It’s the Demand-Side Stupid — Why Credit Ain’t Like Water

In the last few months, governments here and abroad have made every effort to “turn on the taps” of credit — in Canada, we have more than half a dozen such programs (and counting) under the banner of the EFF (Extraordinary Financing Framework), including (but not limited to):

• the IMPP (InsuranceMortgage Purchase Program);
• the CSCF (Canadian Secured Credit Facility);
• the CLAF (Canadian Lenders Assurance Facility);
• the CLIAF (Canadian Life Insurers Assurance Facility);
• the BCAP (Business Credit Availability Program);
• increases in the maximum eligible loan amount under the CSBFP (Canada Small Business Financing Program); and
• increases in the scope of lending practices for the BDC (Business Development Corporation) and EDC (Export Development Canada).

But as Jamie Galbraith rightly points out, in his inimitable style, this metaphor falls down in one major respect — it has nothing to do with reality.  Credit is a demand-driven outcome — banks create this type of money ex nihilo (as the Post-Keynesians are fond of saying) whenever they make a new loan.  It doesn’t “flow” anywhere on its own unless someone’s sucking through a tube at the other end.  Post Keynesians call this the endogenous money theory and it stands in contrast to what should be the discredited money-multiplier theory (and see here as well for statistical support for this claim)

From an endogenous money perspective, it is easy to see that loans can’t be foisted on people anymore than cars, home purchases and even home repairs (hello Budget 2009 Home Renovation Tax Credit) can be foisted on people who are worried about their next paycheck. People make these commitments when, and only when, they have some sense of security about the future (or someone’s giving things away for free, which may amount to the same thing).  In case you haven’t noticed, a sense of optimism, security and free things are hard to come by these days. Meanwhile, the banks are doing what banks typically do in downturns — they rebuild their balance sheet by loading up on bullet-proof government debt (see above).

It all leads to one important conclusion: to right this economic ship (mixing metaphors here so apologies), the demand side of the economy needs help.  For most of our history, but especially in the last 20 or so years, Canada has been content to let exports to the U.S. — driven in part by U.S. deficit spending both household and government –  play this vital role but it’s not clear that can happen anymore.  What is clear is that credit supply will take care of itself because there are few constraints  to its creation (setting aside regulatory and prudential ones) other than psychological. The only we have to fear is of course fear itself.

BTW: For a truly wonderful exposition of endogenous money theory — that which underlies Galbraith’s thinking and most modern-day central bank practice but, regrettably, so little public commentary — I would strongly urge anyone who has the time and spare coin to pick up a copy of the Canadian version of Baumol & Blinder’s macroeconomics textbook by Marc Lavoie and Mario Seccareccia, two well-known Canadian Post-Keynesians.

Turn to Chapters 12 & 13 and behold as the riddles of modern macroeconomics are revealed and the fallacies of mainstream ecoomics exposed:

Macroeconomics: Principles and Policy, Thomson Nelson, First Canadian Edition (to be published in 2009).