Pitfalls of credit-induced growth in US

‘Operation twist' in the US would come to an end in June. The Fed didn't drop any hints of an additional bond buying programme after that in its recently concluded Federal Open Markets Committee (FOMC) meeting. However, a programme, on the lines of QE 2 or ‘operation twist', is inevitable sooner rather than later.

Why? The exercise of bond-buying every year, coupled with large government deficits, is here to stay, because the moment this stops, the natural deleveraging cycle would take over — wiping out years of growth created on the foundations of credit.

Credit-driven savings

In the era of commodity-based money, it was savings that would drive credit, and thus growth. So people would save their money in banks, and banks would lend that money to entrepreneurs and corporates. But ever since the dawn of fiat money, it is really credit that drives both savings and growth.

For the last five centuries, it has been accepted that an increase in credit is accompanied by an increase in growth rate. So post-1970, when the central bankers received almost omnipotent control of the nation's monetary policy, they have used this relationship extensively.

Whenever the economy would take a breather to unwind junk investments, essentially in the financial sector, central bankers would enter the scene and artificially reduce interest rates, thereby performing two critical actions: Saving equity and bondholders in the financial sector from losses; and reigniting the growth of credit which would then boost the GDP growth.

However, this has created a vicious spiral — as a result of these interventions, the mal-investments have become even bigger and now threaten to wipe out even the savings of the masses, if a system-wide deleveraging were ever to happen. With a rise in financial and household sector deleveraging (excluding the massive uptick in student loans) post-2008, the increase in government debt is avoiding precisely such a scenario. Now, as we understand from preliminary economics, an increase in government deficit is equivalent to an increase in private sector savings. So the government deficit is not just providing that marginal growth in credit but also allowing the private sector to de-leverage.

Financial sector prominence

Just so that the annual trillion-dollar additional government debt doesn't overwhelm the system, the Fed will constantly engage in its bond buying exercise, and thus try to keep the bond and stock markets afloat.

Both these operations are justified under the garb of the fact that there still is a lot of slack in the economy — which brings us to an important point associated with credit growth of the past four decades. As can be observed from the graph, the impact of a dollar increase in credit on GDP has reduced significantly every decade. So much so that now the real GDP increases by just 8 cents for every dollar increase in credit.

Why this reduced efficacy of credit on GDP? As one can see, even though the credit has been increasing over this time, the financial sector of the economy has seen a massive growth, while the credit growth in corporate sector has lagged behind, so much so that now the total credit in the financial sector overwhelms that of the productive corporate sector.

Irresponsible policies

Isn't it ironic that the financial sector, which is supposed to be a facilitator to the main economy, is now, in fact, the leader, as far as its share in total credit is concerned? This is precisely due to the irresponsible policies of the central bankers that didn't allow the unwinding of the bad debts of this sector and let the bondholders and equity holders be wiped out.

So, with every single intervention, these debts, instead of getting unwound, have ballooned. As a result of this, each of the recoveries since 2001 has produced fewer jobs.

Post 2008, with the overall credit in the financial sector reaching its zenith, what the policymakers are now hoping is that the corporate sector slowly picks up this debt that the financial sector unwinds and during this transitory phase the government carries the baton — helped, of course, by the Federal Reserve. However, this is the same misguided hope that has led the world into the current mess.

Government expenditure, accompanied by the Federal Reserve's bond buying programmes, is nothing more than a transfer of wealth from people who earn their money from labour to holders of assets, thus widening the income gap.

Meanwhile, as our policymakers wait for the corporate sector to pick up the credit creation baton, the misallocation and destruction of the resources in the real economy continues, ensuring that the next fall would be even bigger.

(The author is an independent financial consultant at Random Chalice Financial Research, Delhi. The views are personal.)

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