By Dirk Bezemer, University of Groningen
The significance of credit goes beyond simply accommodating changes in the economy’s fundamentals. Credit itself may be among the drivers of the business cycle. There is no dearth of explanations for this observation — if anything, we have too many: Hayek’s mal-investment theory, Fisher’s debt deflation theory, Keynes’ theory on the collapse of effective demand, Minsky’s financial instability hypothesis, Schumpeter’s creative destruction theory, Koo’s balance sheet recession (an extension of Fisher), and Perez’ financial cycles description (an extension of Schumpeter). Contemporary cutting-edge DSGE models have financial accelerator mechanisms, which ensure that any exogenous shock is amplified by nominal rigidities, interpreted as representing the credit system.
All these models offer narratives that explain the boom-bust dynamics of credit, and that provide us with reasons why this engenders boom-bust dynamics also in the macroeconomy, a dynamic that would not otherwise — in the absence of a financial system — exist. In these models, the ups and downs of the private credit system is not a stand-alone casino that macroeconomists can ignore. It is not “the oil that smooths the running of the economic engine,” as the usual allegory has it. If anything, it is more like the fuel for the economic engine in the upturn, without which growth would not be possible. In the downturn, it becomes sand in the wheels of commerce. Without debt, the bust would never be so deep.
With the exception of Richard Koo’s, all these theories miss an important feature of financial systems today: they were constructed with business debt in mind. In them, loans are extended by lenders to nonfinancial firms to finance working capital or new investment. However, today, most credit does not finance new output, but transactions in assets, especially existing assets, like real estate. This paper argues that this structural change in debt—what we label the “debt shift” — needs to be placed at the heart of a theory of debt and the business cycle. Most advanced and emerging economies today are financialized economies and most of the debt in a financialized economy does not generate wages or profits, but rather fuels capital gains through asset price increases.