I moderated a panel on financial innovation yesterday, about which more when I get the video. But there was a lot of talk of leverage, which is the hidden turbo-charger in a lot of financial innovations, from credit default swaps to structured investment vehicles. And there was a general consensus that if you want to create prosperity and jobs, then leverage is in principle a good thing: more debt means more growth which means more prosperity. For a prime example, see this post from Gregory White, who reckons that whenever household debt is going down rather than up, “the economy will stink.”
The challenge I put to the panel yesterday was to come up with an innovation which produces more growth with less leverage
That last sentence almost makes FLG want to take back everything bad FLG has ever said about Felix.
Let's get back to econ 101. There are two things individuals can do with their income: spend it or save it. At the most basic level, this is a choice between consuming now or in the future. But then you have to think about what saving is. Inevitably, saving is giving your money to somebody else in return for money later. What do they do with that money? Well, people don't often borrow money unless they have something they want to spend it.
So, you then have a saver and a borrower. A key factor, perhaps the key factor, that determines how much to save/borrow is the interest rate. Higher interest rates encourage savings and discourage borrowing. Lower interest rates discourage savings and encourage borrowing.
Theoretically, the way in which saving and borrowing (which you can consider the entire financial system) contributes to economic growth is by redistributing capital to its most effective purposes. The easiest way to think about this is that as long as a business owner expects to generate a higher return than the interest rate it costs to borrow the money, then they'll keep borrowing money and keep contributing to economic growth. That's in theory and it sounds great.
In practice, we have a couple of problems. First, it's not always that smooth. There are times when that borrower who expected to get a return higher than the interest rate doesn't. Most of the time, this is due to poor decisions or bad luck or whathaveyou, and it may be catastrophic for the borrower, but the banks price some of this in. Less frequently, however, a systematic problem arises because it's not just one or two borrowers who made bad decisions, but a large amount of people whose projected returns are less than the interest rate. Then it puts the entire system at risk. That's more or less what happened during the housing crisis. Second, borrowing has the effect of pulling consumption forward. For example, if I borrow $100,000 today to be paid back over twenty years, then I spend $100,000. As FLG mentioned before, given that FLG is borrowing this money presumably he wants to spend it. Likewise, the person lending me the $100,000 doesn't want to consume right now. So, all things being equal, lending FLG should increase GDP over what it would have been because FLG is spending the money. However, FLG then has a stream of payments moving forward that he has to pay back and will not be using for consumption. If FLG makes a greater return than the interest rate and spends that gain on consumption (let's not get into him saving to keep it simple), then he will, on net, increase GDP over the time. If he doesn't then, we've got problems. But all of that is assuming domestic borrowing and lending. What happens if we introduce foreign borrowing?
Let's say China lends the US $1 trillion. The US then spends it. This increases the American GDP in that year. But the US then has to pay back that money and each of those payments is money that cannot be used for consumption in subsequent years. And, unlike in the domestic case, where those payments go back to other Americans who were saving to consume in the future, and all things being equal will contribute that money right back to GDP, spent Chinese savings do not. And so the US is indeed shifting consumption forward at the expense of future consumption. To the extent that that money isn't used for consumption, but rather for investment opportunities, i.e. Americans are better at finding things to do with money and so the American economy and financial system does some sort of arbitrage to take the money of Chinese savers who want 3% return and give it to Americans who can make 8 or 10% on that money, then it's all well and good. To the extent that those investments don't pan out, we'll, then we're fucked moving forward.
All that is to say that, yes, hypothetically leverage moves money to those who can use money most effectively and so, in principle, it's a good thing. But like all things, there's too much of a good thing and principles don't always hold in practice.