Surprising Findings Point to Perfect Storm Brewing in Your Financial Future

By Lynn Stuart Parramore, AlterNet

Alan Taylor, a professor and director of the Center for the Evolution of the Global Economy at the University of California, Davis, has conducted, along with Moritz Schularickgroundbreaking research on the history and role of credit, partly funded by the Institute for New Economic Thinking. He finds that today’s advanced economies depend on private sector credit more than anything we have ever seen before. His work and that of his colleagues call into question the assumption, commonplace before 2008, that private credit flows are primarily forces for stability and predictability in economies.

Taylor warns that if current trends continue, our economic future could be very different from our recent past, when financial crises were relatively rare. Crises could become more frequent, which will impact every stage of our financial lives, from cradle to retirement. Do we just fasten our seatbelts for a bumpy ride, or is there a way to smooth the path ahead? In this interview, Taylor discusses his findings and suggests ways to safeguard the financial system. Lynn Parramore: Looking back in history at 17 countries, you discovered something interesting about the private sector financial credit market. What did you find? Alan Taylor: Our project compiled, for the first time, comprehensive aggregate credit data in the form of bank lending in 17 advanced countries since 1870, in addition to some important categories of lending like mortgages. What we found was quite striking. Up until the 1970s, the ratio of credit to GDP in the advanced economies had been stable over the quite long run. There had been upswings and downswings, to be sure: from 1870 to 1900, some countries were still in early stages of financial sector development, an up trend that tapered off in the early 20th century; then in the 1930s most countries saw credit to GDP fall after the financial crises of the Great Depression, and this continued in WWII. The postwar era began with a return to previously normal levels by the 1960s, but after that credit to GDP ratios continued an unstoppable rise to new heights not seen before, reaching a peak at almost double their pre-WWII levels by 2008. dollar economy LP: How is the world of credit different today than in the past? AT: The first time we plotted credit levels, well, we were almost shocked by our own data. It was a bit like finding the banking sector equivalent of the “hockey stick” chart (a plot of historic temperature that shows the emergence of dramatic uptrend in modern times). It tells us that we live in a different financial world than any of our ancestors. This basic aggregate measure of gearing or leverage is telling us that today’s advanced economies’ operating systems are more heavily dependent on private sector credit than anything we have ever seen before. Furthermore, this pattern is seen across all the advanced economies, and isn’t just a feature of some special subset (e.g. the Anglo-Saxons). It’s also a little bit of a conservative estimate of the divergent trend, since it excludes the market-based financial flows (e.g., securitized debt) which bypass banks for the most part, and which have become so sizeable in the last 10-20 years. LP: You’ve mentioned a “perfect storm” brewing around the explosion of credit. What are some of the conditions you have observed? AT:We have been able to show that this trend matters: in the data, when we observe a sharp run-up in this kind of leverage measure, financial crises have tended to become more likely; and when those crises strike, recessions tend to be worse, and even more painful in the cases where a large run-up in leverage was observed. These are findings from 200-plus recessions over a century or more of experience, and they are some of the most robust pieces of evidence found to date concerning the drivers of financial instability and the fallout that results. Once we look at the current crisis through this lens, it starts to look comprehensible: a bad event, certainly, but not outside historical norms once we take into account the preceding explosion of credit. Under those conditions, it turns out, a deep recession followed by a long sub-par recovery should not be seen as surprising at all. Sadly, nobody had put together this sort of empirical work before the crisis, but now at least we have a better guide going forward. Continue Reading>>>

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