Steve Clemons and Richard Vague tell us that it's all, or at least
mostly, about debt. The financial crisis and the Great Recession were
"caused primarily by a massive private debt buildup," they write in a
recent white paper: "How To Predict The Next Financial Crisis." The authors will be speaking next month at a conference
on the topic at the Global Interdependence Center in Philadelphia and
presumably they'll lay out the evidence in some detail. They're
certainly on solid ground when they link debt with financial crises.
History is quite clear on this point. But let's be careful here. Citing
debt as the main catalyst that routinely triggers recessions across time is surely going too far.
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This may sound like a subtle distinction, but it's critical
nonetheless. Financial crises and recessions often strike
simultaneously, but one event has been known to arrive without the other
at times. For example, the credit crunch of 1966—"the first financial
crisis in the postwar period," as Martin Wolf labeled it in Financial Crisis: Understanding the Postwar U.S. Experience—wasn't
accompanied by an economic downturn, at least not by NBER's definition
of recession. On the flip side, the brief 2001 slump was basically
crisis-free in terms widespread banking troubles.
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Even so, it's essential to recognize the toxic relationship between
debt and financial crises, a connection that Gary Gorton analyzed
thoroughly in his recent book: Misunderstanding Financial Crises: Why We Don't See Them Coming, which I reviewed
last November. "Banks and bank debt were at the root of every one of
the 124 systemic crises around the world from 1970 to 2007," Gorton
No wonder that a financial crisis can push an economy into recession.
Or is it the other way around? Do recessions cause financial crises?
Analysts can be excused for not answering directly, at least not in
absolute and definitive terms. The problem is that no one's really sure
what's driving business cycles, or even if they're a natural, inevitable
part of capitalism vs. a byproduct of misguided policy and ill-advised
decisions in the private sector, which is to say a phenomenon that can
be "cured." In any case, let's not conflate a diagnosis with an
explanation. It's easy to identify events that precede and/or accompany
downturns, but correlation isn't necessarily causation—a caveat of no
small import in the land of macroeconomics.
A quick example is the popular observation that consumption declines
just ahead of and/or during recessions. A naïve observer could claim
that falling consumption causes recessions. True, but one could just as
easily ask: What causes consumption to fall? Economists have been
looking for answers to such answers in the context of the business cycle
for over two centuries, and it's not obvious that we're any wiser today
than in 1819, when Sismondi first identified the alternating periods of expansions and slumps as a distinct trend in economics.
If you study the ebb and flow of the economy in history you'll soon
discover that there are few constants for identifying cause and effect
in a timely manner. Perhaps the only reliable forecast is that there's
another recession out there somewhere. In my own work
in trying to untangle the various factors that collectively drive the
economy's rise and fall in real time it's clear that there's an evolving
mix of triggers that are linked with recessions. For instance, I track
14 broad economic and financial indicators and individually they present
a mixed record in terms of signaling the onset of a new downturns
through history. Collectively, however, they provide a richer roadmap
for anticipating another drop in economic output. The record's hardly
perfect with a carefully selected lineup of indicators, but the record's
better compared to indicators in isolation throughout economic history.
This brings us back to debt and its connection with the business
cycle. The simple reality is that debt is a problem, can be a problem,
if the economy's slipping into recession. That's another way of saying
that debt is far less threatening during an expansion. In fact, debt may
not be a problem at all under the right conditions. Granted, there are
limits to how much debt an economy can bear—even a growing
economy—without pushing the macro climate into the danger zone. But
deciding where those limits lie, in relative or absolute terms, is a
murky business. Why? Much depends on whether the economy is growing or
shrinking and how the other key variables compare at a given point in
It's tempting to say that high debt causes recessions, but the
empirical record offers no easy lessons. Debt levels can increase for
years without the onset of recession. That implies that there are other
triggers to consider for understanding the business cycle. Monetary
policy, employment, consumer spending, and so on, are hardly irrelevant
here. Debt is surely a factor, but it's a contributing factor, and one with fluctuating degrees of influence through time.
Explaining the big picture from a theoretical perspective opens up
another dimension of analysis, and complication. The standard Keynesian view is that slumps are a byproduct of weak/falling aggregate demand. By contrast, market monetarists
emphasize that recessions are primarily due to a central bank's
willingness to let nominal gross domestic product (NGDP) fall, an
explanation that assumes that monetary policy can prevent or
substantially lessen the economy's fall from expansionary grace.
Every corner of macroeconomic analysis is controversial, of course,
as it has been over the past two centuries. Deciding how an economy
moves away from equilibrium, or even if such a state exists, is the raw
material for great debates and precious little agreement. Par for the
course in macro. So when someone claims that all is explained by
analyzing debt, or any one factor, sign me up as a skeptic.
No one can ignore debt when it comes to dissecting the business
cycle. Sometimes it's the elephant in the room. But assuming that's all
we need to know from here on out is assuming empirical facts not in