There seems to be a special affinity between reflexivity and credit. That is hardly surprising: credit depends on expectations; expectations involve bias; hence credit is one of the main avenues that permit bias to play a causal role in the course of events. But there is more to it. Credit seems to be associated with a particular kind of reflexive pattern that is known as boom and bust. The pattern is asymmetrical: the boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic. By contrast, when credit is not an essential ingredient in a reflexive process, the pattern tends to be more symmetrical. For instance, in the currency market it does not seem to make much difference whether the dollar is rising or falling: the exchange rate seems to follow a wavelike pattern.
I believe the asymmetry arises out of a reflexive connection between loan and collateral. In this context I give collateral a very broad definition: it will denote whatever determines the creditworthiness of a debtor, whether it is actually pledged or not. It may mean a piece of property or an expected future stream of income; in either case, it is something on which the lender is willing to place a value. Valuation is supposed to be a passive relationship in which the value reflects the underlying asset; but in this case it involves a positive act: a loan is made. The act of lending may affect the collateral value: that is the connection that gives rise to a reflexive process.
It will be recalled that we have analyzed reflexivity as two connections working in opposite directions: the “normal” connection where a value is placed on future events, as in the stock market or banking – we have called it the cognitive function; and a “perverse” connection in which expectations affect that which is expected – we have called it the participating function. The participating function is perverse because its effect is not always felt, and when it does operate its influence is so difficult to disentangle that it tends to go unrecognized. The prevailing view of how financial markets operate tends to leave the participating function out of account. For instance, in the international lending boom, bankers did not recognize that the debt ratios of borrowing countries were favorably influence by their own lending activity. In the conglomerate boom, investors did not realize that per-share earnings growth can be affected by the valuation they place on it. At present, most people do not realize that the erosion of collateral values can depress the economy.
The act of lending usually stimulates economic activity. It enables the borrower to consume more than he would otherwise, or to invest in productive assets. There are exceptions, to be sure: if the assets in question are not physical but financial ones, the effect is not necessarily stimulative. By the same token, debt service has a depressing impact. Resources that would otherwise be devoted to consumption or the creation of a future stream of income are withdrawn. As the total amount of debt outstanding accumulates, the portion that has to be utilized for debt service increases. It is only net new lending that stimulates, and total new lending has to keep rising in order to keep net new lending stable.
The connection between lending and economic activity is far from straightforward (that is, in fact, the best justification for the monetarists’ preoccupation with money supply, to the neglect of credit). The major difficulty is that credit need not be involved in the physical production or consumption of goods and services; it may be used for purely financial purposes. In this case, its influence on economic activity becomes problematic. For purpose of this discussion it may be helpful to distinguish between a “real” economy and a “financial” economy. Economic activity takes place in the “real” economy, while the extension and repayment of credit occur in the “financial” economy. The reflexive interaction between the act of lending and the value of the collateral may then connect the “real” and the “financial” economy or it may be confined to the “financial” economy. Here we shall focus on the first case.
A strong economy tends to enhance the asset values and income streams that serve to determine creditworthiness. In the early stages of a reflexive process of credit expansion the amount of credit involved is relatively small so that its impact on collateral values is negligible. That is why the expansionary phase is slow to start with and credit remains soundly based at first. But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values. The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy. By that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline. The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values. Since the collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous. That is the anatomy of a typical boom and bust.
Booms and busts are not symmetrical because, at the inception of a boom, both the volume of credit and the value of the collateral are at a minimum; at the time of the bust, both are at a maximum. But there is another factor at play. The liquidation of loans takes time; the faster it has to be accomplished, the greater the effect on the value of the collateral. In a bust, the reflexive interaction between loans and collateral becomes compressed within a very short time frame and the consequences can be catastrophic. It is the sudden liquidation of accumulated positions that gives a bust such a difference shape from the preceding boom.
Credit Cycle Hypothesis
It will be recalled that I envision a reflexive relationship between the act of lending and the value of the collateral that serves as security for the loans. Net new lending acts as a stimulant that enhances the borrowers’ ability to service their debt. As the amount of debt outstanding grows, an increasing portion of new lending goes to service outstanding debt and credit has to grow exponentially to maintain its stimulating effect. Eventually the growth of credit has to slow down with a negative effect on collateral values. If the collateral has been fully utilized, the decline in collateral values precipitates further liquidation of credit, giving rise to a typical boom/bust sequence.
The trouble is that real life is not as simple as the model I have been working with. In particular, the transition from credit expansion to credit contraction does not occur at a single point of time because it would precipitate an implosion that the authorities are determined to prevent. Official intervention complicates matters. The turning point does not occur at a single moment of time, but different segments of the credit structure follow different timetables. To locate our position in the credit cycle, it is necessary to disaggregate the process and consider the main elements of credit separately.