What might trigger the next financial crisis and recession? Private debt tops the list, explains an economics professor who heads the School of Economics, Politics and History at Kingston University. It’s a potent threat, in part because debt has increased since the 2008 financial crisis and interest rates appear poised to trend higher in the years ahead. Yet the risk bound up with private debt is widely underappreciated in the economics profession, Keen explains in his recent book:
“Even after the [last] crisis, mainstream economists still reject out of hand arguments that the aggregate level and rate of change of debt matters,” he writes. History suggests otherwise, Keen insists, citing the empirical record as proof. The Capital Spectator recently asked Keen for a summary of why debt matters for the business cycle and how the US and other economies currently rank on this critical risk factor.
What is the basic explanation for why private debt is a critical factor for evaluating the potential for a financial crisis?
The basic reason is that bank lending creates money, which is then spent by the borrower. The assets of the banking sector rise (this is the change in debt) and their liabilities rise equally (this is the credit-based increase in the money supply). This adds to demand, but it comes at the cost of an increased claim by the banking sector on the cash flow generated by the non-bank sectors of the economy. When debt is paid down – or the borrower goes bankrupt – money is destroyed, which reduces demand. Money that would otherwise be spent on goods and services is instead cancelled against outstanding debt, or reduces the equity of the banking sector when bankruptcies exceed the loan loss provisions of the banks.
When debt levels are relatively low, this is not a problem: in the 1950s, when US private debt was less than 40% of GDP and interest rates were around 3%, servicing debt took only about 1% of GDP. Now, with private debt four times as high relative to GDP, debt service takes around 5% of GDP – even with low rates today. Changes in debt, which are identical to the creation or destruction of credit-based money, reached 15% of GDP in the US in 2007, and plunged to minus 6% in 2009. That caused a huge collapse in aggregate demand, which caused the Great Recession.
