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