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