Thursday, February 19, 2009

A Closer look at Credit

In Fiat World Mathematical Model by Mish published earlier today, which is an engaging article, he takes the well-known equation in Austrian Economics, that money supply (M) is the sum of printed currency (P) and credit (C), that I've repeated over and over here, and expands on it. He evaluated credit with a multiplier (v) to get the market value of the credit, rather than the absolute value of the credit. So, fiat money supply in a fractional reserve system would be the sum of printed money and what the credit is worth, not what is owed. Using my notation for money supply, we have: M = P + v(C), where v(C), is the fraction of outstanding credit that is likely to be paid back or recovered in a foreclosure. If all loans are good then v is 100%.

I think it is a good estimation, but I have two critiques: first, in a world of fuzzy accounting and bailouts, market value is hard to estimate. Also, money brought into reality though fractional reserve lending, does not simply disappear if the buyer forecloses (say he buys a boat and sinks it the next day, then declares bankruptcy), because the seller still has the money and is buying things with it, and the bank's balance sheet would still face the same restrictions in the short run regardless of whether the buyer forecloses the next day or makes gradual payments over 20 years. Bad credit restricts money supply not because its securities are toxic but because the banks are restricted from lending due to poor income.

What the post points out well is there seems an unacceptable lag between money supply, which remains very high with outstanding credit, and the buying power of the economy.

Also in the article is a welcome estimation of the amount of outstanding credit in the private sector. I'm not sure what is backing up this number or how it was calculated, but the graph shows it to be 4 x 10^7 in millions, or 40 million million, or about $40 trillion.

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