Why Credit Doesn’t Rise Forever? – The Limits of the Physical Economy

In recent years their has been a revival of the Credit theory of the business cycle.  Pre-war it almost became mainstream – especially amongst Hawtry and his followers, such as those around the ‘old’ Chicago School such as Lauchlin Currie.  Put very crudely growth is fulled by a net growth in credit and recession by its net contraction.  When recession triggers negative balance sheets as opposed to just lower profits we have the worse condition of debt deflation and what today we call balance sheet recessions.

Recently these ideas have been revived and updated, via the ideas of Minsky – influencing figures such as Koo, Werner, Keen, Hudson and so on – and it seemed to fit perfectly the boom and bust before and after 2007.

But there is a problem if this is incorrectly treated as a ‘pure’ monetary theory of the business cycle.  Why cannot debt keep growing upwards forever? – after all if growth in debt fuels aggregate demand (the modern idea of credit impulse/accelerator – though an earlier non mathematical version of it was set out by Hawtry) then it can in theory grow exponentially to the sky even with Minskyian ‘ponzi’ investors; so what triggers the inability to service debt and/or a fall in profits?

The problem of course is we dont live in a purely monetary economy, the matching side of the monetary circuit is the circuit in sales and production of goods and services, the real economy.

The beginning of the Great Depression is more complicated than the crash of 2007/8.  Then we didnt have such an integrated economy, not even nationally within the United States.  That meant when you had a crash many areas and people were not touched and hot money simply flowed to the next boom/bust until their was nowhere left to go.

So the Florida Housing crash of 1926 led to the ruin of many but simply a transfer to other property and stock booms, to the extent that by 1928 empty unfinished subdivisions were a national phenomenon, as suburbanisation slowed car company stocks and utility companies took a big hit in 1929 – and we all know what happened then.  Oddly hardly any economic historians (with the exception of Kindleberger of course) asks the question of what triggered this fall in car manufacturer stock and utility stock (some even call it a mystery!) and actually what was happening in American towns and cities in the run up to the Wall Street crash.

But what was it that triggered the 1926 Florida Housing Crash?

The definitive first hand account of this is Only Yesterday by Frederick Lewis Allen in 1931.  It is a social history of the 1920s with a chapter on the Florida Boom, which reads in many ways like it was written about Miami 2005 as much as 1925.  You can read it on Project Gutenberg here.  Reading it again last night it struck me how it showed a classic case study of how physical limits of expansion of production can halt a credit boom in its tracks.

A credit boom depended on the continuation of production of things to spend credit on.  If that slows you get a surplus of inventory over product, and if highly leveraged inventory cannot be sold you cannot cover your debts (see my previous article on Homer Hoyts theory of the cycle on this point), you have to sell and this drives prices down, so a bubble spent on ever rising price expectations is popped, more fool the greater fool.

There was nothing languorous about the atmosphere of tropical Miami during that memorable summer and autumn of 1925. The whole city had become one frenzied real-estate exchange. There were said to be 2,000 real-estate offices and 25,000 agents marketing house-lots or acreage. The shirt-sleeved crowds hurrying to and fro under the widely advertised Florida sun talked of binders and options and water-frontages and hundred-thousand-dollar profits; the city fathers had been forced to pass an ordinance forbidding the sale of property in the street, or even the showing of a map, to prevent inordinate traffic congestion. … Hotels were overcrowded. People were sleeping wherever they could lay their heads, in station waiting-rooms or in automobiles. The railroads had been forced to place an embargo on imperishable freight in order to avert the danger of famine; building materials were now being imported by water and the harbor bristled with shipping.

So the import of building materials had to be restricted in Florida to prevent mass starvation.  You can imagine what impact this had on building.

At the height of the fury of building a visitor to West Palm Beach noticed a large vacant lot almost completely covered with bathtubs. The tubs had apparently been there some time; the crates which surrounded them were well weathered. The lot, he was informed, was to be the site of “One of the most magnificent apartment buildings in the South”–but the freight embargo had held up the contractor’s building material and only the bathtubs had arrived!

So use Miami Harbour to import building materials instead right? The coup-de-gras was cause by the schooner Prinz Valdemar which sank in the mouth of the turning basin of Miami harbor on January 10, 1926, on its way to becoming a floating hotel.

The other aspect of a blockage in production is that with fewer goods on the market you get speculation which further drives up prices and further extension of credit to fund that speculation. But the longer the physical blockage exists the more indebted asset speculators become, and when their balance sheets hit negative they may be forced to sell or default on a purchase with the assett reverting to the previous owner.

It began obviously to collapse in the spring and summer of 1926. People who held binders and had failed to get rid of them were defaulting right and left on their payments. One man who had sold acreage early in 1925 for twelve dollars an acre, and had cursed himself for his stupidity when it was resold later in the year for seventeen dollars, and then thirty dollars, and finally sixty dollars an acre, was surprised a year or two afterward to find that the entire series of subsequent purchases was in default, that he could not recover the money still due him, and that his only redress was to take his land back again. There were cases in which the land not only came back to the original owner, but came back burdened with taxes and assessments which amounted to more than the cash he had received for it; and furthermore he found his land blighted with a half-completed development.

When the rate of distressed assets coming to market outweighs the production blockage shortage then the opportunity for speculative arbitrage goes and ponzi speculative debtors are in deep trouble, as are the banks that leant to them.

As we keep stressing on this blog housing and land is a particularly important potential production blockage in capitalism because of course ‘they arnt making any more of it’.

As an urban planner one thing I do thank the Florida Boom for is the many supurb Garden City plans of John Nolen, after his friend and mentor Unwin the greatest planner.

2 thoughts on “Why Credit Doesn’t Rise Forever? – The Limits of the Physical Economy

  1. Good post, Andrew! There is no getting around it. In order to fully understand the economy you have to deal with the financial side and the physical side. Ignoring the one or the other will lead to poor policy.

  2. Pingback: Bank Lending is Profit Constrained not Equity (Capital) Constrained – A Small but Important MMT Error « Decisions, Decisions, Decisions

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