GDP plus Change in Debt—and the US Flow of Funds

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My recent post “What Bernanke does­n’t under­stand about defla­tion” has hit a chord, with a num­ber of sites around the world repro­duc­ing it—including John Mauld­in’s Out­side the Box col­umn. But it has raised a cou­ple of queries in peo­ple’s minds too:

1. Does my def­i­n­i­tion that “aggre­gate demand equals GDP plus the change in debt” involve dou­ble-count­ing?
2. My fig­ures for the USA are dif­fi­cult to rec­on­cile with the pub­lished US Flow of Funds data.

On the sec­ond point first, I pro­duce an aggre­gate lev­el of pri­vate sec­tor debt in the USA from Table L1 of the Flow of Funds (on page 60 of the June 2010 PDF, and in ltab1d.prn in the ltabs.zip data archive) by adding togeth­er debt data for the fol­low­ing sec­tors:

• House­hold
• Non-finan­cial cor­po­ra­tions
• Non­farm non-cor­po­rate
• Farm
• Finan­cial Cor­po­ra­tions

This omits some of the debt includ­ed in the aggre­gate debt lev­el in the same table—notably gov­ern­ment debt and debt owed by the “rest of the world”. In the inter­ests of mak­ing it eas­i­er to rec­on­cile my table with the data in the Flow of Funds, here’s the same exer­cise applied sim­ply to the very first row in Table L1 (and the first col­umn in ltab1d), “Total cred­it mar­ket debt owed by:”

US Flow of Funds Table L1, row 1 (col­umn 1 in the file ltabs1d.prn)

I also trans­form the data to month­ly by inter­po­la­tion, and the way my data is stored the fig­ure I give for 2006 cor­re­sponds to the fig­ure stored for the end of the quar­ter 200504 by the Fed. I’ve high­light­ed these num­bers in the two tables here to make that more obvi­ous.

Change in debt and aggre­gate demand

On the first point, since I con­sid­er that aggre­gate demand is spent on both goods & ser­vices (which are count­ed in GDP) and the net sum expend­ed pur­chas­ing exist­ing assets (which is not count­ed in GDP), then there is no dou­ble count­ing. A stan­dard text­book aggre­gate demand fig­ure is the sum spent buy­ing goods and ser­vices (for the expen­di­ture def­i­n­i­tion), which omits of course the sum spent buy­ing exist­ing assets as well. That would be all well and good if we lived in a world with­out asset sale—which of course we don’t.

Anoth­er rea­son peo­ple see a poten­tial error here is that they think that a loan sim­ply rep­re­sents the trans­fer of spend­ing pow­er from a saver to a bor­row­er, so that over­all there’s no change in spend­ing pow­er because of a loan: mon­ey is sim­ply trans­ferred from one group that will there­fore spend less (cred­i­tors), to anoth­er that will there­fore spend more (debtors). This is clear­ly the think­ing that Bernanke applied when he, in com­mon with most all neo­clas­si­cal econ­o­mists, dis­missed Fish­er’s “debt defla­tion” expla­na­tion for the Great Depres­sion:

“Absent implau­si­bly large dif­fer­ences in mar­gin­al spend­ing propen­si­ties among the groups, it was sug­gest­ed, pure redis­tri­b­u­tions should have no sig­nif­i­cant macro­eco­nom­ic effects. ” (Bernanke 2000, p. 24)

This is not the case in the real world, for two rea­sons:

1. Cred­it Mon­ey is cre­at­ed by banks “out of noth­ing” by the act of giv­ing a bor­row­er pur­chas­ing pow­er (a loan of mon­ey) in return for record­ing a lia­bil­i­ty by that bor­row­er to the bank (a bank debt). This cre­ates new spend­ing pow­er “ab ini­tio” with­out remov­ing it from oth­er agents. For the mechan­ics of this process, see my “Rov­ing Cav­a­liers of Cred­it” blog entry (click here for the PDF).
2. As Schum­peter argues cogent­ly, the endoge­nous cre­ation of mon­ey by the bank­ing sec­tor lend­ing to entre­pre­neurs is an essen­tial rea­son that cap­i­tal­ism can grow, and it cre­ates spend­ing pow­er that does not orig­i­nate in the exist­ing “cir­cu­lar flow of com­modi­ties”:

   “From this it fol­lows, there­fore, that in real life total cred­it must be greater than it could be if there were only ful­ly cov­ered cred­it. The cred­it struc­ture projects not only beyond the exist­ing gold basis, but also beyond the exist­ing com­mod­i­ty basis.”

   “[T]he entre­pre­neur needs cred­it … [T]his pur­chas­ing pow­er does not flow towards him auto­mat­i­cal­ly, as to the pro­duc­er in the cir­cu­lar flow, by the sale of what he pro­duced in pre­ced­ing peri­ods. If he does not hap­pen to pos­sess it … he must bor­row it… He can only become an entre­pre­neur by pre­vi­ous­ly becom­ing a debtor… his becom­ing a debtor aris­es from the neces­si­ty of the case and is not some­thing abnor­mal, an acci­den­tal event to be explained by par­tic­u­lar cir­cum­stances. What he first wants is cred­it. Before he requires any goods what­ev­er, he requires pur­chas­ing pow­er. He is the typ­i­cal debtor in cap­i­tal­ist soci­ety.” (Schum­peter 1934, pp. 101–102)

So there is no dou­ble-count­ing in “aggre­gate demand equals GDP plus the change in debt”: the rise in debt adds new demand to that gen­er­at­ed by the sale of com­modi­ties alone (and is a good thing here because it finances a large part of invest­ment); and the increase in debt is spent financ­ing part of invest­ment and con­sump­tion (an over­lap that could give rise to dou­ble-count­ing) and also on pur­chas­es of exist­ing assets (where no over­lap is pos­si­ble).

Bernanke, B. S. (2000). Essays on the Great Depres­sion. Prince­ton, Prince­ton Uni­ver­si­ty Press.

Schum­peter, J. A. (1934). The the­o­ry of eco­nom­ic devel­op­ment : an inquiry into prof­its, cap­i­tal, cred­it, inter­est and the busi­ness cycle. Cam­bridge, Mass­a­chu­setts, Har­vard Uni­ver­si­ty Press.

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