1. Debt growth is necessary for GDP growth.
2. As GDP grows, debt levels become too large, leading to an economic crash.
3. Therefore, booms cause busts, through the mechanism of debt accumulation.
I'm not going to say this theory is wrong, or bad. It might be right. But I have a few problems related to this theory.
Problem 1: Misunderstanding Academia
First, a lot of people who believe a version of this theory - private economic forecasters, asset managers, econ writers, heterodox economists, and random punters from the web - get exasperated with mainstream academic macroeconomics, because they think that profs have ignored this idea. I often get told that mainstream academic macroeconomists are idiots, fools, and/or knaves by people whose basic view of the world conforms to a version of the Folk Theory.
But the charge is not quite right. Yes, the main strands of academic macro (New Keynesian and RBC theories) mostly ignored debt dynamics and assumed that recessions and booms are random. Yes, economists didn't pay nearly enough attention to finance before 2007. But a version of the Folk Theory actually did exist in mainstream macro since the 1990s. It's called the Leverage Cycle. To learn more about it, check out this survey paper by the eminent mainstream macroeconomist John Geanakoplos. Since the crisis, of course, theories like this have gained more currency and attention. There is also a huge amount of somewhat-related research that I'm not referencing here, just to keep this short, but at some point I will.
Now, some people are going to look at that paper and not understand the math. Then they're going to assume that Geanakoplos fails to grasp some concept for which they have an English term ("Endogenous money"! "Double-entry bookkeeping"! "Disequilibrium dynamics"! "Complex systems"! "Reflexivity"! "Minsky moments"! etc.). Then on that basis, they're going to continue to claim that mainstream academic macroeconomics fails to believe in the (obviously true) Folk Theory, and continue to call mainstream academic macroeconomists idiots. But because they don't understand Geanakoplos' math - and possibly don't even understand the precise meaning of the English terms they're throwing around - they don't actually know if Geanakoplos' math represents "endogenous money" or "complex systems" or whatever.
So you probably shouldn't listen to these people.
Problem 2: The Illusion of Knowledge
Problem 2: The Illusion of Knowledge
My second, and bigger, problem with the Folk Theory is how the theory fits the data. If you read Geanakoplos' paper you'll notice that it's heavy on ideas, light on facts. Well, that's a problem. The latest research on long-term economic forecasting shows that debt is important for predicting economic cycles. But what's important is not the amount of debt, but the quality of debt, as measured by credit spreads and junk bond shares. That means that, as far as we can tell, you can't predict recessions just by saying "Holy crap, this country is running up a lot of debt, they're about to crash!!"
Of course, that has not deterred many in the econ media from making exactly this sort of claim, especially when it comes to China. For example, a recent piece in The Economist claims that China's large increase in debt indicates a coming crash. At the top of the piece we see the following graph:
We're supposed to see a clear pattern here. Debt rises and hits a peak, then a recession hits and debt levels collapse (deleveraging). China's debt line has recently increased a lot. Hence, we should expect it to collapse soon. It's the Folk Theory.
But this chart is actually really bad. First of all, it suffers from massive look-ahead bias. We know these countries experienced financial crises and lost decades, so of course they're included on the graph. Actually, look-ahead bias is present for China too, since we already know that its economy is now slowing dramatically and that it is experiencing financial troubles.
Second of all, the chart (and the Folk Theory itself) has a huge correlation-causation problem. Suppose, for the sake of argument only, that debt had nothing to do with economic cycles. Suppose it was only along for the ride - when they're more economic activity, people borrow and lend more with each other, and when growth slows down they borrow and lend less, but the activity of borrowing and lending has no effect on how much gets produced. In this hypothetical fantasy world, we'd naturally see debt levels rise most of the time, but we'd see them fall temporarily when there's an economic downturn. In other words, we'd see exactly what's on the graph above. But rising debt levels would be no cause for alarm.
In fact, if you look at that graph carefully, you may start asking questions that are very uncomfortable for the Folk Theory. Why did Thailand not have a debt crisis in 1991? At that point, debt-to-GDP had been rising strongly for over a decade. Why did Spain not have a crisis in 2000? Why did Japan reach a peak debt-to-GDP ratio of over 200% before it had a crisis, while Mexico topped out at 50%?
When I present adherents of the Folk Theory - usually econ writers or private-sector analysis - with these kind of questions, they typically just insist that "debt to GDP can't keep rising forever". But actually in principle, it can. I can borrow $1 million from you and lend $1 million to you, both at the same interest rate, every day, forever, without anything going wrong. Our total debt level will just keep increasing forever, with no limit.
In the real world, of course, there are all kinds of frictions that probably prevent this kind of thing from happening. But unless you understand what those frictions are, and how to measure them, you won't have a good structural theory of where debt-to-GDP levels max out. And we already know that debt levels are a poor forecaster of economic performance.
So in practice, the Folk Theory is much less useful than people believe. If you can't use a theory to make concrete predictions, what good is the theory?
Problem 3: Bad Policy Advice
But my third problem with the Folk Theory of business cycles is the biggest: I suspect that it encourages bad policy. The story the Folk Theory tells is that you can't have good economic times without increasing debt, and that increasing debt always causes a bust. So good times come at a price - you can't have prosperity today without disaster tomorrow.
That kind of story probably has deep roots in human history - it probably comes from the Malthusian Ceiling. It is also a morality tale, rooted in partial-equilibrium thinking - if you borrow and consume too much today, you will be sad when you have to pay it back. But this is a bad way to think about the overall economy, since total debt is mostly just us borrowing from and lending to ourselves. Paul Krugman has written a lot about this.
When we think of the economy as a morality play, it encourages bad policy. For example, it can lead to destructive austerity. The Folk Theory is behind silly statements like "you can't solve a debt problem with more debt." The Folk Theory powers the bad advice of the people Krugman calls "sado-monetarists."
The fact is, something like the Folk Theory might be operating in real life. It is probably just one of a number of things that contribute to business cycles. And because macro data is not very informative, it will be difficult to tell how important of an effect it is. Meanwhile, the Folk Theory is exerting far too powerful an influence over the minds of the economics commentariat and (probably) the private sector.
from Noahpinion http://ift.tt/1Yp9e5K