The Devil's in the Debt

Inequality and borrowing caused the last recession and are still poisoning us.

Grim news in the fall of 2008.

Scott Olson/Getty Images

The 2008 financial crash was a self-inflicted, avoidable economic catastrophe. It wasn't the result of war or political turmoil, or the consequence of competition from emerging economies. It didn't derive from underlying tensions over income distribution or from profligate government spending. 

No, the origins of this crisis lay in the dealing rooms of London and New York banks and shadow banks -- part of a global financial system whose enormous personal rewards had been justified by the supposed economic benefits of financial innovation and increased financial activity. 

Too Big to Fail Many people are legitimately angry that few bankers have been punished. Some were incompetent, others dishonest. Yet they were not a fundamental driver of the crisis any more than the misbehavior of individual financiers in 1920s America caused the Great Depression.

Post-crisis regulatory reforms also miss the mark. Much focus has been placed on making sure that taxpayers never again have to bail out “too big to fail” banks. That's certainly important, but government bailout costs were small change compared with the total harm the financial crisis caused. 

The Federal Reserve has sold all its capital injections into banks at a profit, and made a positive return on its provision of liquidity to the financial system. Across the advanced economies, bailout and support costs will be, at most, 3 percent of gross domestic product. 

The full economic cost is far bigger. Advanced economies' public debt on average increased by 34 percent of GDP between 2007 and 2014. More important, national incomes and living standards in many countries are 10 percent or more below where they could have been, and are likely to remain there in perpetuity.

Such losses could happen again, and neither bankers threatened by prison nor a no-bailout regime will guarantee a more stable financial system. A fixation on these issues threatens to divert us from the underlying causes of financial instability.

The fundamental problem is that modern financial systems inevitably create debt in excessive quantities. The debt they create doesn't finance new capital investment but the purchase of existing assets, and above all real estate. Debt drives booms and financial busts. And it is a debt overhang from the last boom that explains why recovery from the 2007–2008 crisis has been so anemic.

Debt creation is a form of economic pollution. Heating a house or fueling a car is necessary, yet the carbon emissions are harmful to the climate. Lending a family money to buy a house is socially useful, but too much mortgage debt can make the economy unstable.

Debt pollution, like environmental pollution, must be constrained by public policies that go beyond current regulatory reforms. We must focus on the most important causes of the 2008 crisis and recession. Those lay in the specific nature of debt contracts, and in the ability of banks and shadow banks to create credit and money.

Throughout history, religious and moral philosophers have been wary of debt contracts. But economists convincingly argued that debt contracts play a crucial role in capitalist growth. Debt that delivered a predefined return made it possible to mobilize savings and capital investment for 19th century railways and 20th century manufacturing plants. These developments might not have happened if investment had to take a more risky equity form. 

But debt contracts also have adverse consequences: They're likely to be created in excessive quantities. And the more debt an economy assumes, the less stable that economy will be. The dangers of excessive debt creation are magnified by the existence of banks and the predominance of certain kinds of lending. Almost any economics or finance textbook will describe how banks take money from savers and lend it to borrowers, allocating money among investment options. 

This is dangerously fictitious because banks don't lend out  existing money. They create credit, money and purchasing power that didn't previously exist. And the vast majority of bank lending in advanced economies doesn't support new business investment but funds either increased consumption or the purchase of existing assets, in particular real estate. 

As a result, unless tightly constrained by public policy, banks make economies unstable. Newly created credit and money increase purchasing power. But if the most desirable land in urban areas is in scarce supply, the result is not new investment but asset price increases, which induces yet more credit demand and yet more credit supply. 

At the core of financial instability in modern economies lies this interaction between the infinite capacity of banks to create new credit, money and purchasing power, and the scarce supply of urban land. Self-reinforcing cycles of boom and bust are the inevitable result.

If debt can be a form of economic pollution, a more complicated and sophisticated debt creation engine can make the pollution worse. The net effect of pre-crisis financial innovation was to give us the credit cycle on steroids, and the crash of 2008. 

The depth of the recession that followed, however, is explained less by the internal features of the financial system than by the simple fact that, after years of rapid credit growth, many companies and households were overleveraged. Once confidence in rising asset prices cracked, they cut investment and consumption in an attempt to reduce their debts. That attempted deleveraging has stymied economic recovery. 

The crash was thus caused both by excessive real economy leverage and by multiple deficiencies in the financial system itself. But the main reason recovery has been slow and weak is not that the financial system is still impaired, but because of the scale of the accumulated debt burden.

For 50 years, private-sector leverage -- credit divided by GDP -- grew rapidly in all advanced economies. Between 1950 and 2006, it more than tripled. Was this credit growth necessary? 

Leverage increased because credit grew faster than nominal GDP. In the two decades before 2008, credit in most advanced economies grew about 10 percent to 15 percent a year, versus 5 percent GDP growth. At the time, it seemed that such credit growth was required to ensure adequate economic growth. 

If central banks increased interest rates to slow the credit growth, standard economic theory said lower real growth would result. The same pattern and the same policy assumptions can now be seen in many emerging economies, including China: Each year, credit grows faster than GDP so that leverage rises and credit growth drives economies forward. 

But if that is really true, we face a severe dilemma. We seem to need credit to grow faster than GDP to keep economies growing at a reasonable rate, which leads inevitably to crisis, recession and debt overhang. We seem condemned to instability in an economy incapable of balanced growth with stable leverage.

Is that true, and are future crises like the one in 2008 inevitable? 

My answer is no -- but only if we restrain the underlying drivers of credit intensity. One is the increasing importance of real estate in modern economies. In all advanced economies, real estate accounts for more than half of all wealth, most increases in wealth and the vast majority of lending. Real estate is also bound to become more important in the future. 

Another driver is increasing inequality. Richer people tend to spend a smaller share of their income than do middle-income and poorer people. Growing inequality will therefore depress demand and economic growth unless the increased savings of the rich are offset by increased borrowing among middle- or low-income earners. Rising credit and leverage become necessary to maintain economic growth, yet lead inevitably to crisis. 

These factors result in a growth of debt that, contrary to the textbook assumption, doesn't support productive capital investment and new income streams with which debt can be repaid. As a result, they drive increases in leverage that are not required to spur economic growth, yet will produce severe economic harm.

In part 2 of this excerpt, I will explain the policies needed to create less credit-intensive, more stable economies and to reduce the risk of future crises.

(This is the first of two excerpts from "Between Debt and the Devil: Money, Credit, and Fixing Global Finance," published this month by Princeton University Press.)

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