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ОглавлениеBoom and Crisis
Most mainstream economists failed to predict the greatest economic crisis1 of our lifetime: the global financial crisis of 2007–2008.2 In fact, many viewed the economy as healthy or robust even as the crisis loomed. Yet their theories remain largely unchanged, leaving off-target their prescriptions to mend the still-damaged global economy and to reduce continued economic stress.
In the aftermath of this crisis, most of the debate has been on the subject of government debt—on “austerity vs. stimulus.” One side blames government debt for impeding economic growth and thus prescribes a reduction in government spending called “austerity,” while the other side calls for more government deficit spending as the necessary “stimulus” for strong economic growth.
Both sides miss a much more central point.
The primary issue is not public debt but private debt. It was the runaway growth of private debt—the total of business and household debt—coupled with a high overall level of private debt that led to the crisis of 2008. And even today, after modest deleveraging, the level of private debt remains high and impedes stronger economic growth.
Rapid private debt growth also fueled what were viewed as triumphs in their day—the Roaring Twenties, the Japanese “economic miracle” of the ’80s, and the Asian boom of the ’90s—but each of these were debt-fueled binges that brought these economies to the brink of economic ruin.
Those crises are the best known, but almost all crises in major countries have been caused by rapid private debt growth coupled with high overall levels of private debt. The reverse is true as well; almost all instances of rapid debt growth coupled with high overall levels of private debt have led to crises.
There are two claims you can count on: Booms come from rapid loan growth. And crises come from booms.
Alan Greenspan, who was chairman of the Federal Reserve until 2006 and who presided over much of the runaway increase in mortgage loans that was central to the 2008 crisis, wrote recently in reference to this crisis that “financial bubbles occur from time to time, and usually with little or no forewarning.”3
Alan Greenspan is wrong.
It was neither a “black swan event” nor a crisis in confidence. There was plenty of forewarning—in fact years’ worth. This crisis was predictable, and major financial crises of this type can be seen—and prevented—well in advance.
Beyond the issue of rapid short-term loan growth, the United States has been on a long-term and continual path of increasing private debt to GDP. It is astonishing what’s happened: over the past seventy years, the level of private debt to income and GDP—in the United States and across the entire globe—has climbed steeply higher. In the United States, it has almost tripled from 55 percent in 1950 to 156 percent today. What is equally astonishing is how little attention it has received.
While runaway loan growth was the cause of the crisis, loan growth at a more moderate level is a favorable driver of economic growth. This is the seeming paradox that is one of the subjects of this book.
(Note: I will use the terms economic growth and GDP growth interchangeably in this book—GDP growth is simply the sum of private, business, and government spending plus net exports. And income closely mirrors GDP, so whenever I mention GDP growth, it encompasses income growth too.)
When debt growth is too rapid, it brings economic calamity, especially if coupled with private debt levels that are already too high, since high private debt levels make businesses and consumers more vulnerable to economic distress.
In this book, I will argue that for large economies, private loan to a GDP growth of roughly 18 percent or more in five years is the level where that growth is excessive. (I’ll discuss the few exceptions later.) On top of this, apart from any crisis, the accumulation of higher levels of private debt over decades impedes stronger growth. Money that would otherwise be spent on things such as business investment, cars, homes, and vacations is increasingly diverted to making payments on that rising level of debt—especially among middle- and lower-income groups that compose most of our population and whose spending is necessary to drive economic growth. Debt, once accumulated, constrains demand. And debt growth here and abroad over any sustained period always exceeds the income and economic growth it helps create, a troubling phenomenon intrinsic to the system.
Economists refer to the rise in private debt to GDP as part of “financial deepening,” and many view it as a hallmark of economic growth. But just as it is for individuals and businesses, so it is for the economy as a whole—some private debt can be good, but too much is not.
Both the rapid growth of private debt and high absolute levels of private debt get scant attention. Most attention has instead gone to public debt. No one has proposed a systemic way to address this private debt problem.
I hope to help correct that deficit. A key objective of this book is to put the spotlight on private debt, to examine its central place in the economy, and to propose ways to address it so we don’t end up repeating the crisis of 2008.
There is a reason that economists have focused on public debt more than private debt. Public debt seems like much more of a public responsibility—it is “we the people’s” job to manage public debt. Private debt seems off-limits, more like meddling in the private sector and free enterprise with a whiff of Big Brother. Private loan growth—especially in housing and business—is viewed as always being good for us, so “hands off.”
But this is utterly false. GDP growth is influenced by private debt growth as much as, or more than, any other factor. Runaway growth in private debt, especially when combined with high existing levels of that debt, is what has caused most major economic crises of the last century. That makes it a very public issue. Public policy profoundly influences private loan growth, especially through direct and indirect capital requirements imposed on lenders.
There is one more reason private debt is more susceptible to crisis than public debt. Governments with their own currency can, within reason, print money or raise taxes. Private businesses or individuals cannot. Businesses and households more quickly reach the limits of solvency because they must generate income to service and repay the debts.
Many authors have done solid work in portraying the role of private debt in crises—Irving Fisher, Hyman Minsky, Alan Taylor, and Morris Shularick, among others. My principal addition to their work is the specific algorithm for predicting and preventing future crises featured in this book. Of recent note is the helpful work of Atif Mian and Amir Sufi in House of Debt. They argue, as I do, that household mortgage debt was the 2008 crisis culprit and that restructuring mortgage debt is a productive way to inspire growth. Further, they demonstrate that debt drives asset values rather than the other way around, and that the problematic mortgage debt burden that led to the Great Recession fell disproportionately on middle- and lower-income groups. To their work, I add the algorithm mentioned previously for predicting crises, argue that business debt growth is often equally culpable to household debt in causing crises, extend this analysis to all major economies, and emphasize capital requirements as the primary means for preventing future crises.
The Centrality of Private Debt
The financial crisis of 2008—which brought on the Great Recession—arrived in an avalanche of mortgage loans. Builders built more homes than were needed, lenders made mortgage loans that borrowers couldn’t repay, and this orgy of lending itself pushed the prices of homes above sustainable levels, compounding the problem when values collapsed from those artificial highs to levels below loan amounts.
This high mortgage loan growth was part of an overall runaway growth in private debt, and it was private debt growth—not growth in government debt, a lack of consumer or business confidence, or any of the myriad other explanations—that was the immediate cause of the 2008 crisis. US mortgage debt grew from $5.3 trillion in 2001 to $10.6 trillion in 2007, an astonishing doubling in six years. This contributed to high absolute levels of private debt to GDP, a level that reached 173 percent in 2008. In larger, more developed economies, when high growth in private debt is coupled with high absolute levels of private debt, it has almost always led to calamity. Since this buildup of excessive private debt occurred over several years, it should have made the prediction of the crisis and its prevention both possible and straightforward.
But it wasn’t just mortgage loans. Business debt to GDP picked up markedly starting in 2006, and overall private debt increased at a pace rarely seen during the last century in the United States—an increase of 20 percent to GDP in the five years leading up to the crisis. (See Chart 1.)
By contrast, in 2007, the federal government debt to GDP was slightly lower than it had been ten years before and didn’t accelerate until after the crisis. Benign growth in government debt is typical of the period preceding most significant financial crises.
As Chart 2 shows, from the sheer dollar amounts involved, it should be no surprise that private debt would be a primary driver of the economy. This chart shows the increase in key categories from 1997 to 2007—the decade preceding the crisis:
From 1997 to 2007, lenders flooded the US economy with $14.4 trillion in net new private loans. Federal debt increased by a significantly smaller amount—$3.6 trillion—during that same period. An increase in bank loans represents the entry of additional money into the economy. For all the talk of the US government and the Federal Reserve Bank “printing money,” it is private lending that creates the most new money entering the economy. The primary constraint on that new money flooding the economy is the capital requirements imposed on those lenders. Anyone who has been granted a loan and had the proceeds of that loan deposited into his or her account has just witnessed the deposit of newly created money into the system. The idea that savings and deposit growth must precede loan growth and thus leads to loan growth is misguided. Instead, loans create money and are thus a part of what creates deposits.
For this reason, total loans are a more accurate gauge of the amount of money in an economy than the “money supply” (the sum of deposits and currency), which is in large part a by-product of that lending.
The impact of private loans in this period far exceeds the impact of any other category. For example, a 10 percent reduction in taxes for each of these ten years would have brought no more than a $2.5 trillion increase in spending by the private sector, an amount dwarfed by the $14.4 trillion in new private sector spending enabled by this increase in private loans.
As Chart 3 shows, private debt growth is much more closely tied to GDP growth than public debt growth, more evidence that when it comes to debt, it’s private, not public, debt that’s the primary driver of GDP growth. (And when private debt growth sharply exceeds GDP growth, which economists call increased “credit intensity,” it is evidence that too many bad loans are being made. See similar charts for Japan and China in Appendix A. All appendices can be found online at http://www.debt-economics.org/appendix.) Further, as noted by Dr. Steve Keen, private debt growth is also tightly correlated to employment growth (see Appendix B).
Many formally trained economists—as opposed to investment and business practitioners—have not focused on the question of the relationship between debt and growth but instead mainly concern themselves with savings and investment and productivity growth. Productivity gains are, of course, a fundamental driver of growth. But the thesis of this book is that private debt is also a primary driver of growth, especially since it is one of the primary determinants of investment and helps create deposits. Leverage can expand the availability of liquid capital. As leverage increases, so does the amount available to finance business expansion and consumer and household purchases.
Private debt growth is integral to GDP growth. But very rapid growth in private debt often leads to calamity because it is evidence that lenders have lent too much and those loans are leading to the construction or production of too much of something, such as housing. I consider this the “excess credit point.” Our view is that roughly 18 percent growth in private debt to GDP growth over five years serves as the benchmark for when lending is excessive. This is especially true when that level of growth persists for several years and is coupled with 150 percent or more in absolute private debt to GDP. It signals that debt has fueled an increase in the supply of that something (e.g., housing) at a rate faster than sustainable demand. That something can vary from crisis to crisis. In the lead-up to the 2008 crisis, it was largely houses, but in other crises, it has been everything from stocks to skyscrapers.
When I say private debt to GDP grew 18 percent in five years, it means that the private debt to GDP ratio in, for example, 1997, was 18 percent greater than the private debt to GDP ratio in 1992. And if I say that five-year private debt to GDP growth was over 18 percent for two years in a row, it means that, for example, the 1997 ratio was over 18 percent higher than in 1992, and the 1998 ratio was over 18 percent higher than in 1993. I will refer to these five-year growth rates throughout the book.
In fact, whenever you see very rapid loan growth, it is likely that the following three things have happened: First, lenders have lent amounts that will not be fully repaid and financed the building of too much of something. Second, prices have increased well above the trend for those asset categories where the lending has been concentrated (e.g., housing) primarily as a result of that lending, giving both lenders and borrowers a false sense of confidence. And third, because so many bad loans have been made, lenders will incur large losses and require assistance—the very definition of a financial crisis.
A rise in asset values is regularly present in these overlending situations, but it is a dangerously circular phenomenon, because it is the overlending itself that is often the primary driver of this increase. Lending policy itself is a primary driver of values. If everything else is the same and lenders change from requiring a 25 percent down payment on houses to a 10 percent down payment, housing prices will increase—because there will now be more eligible buyers lining up at open houses on Sunday. This loan-policy-driven increase in prices generally encourages even more building and buying because the upward price movement makes housing seem like an even better investment.
Here is one other example: if lenders generally make loans to those wanting to buy a small business at three times the pretax earnings of those businesses, then those businesses will likely be valued at not much higher than three times pretax earnings. However, if most lenders then change their policies to lend at five times pretax earnings, small business values will then tend to increase to an amount of roughly five times their pretax earnings—even if there is no fundamental change in the performance of those businesses. It’s circular.4
It takes only changes in lending policy to change values, but it takes actual income to sustain those values. If lending policy pushes values beyond what can be supported by the borrowers’ incomes—as was the case with much of the mortgage lending in the years before the 2008 crisis—it creates unsustainable values and a false sense of wealth and confidence. Lenders pull back, and booming markets like Las Vegas and Phoenix are suddenly engulfed by “For Sale” signs.
Tripwire: Rapid Private Debt Growth
The press trumpets increases in business loans as a sign that better days are ahead. The housing market is viewed as a key driver of the overall economy, so increases in mortgage loans—which are roughly 70 percent of all consumer loans—are applauded as a sign of the resurgence of this market. Only increases in student loans (and to a lesser extent, credit card loans) are viewed with concern and not because of their impact on the economy, but because of a protective posture toward consumers.
Growth in private loans is generally a positive, but it is a central thesis of this book that such growth can become too high. If credit standards are relaxed and the result is that loans grow too rapidly and too much gets built or produced, that spells trouble.
While US private debt to GDP growth is currently flat, as shown in Charts 4a and 4b (which I refer to as the “debt snapshot”5), the crisis of 2008 came after the point where private loans to GDP had grown 20 percent in five years and total private loans to GDP exceeded 170 percent. (Debt snapshots for all the crises discussed in this book can be found in Appendix C.)
I wondered whether this was also true for the crash of 1929, a crisis for which an endless variety of explanations have been offered. When we reviewed the data, just as in the period before the Great Recession, we saw a pronounced acceleration of lending in the mid- to late 1920s. By 1928, private loans to GDP had increased almost 20 percent, and private debt to GDP reached a towering 161 percent (see Charts 5a and 5b). In fact, this was the first peacetime moment in US economic history when these two “twin peaks” of debt were reached simultaneously, and it was perhaps a time of far less sophistication and resilience in financial markets. Lending in the 1920s was directed more toward business borrowers than was true in the 2008 crisis. In the 1920s, loans poured out to finance skyscrapers, business acquisitions, cars, homes, radios, and much more. Whatever other causes might have contributed to the crash of 1929 and the Great Depression, the rapid run-up in debt was central to the story.
Given the centrality of increased private debt to both the 1929 and 2008 calamities, we looked at the two other largest crises of the last generation to see if private debt played a part there as well: Japan’s crisis of 1991, which followed its “economic miracle” of the 1980s, and the Asian crisis of 1997, which followed the “Asian economic miracle” of the 1990s. As shown in Charts 6a and 6b, in the period from 1985 to 1990, Japan’s private debt to GDP increased by 28 percent and reached 213 percent of GDP. And in the five-year run-up to the Asian crisis of 1997, private loans to GDP for South Korea and Indonesia grew 29 percent and 43 percent, respectively, and in South Korea, private debt to GDP reached 170 percent.
Runaway lending created the Japanese and Asian economic miracles, but those miracles brought crisis.
Though less pronounced, even the Reagan revolution of the 1980s was in part the result of a simultaneous debt surge in both private and public debt that by 1987 had resulted in 19 percent private debt to GDP growth and 41 percent government debt to GDP growth in five years. (See Appendix C.) This followed a thirty-year period ending in 1980 in which, importantly, a long decline in government debt to GDP and increases in private debt to GDP had largely offset each other. As we would expect from our private debt hypothesis, this Reagan-era surge in debt brought the crash of October 1987 and the savings and loan (S&L) crisis of the late 1980s and early 1990s.
Government debt to GDP was relatively benign before the crash of 1929, the US crisis of 2008, and both the Asian crisis of 1997 and the Japan crisis of 1991. In the United States, even with its Middle Eastern wars and a major increase in social program expenditures, federal debt to GDP was no higher in 2007 than it had been a decade before. The five-year increases in government debt to GDP in Japan in 1991 and South Korea in 1997 were both near zero.
In fact, the government debt to GDP ratio sometimes improves in the “runaway lending” period and becomes something of a contraindicator. In Spain, before its recent crisis, government debt to GDP declined by 16 percentage points. The credit boom brings increased income to businesses and consumers, and one result is more tax revenues for the government. Most businesses and consumers feel good, even euphoric, about their financial situation during this runaway lending period. And governments start believing they have found the recipe for economic success, such that the talk is often of economic miracles. But it shouldn’t be, because the other economic shoe is now dangling and threatening to drop.
From our analysis of these crises, our hypothesis is that for major economies, growth in private debt to GDP of roughly 18 percent in five years combined with an overall private debt to GDP ratio of 150 percent or more means that a crisis is likely.
In the United Kingdom, the 2008 crisis came after it had reached 24 percent private credit to GDP growth in five years and 208 percent total private debt to GDP. Judged by the standard of private debt that we are using, the United Kingdom reached worse conditions than the United States. (See Charts 7a and 7b.)
The eurozone—eighteen European Union member states that have adopted the euro (€) as their common currency—has a combined current GDP of $13.1 trillion. However, four countries alone—Germany, France, Spain, and Italy—compose 70 percent of eurozone GDP. Study those four countries, and you have a good sense of the whole.
Spain’s recent crisis came when it had reached private debt to GDP growth of 49 percent in five years and total private debt to GDP of 220 percent; France had reached 21 percent and 150 percent; and Italy had reached 33 percent and 118 percent. Of the four countries, Spain’s lending trends were by far the most egregious (see Charts 8a and 8b). Notably, Germany only reached 122 percent and had a decline in private debt to GDP of 10 percent, but it had a crisis nonetheless because it is so inextricably intertwined with the other eurozone countries. Combined, the four countries had 19 percent growth in private debt to GDP and 144 percent total private debt. Germany is almost a special case because its export rate is so extraordinarily high relative to other countries. In 2012, Germany’s exports to GDP were 52 percent, an enormous number compared to the United States’ 13 percent, France’s 27 percent, and Spain’s 32 percent. Even China—which we think of as a massive exporter—only exports at a level of 27 percent of its GDP. (Therefore Germany is, in some respects, just as dependent on its neighbors as they are on it, though few frame it this way.) Germany’s export dependence on other countries is so high that it is to some degree more useful to think of the eurozone as a single entity—economically at least—where a portion of the rise in private debt of other eurozone countries is to finance purchases from Germany.
As we have shown for other countries, government debt levels were benign and even improving in all these countries in large part because of the growth in private debt and the false prosperity that it brought.
Many of the countries at the periphery of the eurozone were and are in even worse shape. Note the debt snapshots of Greece, Portugal, and Ireland in Appendix C, with Greece’s private debt to GDP growth of 58 percent in five years leading to its crisis. Portugal and Ireland’s current private debt levels are 250+ percent and 300+ percent, respectively, and hang like millstones around their economic necks.
