Friday, 13 March 2015

Do “non productive” loans matter? Nope.


Summary.     There is a myth doing the rounds to the effect that loans that fund so called “productive” activities (like building houses) are preferable to loans that fund so called “non-productive” activities (like the purchase of EXISTING houses). The flaw in that argument is as follows.

The basic constraint on loans and other methods of increasing GDP (like increasing the deficit, cutting interest rates, QE, etc) is inflation. And the latter is sparked off when aggregate demand exceeds the ability of the economy to supply (aggregate supply). And aggregate supply is limited by factors like the size and skill of the workforce. Thus if a series of non-productive loans are implemented, the result will be relatively few demands on the economy, thus such loans leave room for further loans, or other ways of boosting GDP, like interest rate cuts, QE, and so on. In contrast, a series of “productive” loans results in relatively LARGE NUMBERS of people being employed which leaves less room or no room for further GDP increasing.

Thus the fact that a series of loans are “non-productive” is immaterial.
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An example of the idea that “productive” loans are preferable to “non-productive” ones appears in this Positive Money publication, which reads, “However, banks currently direct the vast majority of their lending towards non-productive investment, such as mortgage lending and speculation in financial markets. This does not increase the productive capacity of the economy, and instead simply causes prices in these markets to rise, drawing in speculators, leading to more lending, higher prices, and so on in a self-reinforcing process.”

Certainly that’s a plausible argument. To illustrate, a loan that funds the CONSTRUCTION of a new house creates roughly two or three years work (for plumbers, bricklayers, carpenters, etc). In contrast, a loan that funds the purchase of an EXISTING house creates roughly a week’s work for an estate agent (“realtor” in US parlance) and a week’s work for the bank staff that organise the mortgage.

A point that lends credence to the above productive / non-productive argument is that there some types of loan based activity which without any doubt ARE unproductive in the proper sense of the word: e.g. loans which fund clever clever bets on derivatives which, when they go wrong help cause credit crunches. But by the same token, there are “productive” or GDP increasing loans which fund equally undesirable activities, like loans that fund cannabis farms (assuming for the sake of argument that cannabis farming is labour intensive).

Another example of GENUINELY unproductive loans, are loans granted for the purpose of purchasing existing houses where the net effect of those loans is exacerbate cyclical fluctuations in house prices.

But there remains the important question as to whether there is anything INHERENTLY undesirable about “non-productive” loans i.e. loans that don’t create much employment. Well the answer is: “no, there isn't”.


Flaws in the “unproductive” argument.

The flaw in the “productive / unproductive” argument is that it assumes there is some sort of limited stock of money available for loans. The reality is that there is NO LIMIT to the amount of money banks can create and lend out as long as they think the borrower is credit worthy, and as long as the economy is not at capacity: i.e. as long as the economy can handle the extra economic activity that stems from new loans.


Debt per $ of GDP.

A plausible argument against “non-productive” loans is that they increase total indebtedness per dollar of GDP by more than “productive” loans, and the word “debt” has negative overtones, ergo we all benefit if non-productive loans are minimised.

Well the answer to that is that debt is only a problem where debts are incurred in an incompetent or irresponsible manner. I.e. carte blanche objections to debt as such or to a rise in debt  per dollar of GDP are absurd.


Conclusion.

In deciding between different types of loan, banks should simply do what they already do, namely go for the most PROFITABLE loans. Indeed, profitability is a very good measure of productiveness, unless it can be shown that the profit derives from something underhand or dishonest.









3 comments:

  1. Hi Ralph,
    No objection to banks lending to so called unproductive activities,GDP is an abitrary measure anyway much as inflation is.As long as two parties agree on a loan deal who are we to stand in the way or pass judgement as to whether it is productive or not.

    What we do have to watch of course is that the banks create money to pursue such activity.They will inevitably create too much if the demand is high enough.If they really want to make loans for mortgages or for share speculation fine,but let them go get the money first and risk it.

    We would soon see how good these so called financial wizards really are with some real skin in the game, so to speak.

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  2. It seems to me that unproductive loans need to be examined from an additional aspect. To do this, I expanded " “non-productive” activities (like the purchase of EXISTING houses)" into a defined framework:

    Assume that a bank is making interest-only loans for houses. One particular house is sold and resold under this loan program five times in five years, each time at a higher price. What are the implications of this activity by this bank?

    I think that this example raises many questions about an economic environment that would generate this situation. Usually houses sell only once in 5 years (or even less frequently). Why would this unusual situation occur?

    And then there is the question that I came to focus upon: What would be the effect on valuation of the surrounding houses that did not sell frequently?

    It seems to me that the effect of one bank making frequent loans on one house has a confusing effect on surrounding valuation. Is the bank making substandard loans? Is the down payment too low so the new owner has no "skin in the game". Is the economy in a period of high local inflation? Is the bank just churning the house for it's own profit at the cost of destabilizing the value of surrounding property?

    Without answering any of these questions, I do think the example leads to a contrary title for your post: "Do "non-productive loans matter? YEP". To see why the answer is "YEP", we need to examine the effect of loans on asset valuations, a subject much deeper than this comment.

    Thanks for the post.

    ReplyDelete
    Replies
    1. Roger,

      If what you’re saying is that non-productive loans can lead to house price bubbles, I think I covered that point above in the para starting “Another example of GENUINELY unproductive loans…”.

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