Ramanan — Credit And Economic Growth

Here I expand on Ramanan's SFC analysis with the observation that credit fuels nominal growth, but only up to a point. Then, the credit burden becomes a drag on further spending. At this point the economy adjusts to lower spending. This affects both the business and financial cycles. 

This has to do with expectations in the face of uncertainty, Keynes's "animal spirits," which at tops become Shiller's "irrational exuberance." As the credit wave crests and the cycle rolls over, Keynes's paradox of thrift kicks in. Increasing saving desire of more and more parties results in lagging demand and economic contraction, unless another sector offsets the increasing propensity to say. 

This cyclical behavior of credit is also described in Hyman Minsky's analysis of financial instability.

The rational approach to credit is to manage credit balances in such a way to provide a margin of safety regarding repayment. This is management of cash flow or liquidity, and the penalty for not doing so sufficiently is insolvency.

However, not everyone behaves rationally all the time. At tops, greed trumps fear, and in troughs, fear trumps greed. It is simply not the case that borrowers always hit the sweet spot. If they did, then economic and financial cycles would flatten in an endogenous, credit-based money system.

In any case, credit fuels growth in an endogenous money system where spendable funds enter the system chiefly through bank credit. Therefore, the changing ratio between propensity to save and propensity to spend determines a critical amount of spendable funds created in the consolidated domestic private sector. 

The flow is subject to irrational behavior owing to "animal spirits," in which expectations are driven by alternating balance between fear and greed, for example, that result in differences in liquidity preference. Changing liquidity preference results in different saving/borrowing patterns that are visible in hindsight. But, as Keynes observed, markets can remain irrational longer than one can remain solvent. Identifying cyclical tops and bottoms in advance is difficult to impossible.

The monetarist view is the the interest rate determines liquidity preference rationally. This overlooks the human aspects of expectations and behavior that are affected by strong emotions. Interest rates are highest at tops, where greed impels parties to pay more for liquidity in order to take advantage of apparent profit opportunities or spend more in the consumption frenzy. Then, at bottoms, low interest rates do not necessarily lead to increased borrowing and spending as predicted, owing to the perceived necessity to deleverage and also extreme caution in managing cash flow.

The Case for Concerted Action
Credit And Economic Growth
Ramanan