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How to Predict and Prevent a Financial Crisis

 7 min read / 

After the 2008 financial crisis, the Queen famously asked academics at the LSE “Why did nobody notice it?” Indeed this is a very good question. However, she should have elaborated and asked: why have economists failed to predict every crisis in the past 150 years? Surely with their use of complex mathematics and some of the best brains, they should be doing better than this. Andy Haldane, Chief Economist at the Bank of England, put it rather nicely in saying that the economics profession is “to some degree in crisis”.

In order to stand a chance at forecasting an upcoming recession, it is vital for economists to have a true understanding of the macroeconomic system one lives in. Fair enough, up until 2007 New Keynesian economic models seemed to accurately represent the real world. Economic bodies like the OECD were forecasting a rosy future. Seemingly the recipe for economic stability had been found. Then the biggest financial crisis since the Great Depression erupted with disastrous effects on the global economy. Andy Haldane made a good comparison between the financial crisis and the infamous 1987 “Michael Fish” moment, where everyone was assured that a devastating hurricane would not hit – before it did.

The Wrong Models?

Clearly, something is wrong with DSGE economic models. In order to forecast financial crises, one first needs an economic model that can actually generate real-world crises. There is a central feature of the real world that is not considered by mainstream economists and their models – the level and acceleration of private debt. Debt is regularly referenced when discussing people’s own economic difficulties, yet it is surprising that it is not seen at all in macroeconomic models. Bernanke said that changes in debt “should have no significant macroeconomic affect.” Lending is simply portrayed as the transfer of spending power. This belief has recently been debunked by the Bank of England which confirmed that lending is actually additional spending power being created and destroyed. Aggregate (total) demand in an economy – a key determinant of economic growth – is, therefore, the sum of GDP and credit (growth of private debt), as opposed to simply GDP.

With debt now factored in as part of the macroeconomy, its danger can be realised. During good times, banks, firms and individuals take on more debt to purchase goods and in pursuit of profits. Private debt in an economy cannot increase indefinitely, and inevitably at some point, it falls. When this happens there is a subtraction from aggregate demand and fall in economic growth – possibly even enough for there to be a recession! So what seems like periods of ‘economic stability’, are in fact the planting of seeds for yet another financial crisis.

This all sounds good, but where is the proof? Thanks to economist Steve Keen’s research, there is remarkably supportive empirical evidence. Prior to the financial crisis, private debt in the US and the UK was growing at an unprecedented rate. In 2008, credit turned negative for the first time since the Great Depression, causing the recession.

Source: Open Democracy

Source: Open Democracy

As expected, credit is also tied to employment:

Source: Open Democracy

Familiar dynamics even took place in Japan’s ‘Lost Decade’. Banks were providing finance for technology and industry, as well as for speculation in assets and property in what was called a ‘Bubble Economy’. When the credit growth that fuelled this halted, Japan’s crisis was triggered. Another crisis could be cited, but that is not necessary thanks to Richard Vague who identified a regularity in every economic crisis over the last 150 years: A private debt to GDP ratio of 150%+, and a 17%+ increase in credit to GDP over the five years prior to a crisis. This profound connection confirms that credit is a major cause of booms and slumps in economies around the world. Even more significantly, it provides a baseline for which future financial crises can be predicted.

What to Look at

From Richard Vague’s research, it can be deduced that to successfully predict an upcoming recession, the level of private debt in an economy and its rate of increase must be inspected. A good rule of thumb would be to look at countries that have a private-debt to GDP ratio in the range of 120% – 150%, along with a 10% – 17% increase in credit to GDP over the last five years. If an economy’s values exceed both of these ranges, it is an imminent danger zone. One particularly influential country that is currently at risk is China. In response to the 2008 financial crises, its government instructed banks to lend heavily to property developers. However this came at a price; private debt has risen from 120% of GDP in 2008 to over 200% in 2017. With China accounting for 16% of global GDP, its crisis will have significant impacts on the global economy.

Source: Credit Suisse

It is all good knowing that a crisis will hit, but how could this be prevented? Given that a government has actually identified the issue, there are a few things they could do. An increase in government spending could be utilised to indirectly bring down the level of private debt. However, this may be insufficient. This can be seen in Japan where government spending to GDP had increased from 150% in 2008 to 220% in 2016, and yet, private debt to GDP has remained at around 165%. Another way to reduce private debt is through debt forgiveness.

However, this is unfair to savers and would surely face negative reactions. A more acceptable method would be an increase in the money supply which indirectly reduces the debt burden. But to sufficiently dilute the effect of private debt to an appropriate level, the amount of money that would need to be injected is huge. The best solution is a combination of the above two. There could be a direct injection of money into all bank accounts, however, it is mandatory that the first use of it is to pay off debt. With this, private debt is directly reduced in a practical manner.

The Solution

The solution proposed would merely reset the clock for another bubble. In order to prevent excessive private debt creation in first place, banks must stop financing asset speculation, and instead, lend more to businesses. This would be difficult to achieve as a bank’s business model discourages it from funding risky entrepreneurs. Furthermore, in this system, people are encouraged to undertake greater leverage (e.g. when competing to purchase a house).

Current forecasting is so poor primarily due to the delusional vision of the macroeconomy that is widely accepted. The consequence of credit-fuelled growth is clear, yet it is still at odds with mainstream economic thought. It is simple to identify countries that could fall victim to a crisis and there are measures that could be taken to escape this trap. Nonetheless, in order to truly prevent the possibility of crises of this nature, there is much to be done. Having political leaders and their economic advisers understand credit bubbles is the first step. Then, banking reforms and sensible policy can finally be discussed.

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