By James H. Nolt
When I was young, critical as I was, I took the economic textbook too seriously. I thought low interest rates meant easy or loose credit and high interest rates the reverse. This might be true if there is, as textbooks claim, a credit market. However, during recent years I finally realized that credit is not allocated by markets, but by a largely private political and strategic process of credit rationing.
Textbooks treat loans as a service, and the interest rate as the cost of that service. Then they modify that story a bit by suggesting why the Law of One Price, which says that everyone pays the same price in a competitive market, must be adjusted in the case of credit because not all debtors are equally credit worthy. A single scalar measure of risk ought to explain the “risk premium” or higher interest rate that more risky borrowers must pay based on the greater risk that they would be unable or unwilling to pay the loan back. Presumably this risk is something pretty obvious—measurable by a credit score or bond rating.
During normal times, this rough approximation does indeed provide a workable answer for most borrowers. It could be thought of in Sun Tzu’s terms as the “ordinary force” of credit operations. More interesting is the “extraordinary force” of strategic credit allocation practiced at the powerful heights of the financial system, in the temples where self-fulfilling prophecies are conjured.
Today, we are faced with a number of conundrums about debt if you take seriously what textbooks teach. On the one hand, we have negative interest rates, typical on many Japanese and some European government bonds. This is like paying people to borrow from you. In the world of textbook economics, anything with a negative price goes from a “good” that is desired to a “bad” we are willing to pay to get rid of like trash. Is debt really analogous to garbage? Are some creditors so allergic to their capital that they prefer to pay people to take money off their hands? Certainly this falls outside what textbooks teach.
An even more puzzling question is why the U.S. has the lowest interest rates in world history when credit is so scarce. Many borrowers who would like to borrow anew, or roll over existing loans, cannot. Typically, if the price of something is low, it is because it is plentiful. Prices hike when goods gets scarce. We have scarce credit, but at low rates for those who can still borrow. This is not the world of free markets.
Economic textbooks actually do evoke such a world. They describe socialist central planning, the antithesis of supposed capitalist free markets, as a situation of low prices and excessive demand in which many consumer goods are rationed. Yet, the capitalist credit market is more similar to this socialist planning principal than economists would admit. Many more people and companies desire credit than can access it, even at higher rates. The interest rate seldom rises high enough to bring the number of potential borrowers in line with the number of willing lenders, as is typical for goods markets. Thus, credit is always rationed. Potential creditors have the power to choose their debtors—to award some and refuse others.
Of course, whoever does not get a loan can be said to be unworthy. We are taught to believe this is true. This really becomes a self-fulfilling process. If you cannot borrow, it is because there is something wrong with you.
This breaks down at the level of the economic system as a whole. Business cycles occur when creditors go on lending binge—lending aggressively in one period. Then, at a culminating point, numerous creditors decide that previously worthy debtors have had enough. They begin to tighten up lending terms and requirements. Sometimes interest rates rise. Sometimes there are simply many more potential borrowers who are turned away.
The creditor is like a bartender. How much drink, or credit, is too much? At some point, it might be in your interest to stop facilitating the drunk or borrower to avoid bigger trouble, but that point is subjective, particularly since you are making money from their addiction.
It is a well-known fact that during a boom many dubious borrowers get loans. During downturns, many solvent borrowers are turned away. This difference is not caused by a sudden change in systemic risk, but by a sudden change in strategic behavior by many creditors. Change in strategy necessarily precedes the change in risk.
What economists seldom consider, because they are not trained to think strategically, is why creditors might switch from bull to bear, why they might tighten credit. When enough of them do tighten, their bearishness can become a self-fulfilling prophecy because tightening credit necessarily slows down purchases and reduces asset prices. Such tightening is sometimes targeted at particular classes of assets, yet collapsing the prices of any class of assets can have a contagion effect to other asset classes as investors sell good assets to cover their losses on bad ones. This is what happened in 2008.
Generally, a strong bearish interest will periodically recur because inflation erodes the value of the typical assets creditors hold: bonds and loans. These are promises to receive money in the future, but if that future money is worth less, so are the typical creditor assets. So, creditors hate inflation. Collectively, creditors have the power to fight it by simply tightening credit. They have a strategic interest in doing so through credit restriction.
If creditors were like the denizens of a textbook free market, there would be millions of them—none significant enough to have any influence on the market. In this fantasy world, the market is a collective outcome, a myriad of individual decisions but not a strategic one.
In the real world of credit, financial power is highly concentrated. During the 19th century, enormous players like the Bank of England and the Rothschild banks were individually powerful enough to change credit conditions by their own behavior, but also influential enough to impact the behavior of their numerous business associates and, though their press announcements, the wider public.
During the first third of the 20th century, the United States had thousands of banks and other financial companies, but only a few with enormous influence, including J.P. Morgan and the Rockefeller banks.
Finance today is concentrated globally to an unprecedented degree. Several of the largest banks have trillions of dollars of assets on their own balance sheets, but besides that they manage the wealth of financial transactions of tens of trillions of other people’s money. Even one such megabank is big enough individually to influence credit conditions; several cooperating together can reliably create a trend.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
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