I don't understand credit

Or how it affects the real economy. (This is part of my general ignorance of / disbelief in macro).

In micro, a common technique is to look past the money to the stuff. For example, if someone prints a bunch of new dollars (inflation), then we don't have any more wealth. More dollars chase the same resources, and prices go up, but we aren't any better off. In fact, the people closed to the new dollars (the spenders, the first receivers & re-spenders) benefit at others expense. Similarly, government spending always comes from somewhere, so to act as though it "stimulates" the economy when in reality it just moves spending from one place or time to another is bogus. It's not about money, it's about the allocation of resources.

But then I read in the paper:

Without a mechanism to shed the bad loans on their books, financial institutions may continue to hoard their dollars and starve the economy of capital. Americans would be deprived of financing to buy houses, send children to college and start businesses. That would slow economic activity further, souring more loans, and making banks tighter still. In short, a downward spiral.

Fear of this outcome has become self-fulfilling, prompting a stampede toward safer investments. Investors continued to pile into Treasury bills on Thursday despite rates of interest near zero, making less capital available for businesses and consumers.

Superficially, this makes sense, just like it makes superficial sense that government spending creates jobs. But then I think "look past the money to the stuff."

Before tight credit and after tight credit, the resources in the economy are the same. The people, the skills, the capital, the natural resources - all the same. So how can tight credit slow down the economy? The factory that my business doesn't build means that the factory building resources are available to someone else more cheaply.

In fact, shouldn't the effect be the opposite? If tight credit means higher interest rates, then it encourages saving and investment over consumption. In fact, tight credit cures itself - it raises interest rates, which encourages saving, which provides more credit.

I am especially suspicious of the phrase "hoard their dollars and starve the economy of capital". Dollars are not capital, they are pieces of paper. You could burn them all, and the economy would still have all the capital it had before. Hoarding should just cause temporary deflation, as a lower supply of dollars chases the same amount of stuff.

But maybe I'm missing something about the nature of credit? Please enlighten me.

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How temporary?

Hoarding should just cause temporary deflation, as a lower supply of dollars chases the same amount of stuff.

That's true in the long view, but how temporary and how severe will the deflation be?

In a deflationary period, the incentives for hoarding increase since dollars gain value when stuffed under a mattress, potentially leading to a deflationary spiral.

Deflationary Spirals

"In a deflationary period, the incentives for hoarding increase since dollars gain value when stuffed under a mattress, potentially leading to a deflationary spiral."

I spent part of yesterday debunking some of the thinking behind this fallacy over at Reason. Hoarding [of gold or money] is not the bugaboo you make it out to be. It certainly doesn't cause "deflationary spirals".

Fractional reserve banking not hoarding [of money] is the cause of bank runs., and fractional reserve deflationary spirals.

It's almost as if you believed that my deciding to save some of my own cash outside a casino was the cause of you losing at poker in the casino.

No, you're pretty much right

You've pretty much got it. The only thing is:

If tight credit means higher interest rates, then it encourages saving and investment over consumption. In fact, tight credit cures itself - it raises interest rates, which encourages saving, which provides more credit.

The question is how long does it take for tight* credit to cure itself. Government agencies, central banks and institutional investors tend to want the good stuff now (so they can take credit for it). They might not be willing to wait long enough for people to start saving again.

* I use the term here for the sake of argument, presuming there's some magical rate of credit, like the bubble in a plumb level, to which the economy should aspire.

In fact, shouldn't the

In fact, shouldn't the effect be the opposite? If tight credit means higher interest rates, then it encourages saving and investment over consumption. In fact, tight credit cures itself - it raises interest rates, which encourages saving, which provides more credit.

Tight credit also has to do with fear of insolvency, lack of information about the credit worthiness of the counterparties. The amount of resources in the economy is not the only relevant factor, information is valuable too. A price discovery process needs to happen for credit to remain possible, it takes time, it takes error.

Government wants to make it faster and easier by setting the price. This, of course, does not work. It either creates too much bad loans or too little credit.

"Before tight credit and

"Before tight credit and after tight credit, the resources in the economy are the same. The people, the skills, the capital, the natural resources - all the same. So how can tight credit slow down the economy? The factory that my business doesn't build means that the factory building resources are available to someone else more cheaply."

This same logic means that trade doesn't matter either. After all, the amount of the resources stay the same before and after they're traded. But of course some resources are more valuable to some people than others. In your factory building example, those resources might be still exist but you can't use them to grow your business. Fewer innovations occur because of decreased R&D, and fewer new factories are built. In short, less *new* capital is created--fewer people are educated and trained, steel is more likely to stay as worthless steel instead of being made into productive factories. You're right that this situation will right itself, but that doesn't mean that it's the same as the previous situation in the short term. This is not an argument that a massive bailout is a good idea. In fact, it will probably make future crises like this one more likely.

Indeed, by similar logic

Indeed, by similar logic nothing matters (which is true), in light of the first law of thermodynamics. Energy persists through every transaction.

David Friedman discusses and rejects such a view in Hidden Order.

I like Alex Tabarrok's

I like Alex Tabarrok's metaphor of a bank as a bridge between savers and borrowers.
http://www.marginalrevolution.com/marginalrevolution/2008/09/where-is-the-cr.html
You really need them to avoid fording the transaction costs. One problem with "looking past the money to the stuff" is that it's hard to see the transaction costs, eg, the distribution of information, as "stuff."

Slow Down

"So how can tight credit slow down the economy?"

Depends on your definition of slow down. A counterfieter living in your community can speed up the economy, and when he moves away that will slow down the economy.

The speeding and slowing are not values in and of themselves. Just like while driving hitting the gas or brakes aren't positive things in and of themselves.

The purpose of the free market is to hit the gas and apply the brakes when needed, and it's all automatic. It isn't about loose credit but too loose credit at below market prices. That's what's bad.

"In fact, shouldn't the effect be the opposite? If tight credit means higher interest rates, then it encourages saving and investment over consumption. In fact, tight credit cures itself - it raises interest rates, which encourages saving, which provides more credit."

Well, it's not about speeding up or slowing down. Yes, high interest rates will encourage savings, and that might be good or bad, depending on the situation in the market. If you get the naive notion that higher rates in and of themselves are a good thing then you run into problems again.

If you set a floor on interest rates that is above the market price then producers will surely want to save, and will produce more than they consume, which does create more of "the stuff", the goods.

However, what about the borrowers of that increased capital? If you've set a floor then you priced many of them out of the market. There will be borrowers who have what are profitable schemes to invest those saved goods. They could put those goods to productive use but they will not, and precisely because it's not worth it at those interest rates.

"In fact, tight credit cures itself - it raises interest rates, which encourages saving, which provides more credit."

No, it does not. "Tight credit" is relative to economic conditions. If the "tight credit" is below the market rates then yes it "cures itself". If it is above market rates then it makes things worse.

Suppose the Fed has decided to put a floor on interest rates above the market prices. How will it do that? Market forces will fight this. Interest rates will try to drop because many producers will not take out loans at those rates, and many savers will not be able to find borrowers.

Well how does it put floors on other prices, like say corn? Same thing happens, too many producers at the higher price and too few consumers. The government can buy up the goods but then what does it do with them? It can dump them on the market as that would lower the price. So it must destroy those goods.

Likewise the government would have to do the same to savers in order to maintain high interest rates. It would have to borrow from savers and then "do something" with the money other than giving it to borrowers, and then somehow end up with extra money to give back to the savers.

There are several ways to do this in a fiat system and all are bad. For one thing they could just print more money and hand it back to the savers in addition to the original money saved. This is inflationary and interest rates would after a while consist an inflation component. If the government set a goal of say a 20% interest rate, and the average market rate was 4% then eventually the inflation component of interest payments would be 16%.

Now it might sound like this wouldn't be a problem if only the government consistently injected the same amount of cash into the system. If the government consistently inflated the currency at 16% then the market would adjust to the new conditions and factor in this inflation. That is wrong.

It is wrong, firstly because in the example the government is targeting interest rates. Since the market rate must fluctuate to adjust for economic conditions the government cannot know what the proper rate is and thus may be injecting too much or too little money in trying to maintain a rate of 20%. In fact, by definition it will always be working against the market whenever rates fluctuate greater or lesser than the starting 4% market rate. That is, if everyone has factored in the 16% interest rates.

Another reason it is wrong is because the high interest rate mutes the market signal. It used to be that a climb in the market rate of interest of 2% was a very strong signal for people to save. A climb from 4% to 6% is a strong signal. It's a 5% increase.

However, in a system with a base inflation rate of 16% and an average rate of interest of 20% the 2% climb is insignificant. The market signal is muffled to a mere 10% climb. That's a muffling by a factor of five below what the market would signal savers.

Thus five times less true savings would occur than under the free market. So "tight credit" would actually reduce savings over time.

Not only that but if I talked about the capital borrowers there would also be problems.

Correct economic theory states that by the "laws of economics, which are like the "laws of physics", the setting of interest rates in either direction away from market prices will result in inefficiencies, and problems.

In other words the FED is a problem and not a solution.

>I like Alex Tabarrok's

>I like Alex Tabarrok's metaphor of a bank as a bridge between savers and borrowers.

Great concept! Agree with the original post that money is a piece of paper. Less than that, 90% of "money" is an entry in an electronic file. Look at money as an IOU. No one collects IOUs for their own sake but because they can be traded for consumer stuff. Why interest? because an IOU in the hand is worth two in the bush.

When the govt prints to many IOUs . . . .

...we're doomed.

...we're doomed. LOL

Seriously, I dig the concept of money being just a piece of paper with a big IOU on it. But then again, money has been the blood of economies since time immemorial. Even if we go back to the age of bartering, I think credit will still hold a significant part in micro and macro economy. It's just human nature, I guess.

Kevin