It’s pretty obvious how credit drives my personal household consumption. If I borrow, I can get a nice big TV and a new car, but eventually I'll have to skimp to pay it back. In a way, the consumption-fueled borrowing binge is an illusion of wealth – after all, borrowing doesn’t increase my salary. Pleasure today means pain tomorrow.
Lots of people seem to think that national economies work something like this. Credit, we are told in article after news article, “fuels” or “drives” growth. Bridgewater Associates founder Ray Dalio, possibly the most successful macro investor in human history, makes this claim in his famous video, “How the Economic Machine Works.” The post-Keynesian economists, a heterodox school of thought exiled to the academic wilderness, have a perspective similar to Dalio’s. On the other side of the political spectrum, the Austrians – another exiled heterodox bunch – believe something similar. Google “credit fueled economic boom” and Austrian Business Cycle Theory is one of the first results.
It isn’t just investors and heterodox economists who believe that credit is the fuel that powers the business cycle – almost every pundit and news outlet seems to believe something similar. In 2009, The Wall Street Journal said that China’s growth was being fueled by cheap debt. In 2013, the Financial Times declared that credit was the only thing allowing China’s economy to tread water. And just recently, Quartz claimed that China’s unwillingness to allow more lending in the face of a slowdown is actually a good thing, since it chooses pain now over greater pain later. The language of the credit-drives-growth theory is everywhere. It is pervasive.
It seems like the only people who don’t instinctively believe in credit-fueled growth are academic economists.
The academics have good reason for being skeptical. After all, production isn’t the same as consumption. In the example of me borrowing to buy a TV and car, my debt binge doesn’t make my salary – my production – go up at all. But in an economic boom, a country’s total production really does rise – that’s what fast growth means. In other words, if credit fuels economic booms, then it must do it in a fundamentally different way than the way it fuels a personal consumption binge.
Another reason academics are suspicious of the theory of credit-fueled growth is that when we talk about “credit” at the national level, we mean gross, not net. Most of the money that gets borrowed during a boom is borrowed from people in the same country (at least in a big economy such as the U.S. or China). In fact, during its so-called credit-fueled growth binge, China was actually a net capital exporter, meaning Chinese people were saving more than the entire Chinese economy was borrowing. If taking on debt lets a borrower increase his consumption, why doesn’t making that loan force the lender to decrease his consumption? In other words, if credit is just one American lending to another, or one Chinese person lending to another, why does it boost growth?
Here’s an alternative idea: Maybe credit is a follower, not a driver, of the boom-bust cycle. Maybe credit grows when the economy is growing, because of the need to finance investment, and shrinks when the economy is shrinking, because of the lack of investment. In retrospect, looking at a chart of credit growth vs. GDP growth, it might look like credit caused the cycle, but in fact it was just a passive tag-along. Maybe the cycle was caused by something else – productivity changes, or changes in monetary policy, or changes in people’s sentiment and animal spirits.
I’m not saying I think that’s right. Maybe credit really does drive growth. Maybe excess credit really does force a boom to turn into a bust. But no one has yet come up with a really compelling, testable explanation for how that happens. And no one – except maybe Dalio – has managed to use credit levels, credit-growth levels, acceleration of the ratio of credit-to-gross domestic product, or any such measure to predict when booms and busts will happen.
So this thing that almost everyone believes about the economy is really just a conjecture. Our faith in it is probably based in part on shaky analogies and bad intuition. It might be true, but we shouldn’t regard it as obvious.
Noah Smith is an assistant professor of finance at Stony Brook University and a freelance writer for a number of finance and business publications.