of the extra disposable income was being lost to saving. But it was argued that the higher the MPC, the greater the overall impact of the stimulus would be. Instead, Friedman claimed that consumption was not driven by current income (or changes in it) but, rather by expected permanent income.

Permanent income becomes an unobservable concept driven by expectations. It also leads to claims that households smooth out their consumption over their lifetimes even though current incomes can fluctuate. So when individuals are facing major declines in their current income – perhaps due to unemployment – they can borrow short-term to maintain the smooth pattern of spending and pay the credit back later, when their current income is in excess of some average expectation.

The idea led to a torrent of articles mostly mathematical in origin trying to formalise the notion of a permanent income. They were all the same – GIGO – garbage in, garbage out. An exercise in mathematical chess although in search of the wrong solution. But Friedman was not one to embrace interdependence. In the ‘free market’ tradition, all decision makers were rational and independent who sought to maximise their lifetime utility. Accordingly, they would borrow when young (to have more consumption than their current income would permit) and save over their lifetimes to compensate when they were old and without incomes. Consumption was strictly determined by this notion of a lifetime income.

Only some major event that altered that projection would lead to changes in consumption.

The Permanent Income Hypothesis is still a core component of the major DSGE macro models that central banks and other forecasting agencies deploy to make statements about the effectiveness of fiscal and monetary policy.

So it matters whether it is a valid theory or not. It is not just one of those academic contests that stoke or deflate egos but have very little consequence for the well-being of the people in general. The empirical world hasn’t been kind to Friedman across all his theories. But the Permanent Income Hypothesis, in particular, hasn’t done well in explaining the dynamics of consumption spending.

Getting back to the paper mentioned in the beginning, it finds deployment of a rich dataset arguing to point where the permanent income hypothesis of Friedman is nailed to the coffin. If the permanent income hypothesis was a good framework for understanding what happens to the consumption patterns of this cohort then we would expect a lot of smoothing going on and relatively stable consumption.

Individuals, according to Friedman, are meant to engage in “self-insurance” to insure against calamity like unemployment. The evidence is that they do not.

The researchers reject what they call the “buffer stock model” (which is a version of the permanent income hypothesis).

They find:

1. “Spending drops sharply at the onset of unemployment, and this drop is better explained by liquidity constraints than by a drop in permanent income or a drop in work-related expenses.”

2. “We find that spending on nondurable goods and services drops by $160 (6%) over the course of two months.”

3. “Consistent with liquidity constraints, we show that states with lower UI benefits have a larger drop in spending at onset.” In other words, the fiscal stimulus coming from the unemployment benefits attenuates the loss of earned income somewhat.

4. “As UI benefit exhaustion approaches, families who remain unemployed barely cut spending, but then cut spending by 11% in the month after benefits are exhausted.”

5. As it turns out the “When benefits are exhausted, the average family loses about $1,000 of monthly income … In the same month, spending drops by $260 (11%).”

6. They compare the “path of spending during unemployment in the data to three benchmark models and find that the buffer stock model fits better than a permanent income model or a hand-to-mouth model.”

The buffer stock model assumes that families smooth their consumption after an income shock by liquidating previous assets – “a key prediction of buffer stock models is that agents accumulate precautionary savings to self-insure against income risk.”

The researchers find that the:

the buffer stock model has two major failures – it predicts substantially more asset holdings at onset and it predicts that spending should be much smoother at benefit exhaustion.

us_pih_study_2016

7. Finally, the researchers found “that families do relatively little self-insurance when unemployed as spending is quite sensitive to current monthly income.” Families “do not prepare for benefit exhaustion”.