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idered that the persistence and gradual worsening of our economic troubles is in any way related to persistent increase in debt there were problems before the crisis and then there was the crisis and the crisis was brought on by excessive debt excessive finance at least that is what rajan said some two years before the crisis but somehow rajan does not seem to see any connection between our growing debt and the problems we had before the crisis for him it is as if the crisis was anomaly the excessive debt as a problem was anomaly and the anomaly soon vanished this is the emptiest of arguments my god man the debt has been a problem since the 1960s think of it in those terms analyze it in those terms it explains everything posted by the arthurian at 4 00 am 1 comments friday may 11 2012 andrew haldane financial arms races happy birthday aaron one thing i know for sure from my dpd graph is that the ratio varies the amount of debt there is per dollar of circulating money varies since i first became convinced of the significance of that graph i have been expecting to see policymakers turn things around and bring the ratio down well since the crisis the ratio has been coming down but policymakers had nothing to do with that no that s not entirely true policymakers did create the crisis after all in an anonymous comment some days back while i was up to my eyeballs writing the debt and inflation posts nonny wrote ot but since we were discussing phillipon s papers on our bloated financial sector a while back i thought you guys might like this related paper by andrew haldane http www bankofengland co uk publications documents speeches 2012 speech565 pdf it covers the same ground as in his recent inet presentation i e the futility and resulting destruction of the arms race in finance and he s as good a writer as he is a speaker well i must say nonny is right haldane is an excellent writer maybe too good i d put him in a class with krugman with both of them i worry that i ll be convinced by the good writing when what i really need is good economics setting aside the quality of writing there is still much of value in haldane s paper i think page 4 by any historical metric the pre crisis period was an extra ordinary one for the financial sector this is no better illustrated than in the returns to financial sector labour and capital between 1989 and 2007 the nominal gross value added of uk financial intermediaries rose more than threefold or by about 8 on average per year over the same period value added of the non financial corporate sector rose by about 5½ per year assuming they start out equal and grow at the rates haldane reports for the 1989 2007 period finance grows from 100 to 400 while the productive sector grows from 100 to 262 finance increased 52 more than the productive sector by haldane s numbers page 5 measures of executive compensation rose even more dramatically in 1980 a similarly skilled individual earned about the same in investment banking as in the non financial sector by 2005 that same person would be benefitting from a salary four times that of their non financial sector counterpart what explains this extra ordinary period of high returns in finance arithmetically the answer is simple leverage leverage debt and more debt but the simple answer is not good enough for andrew haldane but what drove those behaviours in the first place he asks competition he answers competition for high returns on equity competition in financial sector pay as wages and equity returns ascended the races in pay and returns joined forces that spiral defined the pre crisis arms race in financial returns it generated an equilibrium of synchronously high returns and pay as banks unilaterally militarised as defence against their competitors the result haldane says was sub optimally risky sure but is andrew haldane suggesting that the problem is in our competitive spirit that the problem is human nature one must wonder then why it becomes a crisis only occasionally and if andrew haldane has doubts about competition then we may have doubts about andrew haldane but i don t see it there was competition in the non financial sector too without the extreme effect it had in finance what finance did have that nobody else did was demand for the product demand for loans there is more then haldane offers some interesting conclusions what public policy lessons might be drawn from these financial arms races first because they generate sub optimal outcomes policy intervention can be justified second to be effective this intervention needs to constrain behaviour across the financial system as a whole third what tools might such agencies bring to bear in tackling financial arms races in return speed and safety with hindsight it is not difficult to identify instruments which might have slowed the pre crisis race for excessive returns in banking the most direct and effective would have been to place tighter constraints on banks leverage this would have defused the return on equity race at source yes very nice but how would you design the constraints on bank leverage how would you design those constraints to withstand the continuous pressures driving financial expansion what are those pressures and why does haldane not address them i say we can constrain bank leverage by cutting demand in half cut the demand for loans in half cut the borrowing in half undermine the source of financial profits yes but if it is so easy why haven t we done it good question we haven t done it because it requires changes in the assumptions that underlie policy but i m getting ahead of myself what we need to do in order to reduce the demand for loans is to move away from credit use and move toward increased reliance on the dollar we have to provide the economy with a lot more money that gets turned into a lot less debt no not we policy has to provide the economy with a lot more money that gets turned into a lot less debt only policy can do it and that s where the changes to our assumptions come into play the federal reserve seems to think that a dollar of credit in use is just as good as a dollar of money in circulation it isn t just as good it s better for the lender and worse for the borrower because of the cost of interest that applies to credit but not to money better for the lender and worse for the borrower doesn t that explain the growth of finance doesn t it explain the laggard performance of the economy we need to take income out of the non productive sector and put income into the productive sector again where it was when our economy was good to policymakers i say this we need to stop assuming that credit is as good as money we need to stop encouraging the use of credit to stimulate growth we need to stop taking money out if circulation to fight inflation we need to accelerate the repayment of debt to fight inflation we need to assure that there is enough money in circulation to sustain the existing level of economic activity and then use credit for growth then when the economy grows we need to pay down that debt and counterbalance the deflationary effect by increasing the quantity of money in circulation haldane s recommendations in the last few pages of his pdf haldane offers several parts of a solution he wants tighter constraints on banks leverage he wants to require banks to adopt better performance metrics he wants banks to avoid linking remuneration to return on equity targets he wants to restrict cash distributions by banks to shareholders and staff he wants to set remuneration codes for example maximum ratios of cash distribution and minimum periods of pay deferral he wants to reconsider the instruments used for remuneration he wants to place direct restrictions on excessive message traffic he wants to strengthen market making commitments he wants to strengthen circuit breakers across exchanges and he wants greater transparency andrew haldane thinks like a banker he looks for ways to minimize the problems arising from the excessive expansion of finance but he fails to consider simply reducing the size of finance and reducing the role of credit i don t object to haldane s recommendations heck i don t even know what most of them are but let s say haldane is right let s say the crisis arose because we didn t have his recommended policies in place if we didn t have those policies in place it is because of policymakers faulty assumptions about money and credit and if you have any doubt about policymakers assumptions ask yourself why at the onset of the crisis we had 3 50 of credit in use for every dollar s worth of gdp but only 10 cents of spending money posted by the arthurian at 4 00 am 0 comments thursday may 10 2012 private debt 2012 19 relative to gdp the red line shows the gross federal debt the big one relative to gdp the blue line shows everybody else s debt posted by the arthurian at 4 00 am 0 comments wednesday may 9 2012 debt and inflation 4 recalculating far as i know it is gdp that is most often expressed as real values the conversion takes gdp values for a number of years strips away the inflating prices from each value and replaces it with the price level of some base year fred s gdp deflator uses a base year of 2005 fred s consumer price inde x uses a base period of 1982 84 a base that remarkably must be older than some economists the 1982 83 edition of the statistical abstract back when we were still using gnp instead of gdp used 1972 as a base year for the deflator and 1967 as a base year for the cpi the bicentennial edition of the historical statistics used 1967 for the cpi and 1958 for the deflator but you can use any year for a base year if you have the data pick the year you want to be the base year then divide each year s gdp by that same year s deflator and multiply by the deflator for the year you picked that s it the year you picked is the base year for your results the blue line on graph 1 below is the gross federal debt the other three lines show inflation adjusted federal debt using three different base years the red line uses the default 2005 base year and maybe you can see the red and blue lines cross just at 2005 on the graph graph 1 the gross fededal debt blue and three surreal adjustments the gold line shows the same federal debt and uses the same calculation for inflation adjustment as the red line but with a base year of 2010 the whole gold line is scaled up a little from the red one because prices went up a little between 2005 and 2010 and the gold and blue lines cross in 2010 you can see that the red and gold lines are similar and that both show the trademark flatness before reagan came to office as noted in an earlier part of this series the unadjusted blue line lacks that flatness through the 1970s the worst of the inflation the green line shows the flatness in the years before reagan like the red and gold the green line shows the same inflation adjusted debt data with a different base year this time the base year is 1947 this means the green and blue lines cross at 1947 basically the green line is a scaled down version of the red and gold all three versions of inflation adjusted debt rely on the same calculation that is commonly used when the inflation adjustment is made to gdp this is the calculation i ve been calling surreal the one that i say produces erroneous results when used for inflation adjusting debt graph 2 presents two improved calculations of the inflation adjustment of debt the green and gold lines graph 2 alternatives to the surreal calculation first off the blue line is the gross federal debt unadjusted the red line is inflation adjusted by the surreal calculation with a base year of 2010 meaning the lines cross in 2010 but here s the thing if inflation erodes debt then they shouldn t meet in 2010 the red line should be higher in 2010 the 60 plus years of erosion by inflation should have made the debt we owe today less than the debt we would have owed if there was no inflation the standard calculation used for inflation adjustment the surreal calculation tells us that there has been no erosion of debt more precisely it tells us that there has been no erosion in the base year but that there has been erosion in other years the surreal calculation cannot possibly be valid for inflation adjustment of a stock like debt that carries over from year to year again when we use the most recent year as the base year the surreal calculates out the same as nominal debt in that year this cannot be correct it means there was no inflation adjustment but the original purchasing power borrowed must have been greater than the outstanding debt today if there was a loss to inflation certainly a different calculation is needed the gold line presents the result of one such calculation it begins with the 1947 value unadjusted thus the gold line has 1947 as base year for the next year 1948 i adjusted the 1947 total for one year s inflation and to it added the new debt for 1948 unadjusted for 1949 i take the total from 1948 and adjust it for one year s inflation then add to that the new debt of 1949 i followed these steps repeatedly for each year all the way through at the end in 2010 the inflation adjusted value for gross federal debt came to 20 152 3 that is half again as much as the unadjusted federal debt in other words this calculation shows that there has been erosion of debt by inflation the green line shows another alternative to the surreal calculation of debt here we begin by adjusting the 1947 value using 2010 as the base year this makes the green line start at exactly the same level as the surreal calculation s red line by the way for the next year i carry forward the previous year s adjusted value and add to it the new debt for 1948 after adjusting the new debt for inflation through 2010 for 1949 and after this process is repeated so that the inflation adjusted total always reflects base year 2010 values at the end in 2010 the inflation adjusted value for the gross federal debt comes to 20 152 3 exactly the same as for the gold line you know when i knew for sure i was onto something with this when i saw graph 2 four lines four different sets of numbers but only two starting points and only two end points the source data for this post is from fred the worksheet i used to generate graph 1 is in this google docs file the worksheet i used to generate graph 2 is in this google docs file posted by the arthurian at 4 00 am 1 comments labels 5 debt and inflation tuesday may 8 2012 debt and inflation 3 nomenclature suppose i borrow a dollar when the price index is 80 if i pay it off when the price index is 125 the erosion of debt by inflation is easy to figure we can do it two ways we can multiply the debt by 80 and divide by 125 that tells us how much the dollar is worth that we are paying back it is worth 64 cents of the dollar we borrowed or we can multiply the debt by 125 and divide by 80 this tells us how much we would hav...