As the financial crisis approached in 2008, mainstream macroeconomic models by design ignored the role of finance and debt and thus managed to miss the oncoming freight train. Fortunately, several economists, e.g., Steve Keen, Michael Hudson, Dean Baker and Wynne Godley, etc., did not. They linked the "Great Moderation" (low inflation and moderate growth) to the rise in indebtedness. From 2003 to 2006, household (mainly mortgage-related) debt increased annually by double-digits, pushing up house prices before unraveling in 2007-2008. And we all remember what followed.
We have argued elsewhere that the decision by mainstream macroeconomics to ignore finance and credit was based on the assumption (embedded in Loanable Funds Theory) that credit cannot exceed already existing savings and thus has no effect on the real economy (see here). This assumption rendered these models useless to anticipate the oncoming crisis. In a sad twist, former American Economics Association President and Nobel Prize winner Robert Lucas defended this “miss” in 2009 with the following statement:
This statement obviously did not do much to assuage people who endured job/business losses or portfolio declines of 30%-40% in the crisis. Andrew Haldane (see here) responded correctly that “this is no defense.” Economics must endeavor to address the "social costs of extreme events." We agree!
How do we describe a financial cycle and then marry it with other risks? A simplified financial cycle tends to evolve as follows. In the early phase, private sector credit increases, but the rise is more than offset by the surge in asset prices (itself due in large measure to credit growth) and net worth. Throughout this phase, balance sheets appear robust ("paradox of financial stability"), and this sets the stage for additional credit growth, etc., as discussed here. This pattern tends to persist until eventually (inevitably) the growth in net worth and asset price appreciation slows relative to credit growth. As balance sheets adjust, debt ratios continue to rise (perhaps more slowly) and debt service comes to occupy an increasing proportion of income. This slows growth in consumption and incomes. The central bank responds by lowering short-term interest rates, and eventually a financial crisis and recession likely ensue.
So why did current mainstream macroeconomic models decide to ignore finance? In our view, an important distinction between the productive and financial circuits of capital was lost after World War II. Prior to World War II, economists - e.g., Keynes and Schumpeter, to name two, though there were many others in the 19th century, including Marx and John Stuart Mill - understood that there were two distinct circuits of capital, namely (1) the productive circuit, and (2) the financial circuit. The absence of this distinction during the initial post-war period (1945-1970) did not have much of an impact, given that finance was highly regulated, memories of the Great Depression were still fresh (constraining household borrowing) and credit was used primarily to support capital formation and productive activity.
However, as financial markets were deregulated and liberalized, beginning in the 1980s, finance emerged as a much more important component of economic activity, for at least two reasons:
- First, after remaining steady from 1945 to 1970, private sector credit growth outstripped growth in income as access to credit was eased via lifting of restrictions (e.g., Regulation Q). Private sector credit increased from 94% in 1980 to 165% of GDP in 2007, before the crisis hit. It has since declined but remains historically high at 150% of GDP today.
- Second, the vast majority (75%) of new credit was allocated to support asset purchases (mostly mortgages), not productive activity.
We examine the implications of this shift for both circuits:
Lending To The Productive Circuit: A decision to lend to finance productive capital generates wages that facilitate consumption and profits that are used to service and/or pay off debts. Money is created when the loan is established and later destroyed when the loan is paid off (for more information about this topic, see here). Loans for productive activity contribute directly to GDP growth and have minimal implications for financial stability. The Federal Reserve and other central banks have acknowledged that there is roughly a one-to-one relationship between GDP and credit creation for productive activity.
Lending To Finance Asset Purchases: A decision to lend to the Finance, Insurance and Real Estate (FIRE) sector fuels capital gains that are not included in GDP growth (although "wealth-effects" do contribute to aggregate demand). Unlike loans to productive capital, debt within the financial circuit tends to accumulate over time.
These structural changes (more rapid credit growth and the dominance of lending to finance) likely explain the combination of slower GDP growth and increased financial stability over the past three decades. Much more economic activity has become dedicated to finance. For example, 40% of corporate profits were derived from finance in the years leading up to the crisis.
Today, the challenge has less to do with the ongoing build-up of outstanding debt (which has slowed sharply post-crisis) and more to do with the large private sector debt stock (150% of GDP). This has become a significant weight around the ankles of low and moderate income households, whose marginal propensity to consume (absent the debt) would be significantly higher than that for wealthier segments of society. This debt burden will continue to hamper economic growth.
The financial cycle returned with a vengeance over the past several decades, yet it was ignored by mainstream macroeconomic models, which focused on inflation and GDP. However, this third dimension, comprised of balance sheets, credit ratios, asset prices and net worth, should be incorporated into a macro-financial approach.
Economic growth slowed noticeably after 1980 and even more so since the crisis in 2008. In our view, neither of these events was a coincidence. The decline in GDP growth from 1980 to 2007 reflected the shift in lending away from productive activity toward finance and asset purchases. (We acknowledge other factors, including globalization, technological changes, lower inflation, etc.) Lending to the financial sector has a much smaller impact on economic growth than lending to finance capital formation and production. And much of the credit created in the more recent period was used to support consumption (e.g., home equity withdrawals) given declining incomes.
Since 2008, credit growth has slowed dramatically (averaging less than 3% per year), yet private sector debt stock remains very high. As Steve Keen states, after the Great Depression and Second World War, private sector debt had declined to about 37% of GDP (see here), setting the stage for rapid credit growth in the postwar period. Nothing like that has happened this time. Households and businesses remain highly leveraged and servicing this debt burden will likely continue to hinder economic growth for some time. In fact, given the withdrawal of QE and the Fed's stated objective of raising short-term interest rates, debt service burdens appear likely to increase further. All of which increases the potential exposure to financial crises and/or recession down the road.
For this reason, macroeconomic foundations that incorporate financial stability considerations are essential for macroeconomics. One way to address this need for investors is to develop a regime-based investment framework that marries financial stability and macroeconomic risks. For more information, see here and here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.