Forget about the unemployment rate, the inflation rate, the gross domestic product, the Dow
or the yield curve, because the most important economic number right now is one that’s largely invisible: The supply of credit to the U.S. economy.
Why do we care? Because the flow of credit may be the most important variable in whether the economy booms or busts. That’s the message from Keynes, Hayek and Minsky.
Easy credit helps the productive economy grow, but if taken too far it can lead to dangerous bubbles in stocks, housing or other assets that too often end with a big bang and a credit squeeze that hits the innocent and guilty alike.
The Fed is almost always taken by surprise when the supply of credit dries up and the economy plunges into recession. The Minsky moment always sneaks up on the Fed because it doesn’t have good data on the supply of credit.
Decisions about lending and borrowing are, at the bottom, emotional decisions, largely hidden from the view of economists and policy makers.
Look at the way the stock market
and the bond market
have overreacted in recent months to small changes in the expected path of monetary policy, or the way they have swung wildly in reaction to rumors about the status of U.S.-China trade talks. Or the way housing prices became untethered from fundamentals last decade.
When stock market bulls or the president of the United States demand lower interest rates, what they want is more credit. When people worry about inflation sneaking up on us, or about dangerously high levels of corporate debt, what they want is less credit.
The last two recessions occurred after the Fed allowed bubbles to be inflated by easy credit.
With the economy slowing from an unsustainable 3% pace, with the unemployment rate sitting near 40-year lows and core inflation stuck stubbornly below 2%, with the stock market near record levels, bond yields falling and the yield curve briefly inverting, the crucial, unknowable question for the Fed, for markets, and for everybody else with a stake in the economy is this: How much credit is being supplied?
Is the Fed squeezing credit and driving us into recession? Or is the Fed making credit too easy to obtain, blowing bubbles, or allowing inflation to take hold? Or is everything fine?
The Minsky moment
It would be nice to know where the credit markets are heading, because the Fed is almost always taken by surprise when the supply of credit dries up and the economy plunges into recession. The Minsky moment — the moment when all the lenders and investors rush for the exit — always sneaks up on the Fed because it doesn’t have good data on the supply of credit.
When the level of lending changes, it’s hard to discern the cause: it could be due to a change in how much credit is being demanded, or how much credit is being supplied by banks and institutions that invest heavily in bonds. The difference is important to the Fed, because a widespread credit squeeze can kill an expansion with little warning.
In response to the financial crisis, the Fed and major economic research outfits have developed various indexes to measure financial conditions so we can get a heads-up on turning points in credit. These indexes can have hundreds of components — bond yields and spreads, stock prices, currency exchange rates, and survey data on lenders’ and borrowers’ sentiment.
Their value is questionable though, because even in hindsight they fail to show any advance warning that the credit markets were going to be squeezed tight in the run-up to the Great Recession of 2007-09.
That may be why so many analysts are taking the inversion of the yield curve so seriously. At least the yield curve actually gives a warning, and a reliable one (so far) at that.
One possible message we can take from an inverted yield curve is that banks and other providers of credit will find it unprofitable to lend because the Fed has tightened too much. If you borrow short and lend long, an inverted yield curve means you can’t lend profitably.
Another possible message from the inversion is that the animal spirits that animate a growing economy will turn negative — that we’ll talk ourselves into a recession by pulling back because we think everyone else will too.
Adjusting credit is all the Fed does
Almost everything the Fed does — raising or lowering the federal funds rate, adding or subtracting from its bond portfolio, as well as its guidance about what it might do in the near future — is aimed at adjusting the supply and demand for credit in order to achieve price stability, maximum employment, and a stable financial system.
If the economy is weak, the Fed lowers interest rates to encourage lenders to supply enough credit to bring the economy to full employment, but not so much that it creates inflation or bubbles.
If the economy is overheating (or heading that way), the Fed tries to limit credit growth by raising rates.
It’s hard to find the appropriate level if you don’t know how much credit can be supplied at the current price (the interest rate).
The Fed knows (approximately) how much real resources can be supplied in the near term. The unemployment rate tells them the supply of labor. The capacity utilization numbers say what the supply of manufactured goods is. It knows the potential near-term supply of oil, soybeans, steel, houses, cars, airplane trips, haircuts, smartphones, and a thousand other goods and services.
But credit is different, because credit can be created almost at will. There’s no physical stock of credit in bank vaults waiting for customers. How much credit will be supplied is determined as much by sentiment, judgment and animal spirits as it is by physical or financial factors.
What the data say
The data on lending show a mixed picture since the first of the year. Some borrowers can get all the credit they can afford, but others seem to be getting squeezed out of the market.
• Only 2% of small-business owners say their main business problem is the availability of credit.
• Core bank lending (defined as commercial and industrial loans, real estate loans, and consumer loans) rose at a 6.6% annual rate over the past 13 weeks and at a 5.3% pace over the last year, according to Jim O’Sullivan, chief U.S. economist at High Frequency Economics.
• There has been some weakening in pockets of the bond market, especially in leveraged loans to companies with poor credit, and in asset-backed loans, the very areas that the Fed and others have said were overextended. New issues of investment-grade bonds, meanwhile, have slowed modestly as the need for borrowing to fund stock buybacks and mergers has waned.
Importantly, the watchdogs that sound the alarm for a credit squeeze aren’t barking.
Typically, when the credit spigot closes, the first thing you’ll see is distress when companies cannot roll over maturing debt. You’d see short-term interest rates spiking as companies scramble for operating cash, you’d see layoffs of workers that cannot be paid, you’d see orders and leases being canceled, you’d see delinquencies and defaults rising, you’d see fire-sales of assets.
We don’t see any of that right now. There is almost certainly no credit squeeze right now. Almost all qualified borrowers can get a loan.
But that doesn’t answer the question we need to know but can’t: Is the level of credit being supplied appropriate for the economy we want?