The Dangers of Private Sector Credit Overgrowth

A paper by Moritz Schularick and Alan Taylor at the National Bureau of Economic Research (NBER) entitled "Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870 to 2008" looks at the behaviour of private sector money (i.e. the supply of money), credit (i.e. loans) and output (i.e. GDP) over the very long-term and is used to study the rare events that are associated with financial crises for 14 developed economies over almost 140 years.  By looking at regular business cycles and events like depressions and financial crises, the authors are able to examine how the dynamics of money and credit have shifted over the long-term and what impact these changes have had on the economy.  Their research sought to answer three questions:

1.) which key facts can be derived from looking at long-term trends in money and credit?

2.) how have the responses of money and credit to financial crises changed over time?

3.) what role do credit and money play in creating monetary crises?

From the dataset which covers the years from 1870 to 2008 for 14 developed economies, the author found that there were two distinct eras of financial capitalism:

1.) from 1870 to 1939, money and credit were volatile but over the long-term, they maintained a roughly stable relationship to each other and to the size of the economy as measured by GDP, excluding the Great Depression when money and credit collapsed.  During this period, broad money grew at an average annual rate of 3.57 percent and loans rose by an average annual rate of 3.96 percent.

2.) from 1945 to 2009, money and credit began a long post-war recovery, surpassing their pre-1940 level compared to GDP by 1970.  After 1970, credit grew more rapidly than broad money through both increased leverage and funding from the non-monetary liabilities of banks.  This is largely because central banks have supported the growth of the monetary base, keeping bank lending at high levels.  During this period, broad money grew at an annual average rate of 8.61 percent and loans grew at a much faster annual average growth rate of 10.92 percent.  Since 1950, there has been a rapid decline in safe assets on banks' balance sheets, particularly in the share of government securities as shown on this figure:

This means that we have entered an age of unprecedented financial risk and leverage and that the economy today is more heavily reliant on private sector credit than it has been throughout the past century and a half.

These two financial eras mentioned above are clearly shown on this figure:

The figure shows us that money and credit grew slightly faster than output from 1870 to 1890 (the classic gold standard era), remained stable until the credit boom of the 1920s and then collapsed during the period from the Great Depression to the Second World War.  After the Second World War, bank loans rose very quickly compared to output and compared to broad money.  The increase in debt was related to new sources of funding which added to non-monetary bank liabilities. (i.e. through the issuance of debt securities)  As well, you will notice that the ratio of bank assets to GDP rose markedly after the 1950s, however, as I noted above, many of these assets are considered to be "less safe" than the government-issued securities that they replaced.  By the year 2000, loan-to-money and asset-to-money ratios were around twice their pre-war average.  

Although the relationship between money and credit varied somewhat by country prior to the Second World War, this pattern was repeated in all fourteen advanced economies in the study during the period from the 1870s to the 2000s as shown on this graphic:

As the authors put it:

"This is a global story of decades of slowly encroaching risk on bank balance sheets, not one confined to a few profligate nations."

The authors also looked at money, credit and the consequences of financial crises over the 140 year period and found that there were two very different monetary and regulatory frameworks in place, mainly the shift away from gold to fiat money, the greater emphasis on bank supervision and deposit insurance and the greater role of the Lender of Last Resort.  The authors found that, despite the implementation of financial stabilization policies after the Second World War, the impact of financial crises in the years between 1945 and 2009 have been just as potent as they were in the pre-Second World War era.  In fact, even when the Great Recession is excluded from the post-Second World War era, while there were fewer financial crises, those that occurred remained quite severe when measured using declines in GDP.  In a recent interview, Alan Taylor notes that a study of 200-plus recessions it was found that when there is a run-up in loan-to-GDP ratios, the risk of financial crises become more likely and recessions tend to be more painful.  When looking at the period from 2008 to the present through the lens of historical credit and GDP data, it becomes much less surprising that the Great Recession was a deep recession followed by a long, mediocre recovery.

The notion that financial crises are booms in credit that have gone bad is not a new one.  We live in the "Age of Credit" where financial innovation combined with easing of the banking regulatory system has allowed lending to uncouple from money which has set in motion an unprecedented expansion in the role of credit in the world's economy.  The world's economy has never experienced a run-up in credit like it has since the 1970s.  This could result in one of three outcomes:

1.) The economy gradually delevers and the credit-to-GDP ratio drops to pre-1970 levels when economic growth was strong and there were no financial crises.

2.) The economy stabilizes at the current credit-to-GDP ratio over the long-term.  Households and companies do not lever up and the banking sector does not expand their balance sheets.

3.) The economy sees the credit-to-GDP ratio rise further and eventually the banking systems of all developed economies become larger than their national economies as was the case in Iceland where the banking system imploded.

This study shows us that individuals, governments and central bankers ignore the growing role of credit at their own peril.  By controlling the growth of credit, we might just avoid another Great Recession, although, the recent growth in consumer and corporate debt suggests that this scenario is highly unlikely.