The origins of the next crisis

William White, the former chief economist at the Bank of International Settlements (BIS) gave an important speech at George Soros’ Inaugural Institute of New Economic Thinking (INET) conference in Cambridge.  While everyone is casting about for the one magic bullet solution which would have prevented this and future crises, he placed the blame for the credit crisis on short-termism, pointing the finger most notably at economists and their models. White said that the models almost all economists use are ‘flow’ models which leave no room for ‘stocks’ and thus completely miss unsustainable secular trends.

In essence, White was saying: "it’s the debt, stupid."  When aggregate debt levels build up across business cycles, economists focused on managing within business cycles miss the key ingredient that leads to systemic crisis. It should be expected that politicians or private sector participants worried about the day-to-day exhibit short-termism. But White says it is particularly troubling that economists and their models exhibit the same tendency because it means there is no long-term oriented systemic counterweight guiding the economy.

This short-termism that White refers to is what I call the asset-based economic model. And, quite frankly, it works – especially when interest rates are declining as they have over the past quarter century. The problem, however, is that you reach a critical state when the accumulation of debt and the misallocation of resources is so large that the same old policies just don’t work anymore. And that’s when the next crisis occurs.

Let me take you through my thinking on this step by step. This is a pretty long post because I want to cover a lot of topics. But they should fit together from the economic models to the likely outcome.

The topics are:

  • The concentration of economic models on flow and the failure to model debt stocks
  • The empirical evidence that debt stocks have been increasing across a broad swathe of private sector dimensions
  • The doom loop of ever lower interest rates that allows debt stocks to increase
  • The effect that a secular decrease in interest rates has on an economy’s ability to increase debt loads
  • The evidence that monetary stimulus is no longer effective in allowing debt levels to increase
  • The likely outcome of a balance sheet recession and a secular decrease in debt

The concentration of economic models on flow

First, from a post called "Why economists failed to anticipate the financial crisis," I echoed White’s sentiments when reviewing a widely read piece by Paul Krugman on why economist’s failed to anticipate the crisis:

Paul Krugman is a Keynesian. So, his prescription is fiscal stimulus. Have the government pump money into the economy and it will alleviate some of the pressure for the private sector. There is some merit to this argument on stimulus. Many Freshwater economists say monetary stimulus is what is needed. If the Federal Reserve increases the supply of money, eventually the economy will respond. This is what Ben Bernanke was saying in his famous 2002 Helicopter speech at the National Economists Club.

Yet, I couldn’t help but notice that Krugman mentioned the word debt only twice in 6,000 words. In fact, it is in the very passage above where Krugman uses the term for the only time in the entire article. And here Krugman refers to government debt; no mention of private sector debt whatsoever.  I have a problem with that….

This economic Ponzi scheme is what I have labeled the asset-based economy. As with all things Ponzi, it must come to a spectacularly bad end. One can only Inflate asset prices to perpetuate a debt-fuelled consumption binge so far. At some point, the Ponzi scheme collapses. And we are nearing that point.  We still have zero rates, massive amounts of liquidity, manipulation of short-term rates, manipulation of long-term rates, and bailouts galore a full 15 months after Lehman Brothers collapsed. This is pure insanity.

The reason economists failed to anticipate the crisis is because they were fixated on avoiding downturns and driving the economy to unsustainable growth rates by using debt to consume today what will be earned in the future. Debt is the central problem. When debt to income or debt to GDP doubles, triples and quadruples, it says you have doubled, tripled and quadrupled the amount of future earnings you are consuming in the present (see the charts here and here). That necessarily means you will have less to spend in the future. It’s not rocket science.

Private sector debt stocks have been increasing

The second post of charts I referenced above (A brief look at the Asset-Based Economy at economic turns) gives you a visual of the massive leveraging in the U.S. economy we have witnessed over the past generation. The charts demonstrate that debt has been increasing on a secular basis across the entire private sector despite numerous downturns.

Debt levels at the end of Q2 2009 are 357% of GDP, a massive increase from the 160% that prevailed in 1982. The data clearly demonstrate that since 1982 the U.S. has relied on an increase in debt, even during recession, to avoid downturns…


Government Debt

This chart is fairly benign when you look at aggregate levels as a percentage of GDP.  Pundits forecasting an imminent increase in U.S. interest rates because of too much government debt have obviously not looked at these data. However, what is striking is the huge and unprecedented surge in debt as a percentage of GDP since the latest downturn hit.  This discrepancy to nominal GDP cannot go on indefinitely…


Household Debt

…the increase in debt levels in the household sector are pretty astonishing. In 1952, it began at 24% of GDP, rising to around 40% by 1960, where it remained through the Ford presidency. Afterwards, it shot up again to its present 97%, four times the level a half-century ago…


Mortgage Debt

This pattern is largely the same as the previous one.


Consumer Credit Debt

Consumer Credit seems to be much more volatile than mortgage credit.  You can see the fluctuations in comparison to nominal GDP are greater.  And the absolute amounts are much less than in the mortgage market. The conclusion I draw from this is that,to the degree household debt levels have increased unsustainably, it is mortgage debt which is to blame.


Non-Financial Business Debt

There is a lot more volatility in capital spending as reflected in non-financial business debt levels as well.  Nevertheless, there has been a secular increase in debt levels of the business sector, from 30% in 1952 to the present 78%…


State and Local Government Debt

Since the 1960s, state and local government debt levels have been basically flat as a percentage of GDP…


Federal Government Debt

This chart looks basically the same with the total government debt charts as Federal Government debt dominates.  What you should notice is that debt levels are lower now than they were in the 1950s and have just passed the post 1950’s high-water mark in 1993 of 49%…


Financial Services Debt

…Not only do Financial Sector debt levels rise from negligible to percentages well over 100% of GDP, but the entire post-1982 period sees zero decline compared to nominal GDP until last quarter.

What conclusions can one draw here?

  1. The financial services sector is six times more important than in 1982 when its debt is measured as a percentage of GDP.
  2. The financial sector protected the American economy since 1982 by increasing its debt burden relative to nominal GDP even during recession.
  3. The financial services sector contracted in Q2 relative to GDP for the first time since 1982.  If this is a rear-view mirror view, that means recovery could continue. However, if this is a canary in the coalmine, that is negative for the U.S. economy. This number bears watching.


Foreign Debt



The Doom Loop of ever lower rates and increased leverage

These are not just increases in relative debt loads. We are talking about debt increasing at a rate out of all proportion to the underlying rate of economic growth. This increase in relative debt burdens is quite unhealthy and has created an ever-lower interest rates to prevent economic calamity followed by an ever-increasing severity of financial crisis, the Doom Loop.

What is the doom loop?

It is the unstable, crash-prone boom-bust lifestyle we have now been living for some 40 years, where a cycle of cheap financing and lax regulation leads to excess risk and credit growth followed by huge losses and bailouts. With interest rates near zero everywhere, the doom loop seems to have hit a terminal state where debt deflation and depression are the only end game unless serious reform measures are taken.


Source: The doomsday cycle, Peter Boone and Simon Johnson

Because these measures themselves are deflationary and depressionary (with a small-d), in my view, they will not be taken.

Make Markets Be Markets: The Doom Loop

Low interest rates make a debt-servicing mentality seductive

Why has this debt build up been allowed to continue? I owe these changes to the debt-servicing mentality enabled by a secular decline in interest rates.

The debt service mentality

During the boom and bubble which led up to the financial crisis, many in the financial community looked to debt service costs in the private sector as the only relevant metric to gauge whether debt levels were sustainable – both for individuals and in the aggregate. This was bubble mentality which I must take to task now now that we are seeing it crop up in discussions about public sector debts as well. If not, we will likely see some major sovereign bankruptcies in the not too distant future.

The debt service mentality goes a bit like this: Bob and Shirley are looking for a new house. They make $6,000 per month. So they can legitimately afford to pay $2,000 per month for their mortgage. With a 7% interest rate on a 30-year fixed mortgage, that means they can afford to borrow $300,000 – or just over four times income. So, if Bob and Shirley put 10% down on the purchase of a home, they can afford one that costs $330,000.

The problem is when this is the only constraint on borrowing.  What happens to house affordability when Bob and Shirley’s 30-year rate drops to 5%? Suddenly, they can ‘afford’ a $375,000 loan. What if they get a 4% rate? Now, they can afford $425,000 in debt – a loan  more than 40% larger than at 7% and a massive 5.9 times income. Anyone who has a mortgage recognizes this math as integral to the home buying process.

The lower interest rates go, the more affordable any debt load becomes when debt servicing costs are the only constraint. As rates drop toward zero percent, theoretically Bob and Shirley could afford to buy practically any house.  But, of course, interest rates don’t move in one direction.  If rates were to move up significantly when Bob and Shirley wanted to move house, they would face a serious problem. In this sense, artificially low interest rates are toxic. And therefore pointing to debt servicing costs as the only metric of affordability and debt constraints is bubble finance plain and simple.

Here I am talking about bubble finance, not Ponzi finance. In the Ponzi finance schemes in the U.S., we saw fixed rates substituted with lower but unsustainable adjustable rates. Eventually affordability became passé as no-doc, zero-percent down, ninja loans became the norm. In the end, the Ponzi debt scheme collapsed in a heap – as it always must. That’s what we saw in the blow-off stage of the bubble after Greenspan lowered rates early this decade.  But, the debt servicing mentality is what preceded it.

On the sovereign debt crisis and the debt servicing cost mentality

Another economic boom?

So, you have economists using flow models that completely disregard debt. This gives intellectual cover to the asymmetric monetary policy of flooding the system with money every time the economy hits a rough patch. As a result, private sector agents increase debt levels dramatically across the board. All of this continues for a generation because of a secular decline in interest rates which allows the servicing of ever greater debt burdens.

And don’t think for a second, this can’t continue through another cycle.

This dynamic can continue for a very, very long time. In the United States, by virtue of America’s possession of the world’s reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.

So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.

The boy who cried wolf

A soothsayer who counsels against this type of economic policy, but who warns of impending collapse will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at – only to resurface in 2007 and 2008 with their new tales of woe….

The fact is: low quality growth does not lead to immediate economic calamity. It can continue through many business cycles. Even today, it is wholly conceivable that we could experience a multi-year economic expansion on the back of renewed monetary and fiscal expansion.

printing money works.  It does goose the economy as intended and it can induce a cyclical recovery.

Nevertheless, the recovery is likely to be of poor quality due to significant malinvestment. Debt levels will rise and capital investment will be directed toward riskier enterprises. Look at what’s happening in China.  Are you telling me stimulus is not working? It most certainly is.

In the west, stimulus is also working. It is designed to stop people from hoarding cash and to consume. It is also designed to get people out of savings accounts and into riskier asset classes. it is doing just that.

The critical state

But, at some point, all of this must come to an end. In this cycle, we have already reached a critical state in which monetary policy is ineffective. As in Japan for the past decade or more, everywhere we hear that the demand for money has decreased with large business building up significant amounts of cash on balance sheets. Meanwhile small business is starved for capital.

A quote from Paul Samuelson’s 1948 textbook bears noting.

Today few economists regard Federal Reserve monetary policy as a panacea for controlling the business cycle. Purely monetary factors are considered to be as much symptoms as causes, albeit symptoms with aggravating effects that should not be completely neglected.

By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, “no nothing,” simply a substitution on the bank’s balance sheet of idle cash for old government bonds.

Obama forgot Samuelson when he told fat cats to start lending

The reason this crisis is different is that we have reached the lower bound of monetary policy, zero rates.  We simply can’t lower rates anymore. In fact, because of the ineffectiveness of monetary policy, policy makers have taken to other unorthodox methods of policy to get credit growth back. None of this has yet had enough stimulative effect to increase credit. So, where are we headed?

Balance sheet recession

Recovery or not, weak consumer spending will last for years. I happen to think that we are in the midst of a weak cyclical upturn (predicated on the last shot of stimulus we could provide). But, once this particular cycle starts to fade, we are going to be in a different world, the world Japan is now in.

Listen to Richard Koo tell you about what we can anticipate going forward and why normal policy measures won’t work. He makes a very compelling argument.


Koo has suggested that Japan’s enormous public sector debt burden owes to the balance sheet recession Japan is suffering and sees a similar dynamic likely to hit the western world. This means the private sector is in a secular deleveraging trend. I outlined some of my thinking based on Koo’s model in the consumer spending post linked above. 

But, the flaw in Koo’s remedy is that it relies on fiscal stimulus, which has been used to maintain the status quo ante, resulting in a misallocation of resources and continued overcapacity and economic malaise (see Revisiting the sectoral balances model in Japan).

Moreover, I see the increase in public sector debt in a balance sheet recession as a socialization of losses.  If you look at any economy that has suffered steep declines in GDP, what we have seen are a reduction in tax revenue, an increase in government spending and bailouts. This is true in Ireland, the UK, and the U.S. in particular. In effect, what is occurring is a transfer of the risk borne by particular agents in the private sector onto the public writ-large.  The magnitude of this risk transfer via annual double digit increases in debt-to-GDP is breathtaking.

Finally, these debt levels are unsustainable for the world as a whole.  Japan has been able to run up public sector debt to 200% of GDP because it alone was in a balance sheet recession and its private sector was willing to fund this debt. But, things are vastly different now. Sovereign defaults are likely. The debt crisis in Greece is a preview of what is to come.  Those debtors which attempt to most increase the risk transfer onto the public will soon find debt revulsion a very real problem.  And what will invariably happen is that a systemic crisis will ensue. Fiscal stimulus is warranted, but deficit spending as far as the eye can see risks a catastrophic outcome. This is a very different world than we lived in during the asset based economy. But it also a different world than Japan has lived in over the last two decades.

There are four ways to reduce real debt burdens:

  1. by paying down debts via accumulated savings.
  2. by inflating away the value of money.
  3. by reneging in part or full on the promise to repay by defaulting
  4. by reneging in part on the promise to repay through debt forgiveness

Right now, everyone is fixated on the first path to reducing (both public and private sector) debt. I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that.  More likely, the western world’s collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.

And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken.  The question still up for debate is regarding systemic risk, contagion, and  economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.

  1. Las Vegas Real Estate Paul says

    Well worth reading..

  2. haris07 says

    This is an excellent summary Ed. I am a regular reader and always appreciate your insights, but this one piece is very good. It goes beyond articulating any one way to go forward – too many born again MMT’ers and Koo worshippers seem to be trumpeting a deficit spend (and money print) to eternity way out of this mess. After thinking through this a while, I agree with your thesis – that just promotes malinvestment, socialization of losses, penalizes savers and people who have led a more prudent life. Eventually, this will lead to a society that gets doomed into thinking “why work, govt will bail us out with more cheap money anyway, so lets just build asset bubbles and live off of that” mentality and a slow and inevitable decline of society begins. While Austrian debt destruction in and of itself is perhaps not a solution, I think it has to be part of a solution – debt needs to be destroyed, people who speculated excessively need to be penalized, fiscal deficit can be used to cushion the blow a little and prevent a total melt down. Banks need to take writedowns and if shareholders (or even bondholders) need to be wiped out, so be it.

    Anyway, your thoughts and insights are appreciated and have helped me get to the heart of all this in a clear fashion!

    1. Edward Harrison says

      I am a lot less sanguine about sovereign debt. Call it the paradox of deleveraging. When (nearly) all countries are deleveraging at the same time, it creates a demand curve shift which increases fiscal imbalances. In the Eurozone, this will mean that the weakest debtors will face solvency problems going forward (debt not issued in sovereign currency).

      In the US and the UK, this is less of a problem given the debt having been issued in the national currency. The UK has the extra benefit of having a relatively long-dated debt structure, which reduces funding needs when rolling over expiring debt issues.

      However, debt revulsion can still manifest itself via increased interest rates and/or a depreciating currency. If we do see increased interest rates in the U.S. or the U.K (which we did not see in Japan, by the way), then the debt servicing mentality becomes a problem because suddenly you have a much bigger deficit via increased interest payments.

  3. praxis22 says

    Not that Krugman needs defending, but in his defence, and having read the piece in question I’d have to say that he was answering the question, “why did economist get it so wrong” and not “what caused the crisis” as such he focused on models and ideology and the cultural reasons for those, as well as aiming a few well placed digs at rational expectations, Fama and Chicago. Debt is the problem, but he wasn’t addressing the problem, he was addressing why people who do this for a living didn’t see the problem.

    Also “in defence of deficits” :)

    1. Edward Harrison says

      understood. but others of an Austrian persuasion noticed Krugman’s debt oversight as well and I think this goes back to White’s comments about flow models.

      I haven’t yet read Mark Thoma’s post from INET but I believe he also came away with similar conclusions. Let me get the link.

      Here it is:

      1. praxis22 says

        Nice find, but it’s late, and the fact that my brain can effortlessly translate DSGE to Dynamic Stochastic General Equilibrium, probably means I should step away from the keyboard while I still have a chance :)

  4. purple says

    William Buiter, for one, has proposed a world of negative interest rates to get beyond lower bound, and along with that ‘abolishing currency’. Obviously that would have to be part of it. (Although Buiter nobly writes that “As a concession to the poor, we could keep a limited number of 1$ and 5$ bills in circulation.”)

    I suspect that is the direction we will be heading because there is also a lot of profit potential in forcing electronic transactions. Buiter now works at Citi.

  5. Anonymous says

    I think White’s phrase of “short termism” is a bit charitable. I would argue he could easily use the phrase “not rigorous” and get across the same point.

    It would be like a financial analyst just focusing on the income statement of a company and ignoring the balance sheet.

  6. Anonymous says

    One of he most “AMAZING” articles I’ve read . . . maybe E V E R ? ? ?

    My hat is off to the author (Edward Harrison).

  7. Anonymous says

    Sorry . . . I forgot the “T” in the word “the” . . . I’m such a dope sometime . . . But Mr. Harrison’s explanation . . . Is simply amazing and, regretfully, true. (sigh)

  8. Anonymous says

    Not sure how to e-mail Mr. Harrison. But I sincerely think he’s “BRILLIANT”. None of this left versus right or political nonsense . . . He just speaks the truth of where we’ve been and where we’re heading (double sigh).

  9. Anonymous says

    Hey marketpective . . .
    Sure hope U get this. I’m a Canadian and have lived in a socialist state. and seen the ruins to health-care and many, many taxes.

    My Mom (God rest her soul) . . . waited 2 1/2 years ( 32 months ) for her hip replasement. That’s what your looking for under OBAMACARE I guess.

  10. Anonymous says

    Guess whatever I say won’t change how Americans think. It sure won’t bring my MOM back. But she coulda lived alot longer.

    Please don’t EVER . . . EVER think Government Health-Care . . . is ever gonna make for better anything.

    I’m a victim against my wishes . . . I guess . . .

    (sure miss my mom) sigh . . . sorry for all that. Sincerely.

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