GDP growth is compatible with shrinking credit

28 May 2010 by Jim Fickett.

Growth in GDP is compatible with shrinking credit, as long as it is shrinking at a slowing pace. This is important because the US may presently be in exactly this condition – with credit shrinking but at a decelerating pace.

People often get confused when dealing with levels versus growth rates. This post is about one of those confusing cases.

A common misconception is that GDP growth requires growth in the overall level of credit and, similarly, that growth in consumer spending requires growth in the level of consumer credit. For example, in the October 2009 Global Financial Stability Report, the IMF seemed to equate smaller bank balance sheets with lower economic activity:

[Bank] balance sheets will shrink as banks wrestle with increasing loss recognition, while more stringent capital requirements will restrict leverage. Since banks, through on-balance-sheet and off-balance-sheet activities, provide the lion’s share of credit (particularly in Europe), credit constraints may restrain economic activity unless there is a significant offset from non-bank credit channels.

However, as explained by a recent article at, entitled The myth of the 'Phoenix Miracle', by Michael Biggs, Thomas Mayer, and Andreas Pick, the more important variable for economic activity, especially during recoveries, is not the level of credit but rather the growth rate of credit.

We will work through a very simple example to show why this makes sense. The example is inspired by one of Biggs' articles, titled “The impact of credit on growth”, from an internal Deutsche Bank newsletter, which he kindly sent to me in 2008.

Imagine a person who has an income of $5000/month. If this person has no debt and no savings, he can spend $5000/month. Suppose, now, that he wants to spend $6000/month. He has to borrow $1000/month, so, in order to maintain a fixed spending level, his debt has to steadily increase. In this example, a change in the level of spending requires not a one-time change in the level of credit, but a change in the growth rate of credit. So, again, in this very simplified case,

  • A level of spending corresponds to a growth rate of credit
  • A change in the level of spending requires a change in the growth rate of credit

This gets more interesting when we look at a case where credit is shrinking. Imagine a person who is earning $5000/month, using $2000/month to pay down debt, and spending $3000/month. Next suppose that this person decides to only pay down $1000/month while spending $4000/month. Both before and after the change, credit for this person was shrinking. But it was shrinking less quickly after the change than before. Here again, an increase in the level of spending required a change in the growth of credit, in this case from more negative to less negative.

  • An increase in the level of spending can come about either through an increase in the growth of credit or through a decrease in the shrinkage of credit

These examples are of course very much simplified and, in real life, changes in GDP are correlated with both changes in the level of credit and changes in the growth of credit. The level of credit is important for economic activity because, for one thing, it supports capital investment. However Biggs and colleagues have shown that changes in the growth of credit are often more important, particularly during recoveries.

At this point it is appropriate to take a closer look at the growth in bank credit, recently discussed in a previous post. The following graph shows two things. The solid line is net new lending by commercial banks (i.e. the change in total loans and leases, corrected by charge-offs). Commercial bank lending is not the only source of credit in the economy, of course, but it is a very important one, and the connection with GDP is usually taken as given. The second thing in the graph is GDP growth, plotted, as usual for the US, as the quarterly percentage change at an annual rate.

When the lending line is above zero, the level of credit is growing, and when below, the level of credit is shrinking. When the lending line is sloping upwards, the growth of credit is increasing, and when the lending line is sloping downward, the growth of credit is decreasing. So visually, the question of whether the change in GDP is more correlated with the change in the level of credit or with the change in the growth of credit, boils down to this: Does the height of the blue bars seem to depend more on the height of the lending line, or on the slope of the lending line?

The answer seems to be, very clearly, the slope. The deep falls in GDP in 2008-Q3 to 2009-Q1 were associated with a downward sloping lending line, not with a line below zero. And the recovery in GDP growth was associated with the lending line leveling out, not with it rising above zero. For these data, the Biggs thesis seems to be confirmed.

Biggs and colleagues, in the article, show excellent long-term correlation between change in the growth of private sector credit, which they call the credit impulse, and private demand:

For the important question of how current credit conditions are affecting economic activity, this approach, using total private sector credit, would be preferable, because it eliminates the difficulties with the accounting changes that occurred in the first quarter, and which prevent us from accurately measuring bank credit. We will look into this for another post.