Credit Bubbles ultimately harm the nation as a whole

 

The Great Recession, although triggered by the US subprime mortgage crisis, has its roots elsewhere: that both America and Europe were living beyond their means.

Take the United Kingdom for example. According to its central bank, in the decade preceding the Great Recession, UK experienced the largest spike of household debt among developed nations, standing at an alarmingly high 200% of disposable income by 2009.

But Britain was not alone. Starting about 30 years ago and accelerating to precarious levels over the last decade leading to the Great Recession, insatiable appetite for credit has been widespread everywhere, especially in America and most of Western Europe.

Take the US as an example in the decade leading to 2007. According to the Federal Reserve, Household and Consumer debt outdistanced GDP growth considerably in those 10 years to reach $13.8 trillion by 2007, 57% above comparative levels of economic output. The same data also shows that Financial Sector indebtedness had surpassed $16.1 trillion by 2007, 78% beyond the level normalized to GDP growth over the decade. These two "bubbles", of about $5 and $7 trillion respectively, defined the implosive state of America's finances.

What happened in the 6 years that followed the Great Recession in the US is unmistakable. The Financial Sector deleveraged first -- fast and furiously -- slowly accompanied by the

Consumer, both shrinking to 80-90% of Debt to GDP, as a much safer range.

 

Components of indebtedness against U.S. GDP: before & after 2007 (Source: The Fed)

Although the total debt -- Public and Private, including Financials -- in all those years stayed around 350% of GDP, government debt ballooned by about $5 trillion, representing an insidious liability transfer from the private sector to an ill-prepared and unsuspecting government.

 

But the US was hardly alone to shift the burden of the Great Recession to the taxpayer, albeit a large one and in the surprising company of Ireland and Greece.
 

Incremental Government Debt: 2007 to 2012, as a % of GDP (Source: IMF, BIS)

The lesson in this that has not been explicitly drawn is that credit bubbles, manifested as excessive private-sector debt, hurt the whole nation when they burst. The victims are not just reckless borrowers or lenders, but also innocent citizens living within their means, along with all taxpayers, left with liabilities that they have never agreed to endorse. Enduring credit bubbles is like drug overuse: inevitably harmful and systemically weakening.

 

So, what should be done to better preserve the structural health of an economic system, especially if monetary policy is viewed as a credit "regulator" for the domestic economy?

The answer starts by accepting that if increasing money supply is helpful to invigorate a moribund economy, its timely reduction to avert overindulgence is also part of the job.

There are two obstacles however that stand in the way. One is the outdated mandate of the Fed preoccupied with inflation instead of the collateral damage from lax monetary policy.

The other is that deflating bubbles before they burst by restricting credit through higher interest rates is politically unpopular. This is why central bank independence is so critical.

The current dual-mandate of the Fed stems from 1977 when runaway inflation was a major political and social concern. Back then, price stability is all that mattered versus broader financial stability, which may include things such as the steadiness in currency value, or the frequency and severity of systemic shocks to the economy. By these last two criteria, the Fed's performance over the last 20 years has been especially controversial.

But is the real problem the Fed's performance or the misplaced expectations from its outdated mandate? Should the mandate for the Fed – the central bank behind world's reserve currency – be reworked to include broader financial stability, especially better and more dependable ways to predict and avoid severe shocks to the financial system?

The U.K. already serves as a good example of foresight in that direction by explicitly adding the financial stability mandate to the mission of its central bank, the Bank of England, with the Financial Services Act of 2012. Other countries like Canada and Israel also expect more from their central bank than monetary policy managed through setting interest rates. Their experience with mandating higher down-payment requirements to deflate speculative real-estate bubbles – instead of jacking-up interest rates – is especially noteworthy.

It seems the new vice-chair of the Fed, Stanley Fischer, is particularly attuned to the needs of reworking the Fed's mandate. By suggesting that Congress should consider making financial stability an explicit mandate for all U.S. financial regulators, he is pointing out the biggest need for change in American monetary policy: a mandate which should go beyond the management of credit and inflation to also include responsibility for financial stability.

Otherwise, former Fed chairman Alan Greenspan's well known suggestion of the "inherent inevitability of boom and bust cycles in monetary policy" is missing an important point: accountability. Pilots navigating in turbulent weather understand this notion rather well: it's the ability to predict and maintain aircraft stability in the sky that matters, not succeeding at a "soft landing" while escaping a storm which could have been avoided.