Leverage and Efficient Finance

I recently read an argument along the lines of,

Under conditions of ‘sound money,’ taking out loans for purchases like houses, [small?] businesses, et cetera, were much more infrequent. Instead, these things were purchased outright.

My guess is that the implication is that the amount of debt held by the average person today is, in part, owed, directly or indirectly, to ‘unsound’ money. And by ‘unsound’ money, my guess is that this person means the Federal Reserve. I don’t know what period of history he is referring to, but I’d guess the late 19th century. I don’t know if the claim is true, but I think it sounds right, and it doesn’t really matter for the point I’m making. Whether money is ‘sound’ or ‘unsound,’ we should expect, and welcome, the income margin at which people gain access to credit to fall over time.

After the Great Recession, it’s easy to get carried away with looking down on debt. A term that became widely used after the financial crisis is ‘deleveraging,’ which refers to the drawing down of debt. Consumers lived beyond their means; relatively poor people bought houses outside of their budget constraints; businesses took on debt to expand, only to be hit by malinvestment and a demand shortage. But, over-leveraging only makes sense if there is a reference point — an optimal amount of debt —, and we have to remember that this reference point is always moving up.

The optimal amount of debt today is not the same as the optimal amount of debt in 1880, or even 1920 or 1960. Prior to the U.S. Civil War, for example, banking was just beginning to expand westward, and prior to that expansion credit was not really available to large swaths of American society. But, as the banking system grew, and financial intermediation became more efficient and cheaper, new parts of society gained access to credit. Growing the pool of borrowers was an important facet of American growth, because it allowed businessmen to acquire others’ savings to fund investments.

This was one of the main ideas behind securitization, when it was innovated in the 1980s. By pooling loans, and distributing risk, the idea was to make credit cheaper, giving access to credit to poor families, which beforehand had little access. Of course, it seems as if this backfired on the finance industry, given the Great Recession. But, we shouldn’t throw the baby out with the bathwater. That credit was over-expanded, and that these securities would be the very assets that collapsed, warns us against inadequate institutional constraints on banking. But, otherwise, financial innovation is a good thing, and we should be open to it.

Another example of the benefits of growing access to credit is any developing economy. These markets are generally relatively primitive, and this includes their banking sector. Most people in developing countries — even in economies as large as that of Mexico, for example — do not have access to credit, and this is a limit on growth (on their ability to borrow and invest). One sign of progress is financial growth. A country “graduating” to a higher stage in the development process usually does so because they have established some type of credit market; not necessarily for their poorest, but for large business (stock and bond markets) and for government.

Credit markets have, historically, been very volatile. But, this volatility is caused by institutional problems. We shouldn’t look back at some long-gone period of history, when finance was relatively primitive, as the golden age. Instead, we should embrace the positive aspects of financial innovation — which are many —, and be wary of policies that cause instability and capital consumption…policies such as central banking.

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