Credit Demand and Credit Supply

We all now seem to agree that credit in the United States is actually growing during this "credit crunch," albeit at a slower rate than a year ago.  Tyler and others argue that growing credit is actually a sign of the credit crunch.  A credit crunch may show up "counterintuitively as a spike in borrowing" as firms draw on lines of credit.  Contra Tyler this view is certainly "convenient" but I do agree with him that this view is not unfalsifiable.

To wit, let’s falsify it.  The last time we had talk of a big credit crunch in the United States was during the 1990-1991 recession.  Was credit growing during this time as firms drew on lines of credit?  No.  Most of the credit measures that today are growing were in 1990-1991 flat or shrinking.  You can look at the pictures here or look at Table 1 of Ben Bernanke and Cara Lown’s well known paper (Google preview, JSTOR here).  In 1990-1991, for example  business loan growth was zero while today it is well above 10% (the same thing was true in 2001).

Peculiarly, Tyler argues that lack of credit is a leading cause of the crisis but a lagging indicator!   As a result, he needs to resort to non-verified conjectures about credit options to support the credit crunch story.  I have a simpler story, credit is a lagging indicator because it’s credit demand not supply that is the problem.  My story also makes sense of the fact that credit usually lags on the upturn as well – a fact which option value has difficulty explaining.

One error that I believe Tyler is making is to assume that skepticism about the credit crunch implies that one must be downplaying the seriousness of current economic conditions.  Not true.  First, it’s quite possible to have a very serious recession with growing credit – we had this in 82, for example.  Second, if Tyler is correct that the credit crunch is the primary cause of our current conditions then bank recapitalization should restore the economy to good working order.  In contrast, I think the Paulson/Bernanke plan is in trouble because credit demand is shrinking faster than credit supply.

Addendum: In response to Tyler (below) and several people in the comments.  Interest rates are not unusually high, certainly nowhere near as high as you would expect given a "credit crunch."  In fact, interest rates on say 30 year mortgages are falling and are lower now than at the height of the boom and no higher than in 2002 near the beginning of the boom.  I suspect that real interest rates are even lower than nominal rates suggest – inflation expectations anyone?  I wish that more people would present their arguments with data and not with anecdotes.


Alex, if credit demand is shrinking faster than credit supply, why is the price of credit rising? Isn't supply-and-demand supposed to work the other way?


You're making no sense to me. Zero.

I probably don't know as much as you but I strongly expect I'm more educated and informed than the average MR readers. So, you'll need to be clearer and back things up with a few more facts to convince me, and I suspect, other readers.

Uhm, if demand for credit were shrinking faster than supply wouldn't that mean market interest rates were falling? They're not. Witness the LIBOR, mortgage rates, whatever. Tbill rates are down and everything else is up, b/c folks are hoarding cash.

You say there are no reports of people not getting credit. I'm reading these accounts everywhere. I see everyone, not just here but all over the world, hoarding dollars and buying treasury bills. I see a financial crisis larger than anything I've seen or read about.

Please help me see another viewpoint. So far, your stuff strikes me as an extreme form of self delusion.

Alex, on your response, clearly interest rates have been *rising* (the relevant comparison, not "high") and the correct expectations are for *deflation*, not inflation.

Tyler, what you say is incorrect on three counts. First, I said rates on 30 year mortgages have been falling and in the most recent data that is correct. Second, it is very relevant to compare rates across periods - everyone is talking credit crunch when rates are similar to those in the boom when everyone agrees there was a flood of credit! Third, you provide no data on expectations. Here it is. The consensus is inflation not deflation:

Miss a payment or two and it goes up to 29% (!!) interest.
Regulatory alert!

Had these "penalty rates" been capped, as was hoped by some, the card companies ... would have seen more risk.

The "free-markets" regulatory ideology cuts both ways. Arguably, it made consumer lending companies feel too safe. In this instance, too safe that they could run-up a balance in advance of a recovery proceeding, with cumulative late-fees or variable 'default' rates, and thereby help their "recovery rate" assumptions...

By looking at bank lending you are looking at the wrong side of the banks balance sheet.

The growth in bank lending does not show the crises. Rather it reflects the Fed success in offsetting the impact of the credit crunch.

To see the crises you need to look at the other side of the banks balance sheet, how they fund their loans and/or investments. To keep it simple, they do it in three ways. One is deposits. The second is borrowing in the money market. The third is borrowing from the Fed. Clearly, the drop in the volume of financial commercial paper and other short term instruments demonstrates that there is a financial crises. Offsetting this is the massive growth in the Fed balance sheet
that has provided the banking system with an alternative source of funding to offset the drop in money market borrowing.

If you look at the data from this balance sheet perspective you can clearly see that their has been a crises and that the growth in bank lending reflects the Feds success in its lender of last resort in counterbalancing the negative impact of the crises and providing the banks with the credit they need to sustain lending.

The growth of bank lending reflects its normal lagging indicator role. Why are firms borrowing? One to draw on their existing lines of credit because their normal direct access to short term markets has contracted. Second, the early stages of a business cycle is exactly when business credit demands surge as their normal large positive cash flow from sales contract while at the same time their need to finance unusually large inventory holding and to meet their other normal everyday expenditures such as payroll expands. This is an absolutely normal cyclical development and is a major reason bank lending is a lagging indicator.

By looking at bank lending you are looking at the wrong side of the bank's balance sheet. The point that bank lending is expanding is not a sign that their is no credit crunch. Rather it is an indicator that the Fed actions over the last year to provide large scale financing to the banking system is working.

The crises is not on the asset side of the banks balance sheet. Rather it is in the liability side of the balance sheet where they raise the funds to finance their loans and/or investment. To keep it simple this consist of three items.One is deposits. Two is borrowing in the money markets. Three is borrowing from the Fed.

The crises has been the contraction in the banks ability to borrow in the money markets as evidence by the drop in financial commercial paper and other short term instruments. Everything the Fed has done over the last year to provide special financing to the banks has been to offset or counterbalance the banks inability to funds their operations in the money markets. The fact that bank lending is still rising demonstrates the success of the Fed undertaking its lender of last resort. So again, the growth in bank lending does not demonstrate that their has been no crises. Rather it demonstrates the Fed success in dealing with the crises.

Why are firms borrowing? One of course, is to draw on lines of credit to offset their inability to raise funds in the money market. The second goes to the point that bank credit is a lagging indicator. In the early stages of a business downturn business credit demands typically surges. This stems from the point that their normal source of a positive cash flow, sales are drying up as demand contracts. But because sales are contracting they have to finance an unusual surge in unwanted inventories and their normal day to day expenses such as payroll. Until firms can dispose of their unwanted inventories and cut expenses they have to expand their use of credit. This is why credit demand normally expand sharply in the early stages of a business downturn and why bank lending is typically a lagging indicator. This typical early business cycle behavior is exactly what we are now seeing. This did not happen in the last cycle because it was not a typical cycle. It was caused by a collapse in capital spending, not by a contraction of consumer spending as we are now seeing.

The phrase "credit crunch" needs to be defined. I don't believe that looking at prices and quantities alone can determine if we're in a "credit crunch". Suppose that there are 4 states in the economy: high, low, normal and crisis. And suppose further that we are currently in a crisis state. A "credit crunch" is the gap between the current (crisis) quantities (or prices) and one of the 3 other states. I would be conservative and say that a credit crunch should be defined as the gap between "crisis" and "low-state" quantities and prices. If we are going to be in a recession, is the current quantities/prices lower/higher that they "should" be? Going into a recession, is a business owner that would have qualified for loans in a low-state not currently able to get a loan? This is the measure that I think is more interesting.

I'm still not sure if we have a "credit crisis" or not, but we certainly have a "credibility crisis." And, I'm not just talking about the politicians or finance whizzes now. The economics profession itself must earn some credibility. This means that we need to put aside our pet beliefs that the current situation may or may not be good evidence of (e.g., bailout = moral hazard = cronyism; or government mandates for home ownership is the core problem, etc.) and provide some real data and real analysis. This would seem to call for some straightforward measures of new loans being made - and, if the data is not publicly available, a cry from the profession than we don't have the data we need to do our jobs. It also calls for some clarity about how much of the burgeoning crisis is psychological and how much reflects real fundamental.

I'm not optimistic on the last point, however. I've been an economist for 30 years and I never understood macro and still don't. I'm not sure anybody else does either. When I first studied the subject, I was taught standard Keynesian theory that we could fine tune the economy by calculating the correct government budget deficit. In recent years, Keynesian analysis has become an optional subject in some textbooks. Now, it appears that we are rediscovering Keynes' belief that mass psychology drives business cycles. For all the mathematics and sophistication of our theories, I really have to wonder if we have gained any understanding at all. This is what I mean by a credibility crisis.

gabe, you're so right, this is all just a ruse to increase the power of the executive, and in particular the treasury, which makes so much sense for bush and paulson to want to do for obama and whomever he picks for treasury (because the current administration and obama's administration share so many of the same financial goals).

Hey DJ,
When I was elected president I gave thanks to a man named Carrol Quigley who was a Georgetown professor.
Ever read his books? didn't think so.

He revealed in his book that as part of his 20-year study of the power structures of the U.S. and Great Britain, he had an opportunity to examine their "papers and secret records."

His book was published in 1966 by Macmillan, which Quigley believed was systematically suppressed. Plates were destroyed to ensure it would not see a second printing, according to a taped interview discovered in Quigley's archives at Georgetown University by Dr. Stanley Montieth. Apparently some of Quigley's benefactors thought the secrets he revealed were better left untold.

But before the book was deep-sixed, Quigley exposed the little-understood fact that both socialist and communist movements in the United States were funded by the Morgans and the Rockefellers and other financial interests. Quigley was amused by the fact that right-wing populists in the United States mistakenly believed that Communist Party subversion was the root of the threat to national security in the 1950s. In fact, he said, it was simply a symptom of the political manipulation of foreign and domestic policies by the financial elite.

"There is, however, a considerable degree of truth behind the joke, a truth which reflects a very real power structure," Quigley wrote. "It is this power structure which the Radical Right in the United States has been attacking for years in the belief that they are attacking the Communists. ... These misdirected attacks by the Radical Right did much to confuse the American people."

Now listen to what Quigley says about the two-party system and its one plan for control of the population: "Hopefully, the elements of choice and freedom may survive for the ordinary individual in that he may be free to make a choice between two opposing political groups (even if these groups have little policy choice within the parameters of policy established by the experts) and he may have the choice to switch his economic support from one large unit to another. But, in general, his freedom and choice will be controlled within the very narrow alternatives by the fact that he will be numbered from birth and followed, as a number, through his educational training, his required military or other public service, his tax contributions, his health and medical requirements, and his final retirement and death benefits."

at least the price of tinfoil for your hats is likely coming down.

I don't know if this rises to the level of "data", but it may give some color and scale to the credit line issue we have been discussing across other threads here.

It also contains this tidbit:

Loans to companies with risky credit ratings are down 70 percent this year, according to Dealogic, a financial services research firm.

This seems far more indicative of my personal experience in the credit markets.

And this article was written in May before the stuff really hit the fan.

Now, this is progress. I found the following
with some syndicated lending volume data. Most interesting is the chart on High Yield Volume. It certainly shows a drop - but to a level last seen around 1999. This is the problem I have with all of the purported evidence of a "crisis." You can't compare volumes with what they looked like during the bubble - by definition, when a bubble bursts, the volumes will drop dramatically. Or, are people saying that it is a crisis that the bubble can't keep going?

My thanks to Alex for his good sense.

Off topic: I don't believe conspiracy theories chatter, but one thing I do believe is that until the election is over, partisan economic commentators like Brad Delong and Paul Krugman will have nothing good to say about the economy or the financial system. But after the election they'll start to declare that they've studied the fundamentals and things aren't really too bad and markets've overreacted.

The way to prove you're a serious scholar:

(1) Never, NEVER, EVAR! admit your wrong.

(2) Ex-post facto, wiggle theory and evidence around to show your theory wasn't actually proven wrong.

(3) Then muddle your theory a bit more so that its predictions are so vague that it could never again be threatened by cold hard facts.

Smile and live happy and contented in knowing no one will ever again threaten your cherished righteousness.

You don't believe in conspiracy sophisticated. I am coming to understand that all "serious" people believe that Paulson is a altruistic transcendic superman who is just trying to help the average person.

Here in Japan mortgage and consumer rates have not changed significantly but loan evaluations have become harsher and banks are clearly more conservative. One of the ways of measuring this phenomena would be tracking the variation of loans granted to a portion of the total market which did start to have access to mortgages in the past year but does not have now (ex.: foreigners with a work visa and without a permanent visa) in comparison with the past year data. Another and more relevant would be tracking the availability of short-term credit lines for SMEs. Unfortunately, I don't have access to this data, but looking at the historical lack of mobility in the Japanese economy I would conclude that outside of America credit supply is more relevant right now than credit demand. Definitely, looking at rates only is not conclusive.

Nobody knows when the man is talking truth, when is talking nonsence

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