The trade cycle: debt is trade

GDP is high in booms and low in recessions (relative to trend). That is (roughly) how we currently define "booms" and "recessions".

GDP (roughly) measures the volume of trade in newly-produced final goods. But that is a narrow measure of trade. A lot of goods get traded that are not newly-produced. People buy and sell old houses, for example, where by "old" I mean "not produced this year". And those trades are not counted as part of GDP.

There is nothing wrong with excluding sales of old houses from GDP. Because GDP is supposed to measure the volume of production and not the volume of trade. But there is something peculiar in defining booms and recessions and the business cycle in terms of the volume of production, rather than the volume of trade. We produce goods and trade the goods we have produced, presumably because it makes buyer and seller better off, which is why production matters. But trade in old goods, like old houses, presumably makes buyer and seller better off too, so trade in old goods matters too.

In a monetary exchange economy, all goods, both newly-produced and old goods, get bought and sold for money. If something goes wrong with money, we should expect to see trade in all goods, both new and old, get disrupted. Some mutually advantageous trades in newly-produced goods don't get made; some mutually advantageous trades in old goods don't get made either. The decline in production we observe in a recession is just one symptom, albeit an important symptom, of a general decline in trade of both newly-produced and old goods. And production only gets disrupted because trade gets disrupted. We stop producing goods if we can't sell them. Those goods produced for our own use are the exception that proves the rule. Anecdotally, home production increases during a recession.

As I have argued before, first here and then here, we should call it "the trade cycle", not "the business cycle". We should broaden our focus beyond GDP.

What do we trade? We trade newly-produced goods. We also trade old goods. We also trade IOUs. When I sell an IOU, we call it "borrowing". When I buy an IOU, we call it "lending". Borrowing and lending are trade, and those trades happen for the same reason all trades happen -- because the buyer and seller are presumably better off as a result of the trade. Of course there are exceptions, but then there are exceptions to all trades. Everyone has regretted buying or selling something, whether or not it was an IOU.

If you look at business cycles this way, as a trade cycle, in which the volume of trade rises in booms and falls in recessions, it is totally unsurprising that the volume of borrowing and lending should also rise in booms and fall in recessions. Because borrowing and lending is just another type of trade. The same monetary problem that disrupts trade in newly-produced goods, and disrupts trade in old goods, also disrupts trade in IOUs. Because, in a monetary exchange economy, all those goods -- newly-produced goods, old goods, and IOUs --  are traded for money.

What would be surprising and in need of explanation would be if trade in IOUs did not follow the same cyclical pattern as trade in other goods.

Neil Irwin tells me that trade in IOUs is increasing in the US. (HT Mark Thoma). He's right that it's good news. I'm just re-framing what he is saying.

Yes, some IOUs are used as money. Which means that some trades in IOUs create money. And this, depending on the monetary policy followed by the central bank, may create a positive feedback loop. But the job of a good central bank is to replace that positive feedback loop with a negative feedback loop, just like a good thermostat. (I'm talking about "banks", in case you missed it.)

[After this afternoon, I will be taking a couple of weeks away from the blog.]

Comments

[Jonathan Finegold]

Whatever happened to using terms like "credit cycles," "trade cycles," "industrial fluctuations," et cetera, interchangeably?

[Nick Rowe]

Jonathan: good question. I don't know the answer. Were they used interchangeably? I would like to bring back the old term "trade cycle", because I think it is the most inclusive way of framing the question. I don't know why it disappeared. And languages other than English often talk about "the conjuncture", which I think is a good term, because it draws attention to the idea that different things all move together.

[J.V. Dubois]

I think this has more implications than pure semantics. For instance we care about current business cycle because one of its symptoms is disruption in trade with wage labor causing unemployment. Maybe absent of phenomena of unemployment people would be much less sensitive to other disruptions in trade, their large and negative longterm welfare implications notwithstanding.

Maybe there is "downward nominal house price rigidity" that leaves trillions of dollars in real estate "unemployed" even if we have healthy economy with generally low unemployment?

[Frank Restly]

Nick,

"What would be surprising and in need of explanation would be if trade in IOUs did not follow the same cyclical pattern as trade in other goods."

It would not be that surprising. It would be indicative of a change in money velocity through either increased interest rates on existing debt, a change in liquidity preference, or a change in financing arrangement (equity in lieu of debt).

For instance, government expenditures grow but deficit is funded with equity.

[W. Peden]

Jonathan Finegold,

My hypothesis would be that, as GDP became systematically measured, it took precedence over less easily defined and measured quantities, and I'd imagine that this happened no later than the 1950s/1960s.

[Nick Rowe]

JV: trade in labour is a big part of total trade. And the gains from trade in labour are also very big (a lot of producer+consumer surplus, because the opportunity cost is much lower than the value marginal product).

"Maybe there is "downward nominal house price rigidity" that leaves trillions of dollars in real estate "unemployed" even if we have healthy economy with generally low unemployment?"

I think there is, and we do see that. But it's correlated with the rest of the trade cycle. And we also see a lot of "underemployed" houses, where the people living in them would rather be living somewhere else, but are waiting to sell.

Frank: you lost me there.

W Peden: that hypothesis sounds plausible to me.

[Lord]

One good that does not trade old is food, but while food may not trade less, it may go downscale. Relative food prices should also tell you this.

[Frank Restly]

Nick,

Equity is technically not an IOU. Money is not borrowed / lent in an equity financing arrangement.

"What would be surprising and in need of explanation would be if trade in IOUs did not follow the same cyclical pattern as trade in other goods."

Trade in IOU's falls as debt is replaced with equity, but trade in other goods rises as trade in equity rises.

[K]

Nick,

"all those goods -- newly-produced goods, old goods, and IOUs --  are traded for money."

That statement strikes me as a good example of the mistake in this post. In reality, essentially *all* goods (newly produced, old, whatever) are traded for bank intermediated IOUs (deposits, lines of credit, credit cards, cheques, bank drafts, wires, etc), not for what you are calling money. And IOUs (e.g. deposits), of course, are created in whatever volume agreed by the market at the rate set by the CB (ignoring credit spreads).

The simplest way to think of it all (again, ignoring credit risk) is just a quantity of risk free deposits matched by an equal quantity of risk free lines of credit all earning the risk free rate, and all intermediated via a central balance sheet (the banking sector) for ease of accounting.

Money (i.e. currency) is  exchanged in small quantities for IOUs (deposits), chewing gum, or pizza delivery, or, in greater volume, for illegal goods and services. But it doesn't figure significantly in the formal economy. Nothing of consequence in macro changes without "money".

[Nick Rowe]

Frank: "IOU $100" - debt
"IOU 1% of my profits" - equity

K: (Some) commercial bank IOUs are used as money. They cancel them out, and only the net balance has to be transferred between banks, in the form of Bank of Canada money. My IOUs don't get used as money. They let me postpone payment in money, but they don't circulate around the economy.

[Nick Rowe]

I won't be responding to comments for a couple of weeks. Play nice, and have fun!

[Frank Restly]

Nick,

"For instance, government expenditures grow but deficit is funded with equity."

A government does not "turn a profit" and yet there is nothing to preclude it from seeking equity financing.

[Nathan Tankus]

I think you'd really enjoy Pigou's industrial fluctuations. He talks about all of these issues in there and frames it as the definition of V.

your concept that monetary policy should "control" this process like a "thermostat" seems similar to the Hawtrey/Pigou/Cassel idea that raising/lowering the interest rate increases/decreases the amount of "bank credit" by adjusting the rate of return on bank loans. is this essentially your point? what if the relationship is non-linear and changing through time? In other words, what if lower interest rates sometimes put downward pressure on increases in bank credit and higher interest rates sometimes put upwards pressure on increases in bank credit depending on the current balance sheet of the economy? Doesn't the ability for the central bank to use monetary policy to control the "trade cycle" become small to non-existent in such a situation?

[Jonathan Finegold]

W. Peden: You may be right. I think NBER played a role in that, especially since up to 1945 W.C. Mitchell was involved with NBER, and his specialty was the empirical measurement of business cycles.

[K]

Nick,

"I won't be responding to comments for a couple of weeks."

I suppose I get the last word then!

"(Some) commercial bank IOUs are used as money. They cancel them out, and only the net balance has to be transferred between banks, in the form of Bank of Canada money."

That is not how it works, especially in Canada. Lets say you buy a $20 haircut, and pay the barber via your BMO debit card. BMO debits your account and puts instructions in LVTS to transfer $20 to the barbers RBC chequing account. At the end of the day (since there were no other transactions), BMO sees that they are short $20. So they go to interbank market and announce that they need to borrow $20. Since RBC notices that they have $20 of excess funds, they come to the market at the same time and lend it to BMO. At the end of the day the loan balances the initial wire, and no net funds actually get transferred in LVTS. *If* RBC refuses to lend to BMO, RBC ends up in a net long reserve position, BMO has to borrow from the BoC, and BMO wires the $20 to RBC.

But the BoC will get cross because the interbank market isn't supposed to clear through them. It indicates a breakdown of interbank credit. Longer term, the problem can be fixed via BMO issuing new term debt or equity or selling assets, but the interbank market is supposed to clear in the meanwhile, and banks are supposed to determine interbank credit spreads. 

Anyways, the Canadian interbank (repo) market typically always clears all settlement balances so the outstanding BoC balance in LVTS is basically exactly zero. Ie. when you "pay" for your haircut,the barber is giving you a loan which is intermediated by your bank. No quantity of base money is required for settlement.  

"My IOUs don't get used as money"

Not so! You have an IOU balance with BMO which they intermediate to the rest of the market as described above. 

[Peter T]

It's worth thinking through K's point about money as IOU. If, for whatever reason, trade in goods is disrupted, then the possessors still mostly have and can use the goods (the "underemployed house" is still shelter and so on). The stock of goods does not diminish. But a disruption in the "trade" in IOUs causes many of the IOUs to vanish, as the chain unwinds. In good times, the stock of IOUs relative to goods builds up; in bad times it vanishes, disrupting the trade in goods, labour and much else.

[Donald A. Coffin]

Re Johathan Feingold's question (first comment) and your response.

What Wesley itchell wrote about in his "Business Cycles" (about 1920) is, as I recall (n longer having a copy of the book) what you are referring to as a trade cycle. I'm not quite sure when the separation of meanings occurred, but I'd suggest that it accompanied the rise of national income accounting...if we were not measuring it, it was harder to focus our analysis on it.

[Gizzard]

Good post Nick

I've had similar thoughts not expressed as well. I do think there is good reason to focus on new production however, trading old stuff is really a form of recycling and while I am a big proponent of recycling its the creation of new things from these recycled things that are really quite ingenious, and its ingenuity that moves us forward. Trading of old stuff even for money is essentially barter, a zero sum game. Nothing new enters the picture. Its the creation of new things added to the old the gives us the possibility of new opportunities for a growing population. We can certainly keep most current people occupied with out growth of new things but to get more people involved we need more new things to do.

Im sure that borrowing FROM BANKS is not just another type of trade though. Its not the same as me borrowing form your savings

[marris]

At one point, I thought I understood what feature of the business cycle macro-economists should care about. I thought they should care about RGDP. Then Scott Sumner hit the scene, and convinced me that they should care about NGDP. Then a bunch of liberals came along and convinced me that they should care about unemployment. Now Nick is trying to convince me that they should care about RGDT (real gross-domestic trade?). No, that's not correct. Nick's trying to convince me that they should care about NGDT.

My head hurts. I'm going to return to watching Breaking Bad reruns.

[tom]

Trade cycle, business cycle, credit cycle, they're all the same thing. I don't agree that credit expansion accelerates and ecelerates along with trade growth because credit is "just another kind of trade". The credit cycle is the heart of the trade-business cycle and contrary to the author's naive view central banks like commercial banks are by nature procyclical.

[Frank Restly]

Tom,

Nick is not referring to just credit. He is referring to IOU's in general (entire capital market system - debt and equity).

[Steve Roth]

Not sure if you're reading old comments, Nick, just to let you know that I definitely noticed this one, haven't had time to comment.

Especially thinking of it in terms of JW Mason channeling Leijonhufvud channeling Wicksell channeling Ricardo and Tooke.

http://slackwire.blogspot.com/2012/03/graeber-cycles-and-wicksellian.html

Also what Josh characterizes in his update as your "kind of response."

I have the same question he does: have you read that Leijonhufvud paper?

http://www-ceel.economia.unitn.it/staff/leijonhufvud/files/wick.pdf

Incredibly cogent thinking, it seems to me. It really cuts to the crux of the issue I've raised recently re: reflux in a credit-money economy.

[Nick Rowe]

Steve: Yep, I'm reading (and I read your posts), but my brain isn't functioning yet. It's either jet-lagged, or I left it on a farm in England, one or the other.