Quotes from the Book The Next Economic Disaster – Why its Coming and How Avoid It

Executive Summary

• The excellent book The Next Economic Disaster was so good, it was necessary to record some quotes.

Introduction

This book explains research into the relationship between private debt to GDP ratios and economic declines. Richard Vague began this research as follows.

But back in 2009, in the aftermath of the Great Recession, Vague was stunned to hear the debate center on public, and not private, debt. Liberals argued for federal stimulus dollars and conservatives trumpeted budget austerity. On the campaign trail, politicians debated a 3-percent hike in the income tax rate.

Vague, a onetime banker himself, saw it all as political theater pretending to be economic problem solving. So he hired his own band of heterodox economists—not to mention another team to poke holes in his team’s findings—and he unlocked the key to predicting economic calamity.

He found that, throughout history, economic collapse has virtually always occurred when private debt grows by more than 40 percent in a decade when combined with a nation’s private-debt-to-GDP ratio exceeding 150 percent.

In other words: When private debt gets to a certain level, it can topple whole economies—as it has here during the Great Depression and Great Recession. It was a fiscal smoking gun.

Vague’s presentations to policymakers and politicians encountered a lot of agreement—until he got to his cure: Jubilee, a term used for household debt forgiveness decrees in ancient Israel, Egypt and Babylon. That’s right, Vague’s modern-day Jubilee would consist of widespread debt restructuring. In other words: the forgiving of consumer and business loans.

That runs right into the economic article of faith known as “moral hazard”—that such a “bailout” would give rise to a nation of deadbeats.

Vague thinks that reaction is about emotion—as opposed to simple math. “When I say that, mathematically, the best way out of this trap is debt restructuring, people freeze up because they think of not paying your bills as a sin…” he told me when his book, The Next Economic Disaster: Why It’s Coming and How To Avoid It came out six years ago. “Debt is a contract. Contracts are restructured all the time. My entire career in banking, we had a loan-restructuring group.”

Debt Jubilee is by definition a powerful stimulant, and it disproportionately helps those who are burdened the most by debt. You can spend $1 trillion on infrastructure, or you can forgive $1 trillion in debt—both are similarly stimulative.

Question from LV: Are there precedents for the type of Jubilee you’re proposing?

Vague: Of course. We did it with Germany after World War II. We just wiped the slate almost clean, which positioned Germany for a rapid recovery and turned it into a manufacturing powerhouse. Now, many of those who were ultimately paying for that debt forgiveness were the ultra-wealthy and major institutions, but that’s very different from what I’m saying. I’m not proposing punishing anyone.

Also, in the early ‘80s, many S & Ls held mortgages with significant losses, and they needed to sell those loans to get rid of their negative earnings. Well, regulators said you can sell at a loss and spread it out over 10 years. Selling underwater mortgages ended up saving the S & L industry.

We did the same thing in a less formal way with Latin American debt in the late ‘80s. New York banks lent to Third World Latin American countries and the loans started going bad. The normal rules would have meant all those banks went under. Paul Volcker, who headed the Federal Reserve, said, “You know what? We’ll look the other way for a few years,” which provided the benefit of time to deal with the crisis. Banks were able to build up earning shares and could write down debt. That’s what I’m saying now—let’s use time as our ally.

Vague: We need more lenient bankruptcy laws. Bankruptcy is a safety guard on the system, but, right now, if your mortgage is underwater you can’t discharge the excess portion in bankruptcy or or you can’t discharge student debt. That’s absolutely insane.

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US Mortgage Debt From 2001 and 2004

Between 2001 to 2004 US household mortgage debt increased a mind boggling 48% I worried that the inevitable bad loans from this mortgage tsunami would engulf our business as well so I asked industry economists about it, only to hear that since the value of consumer homes and stock holdings had increased more than mortgage loans that there was no cause for worry as a lender I knew that if that were true consumers would have to sell assets to pay back they’re now significantly higher level of debt, and that meant our industry was in for terrible problems by 2007 the same mortgage debt had increased to an unthinkable 99% In just six years, and the financial industry was soon overwhelmed by the greatest crisis since the Great Depression. Before I could begin to look for answers at the bait was hijacked by loud voices invested in moving the debate over to the government’s debt, and a very different and rancorous discussion on austerity versus stimulus. Despite the noise I conducted my own investigation of these issues hiring a team of economists as part of the effort. When we started to dig in, we found the data had an analysis of private debt were not as readily available as we would have thought, particularly outside of the United States so we set out to gather and analyze the data ourselves. The results were eye opening, in fact they were so unexpected that I took another further step of visiting with dozens and dozens of different economists, with a broad spectrum of viewpoint to get their sense of my findings, the reactions ranged from, from rejection to enthusiasm but they were always instructive.

The primary issue was not public debt but private debt, it was the runway grow runaway growth of private debt, the total of business and household debt coupled with a high overall level of private debt that led to the crisis of 2008. And even today, even after modesty leveraging the level of private debt remains high and impedes stronger economic growth.

Rapid private debt growth also fueled what were viewed as triumphs in their day, the roaring 20s The Japanese economic miracle of the 1980s and the Asian boom of the 90s, but each of these were debt fueled benches that brought these economies to the brink of economic ruin. Over the past 70 years, the level of private debt to income and GDP in the United States and across the entire globe has climbed steeply higher in the United States, it has almost tripled from 55% in 1950 in 1950, to 156% today. That is what is equally astonishing is how little attention it is received.

What Debt Level and Level of Growth Leads to Bubbles?

In this book I will argue that for large economies, private loans to a GDP growth of roughly 18% or more in five years is the level where the growth is excessive debt once accumulated constraints demand and debt growth here and abroad over any sustained period always exceeds the income and economic growth that helps create a trouble, laying phenomena, intrinsic to the system. There is a reason that economists are focused on public debt more than private debt, public debt seems like, much more of a public responsibility, it is, we the people’s job to manage the public debt, private debt seems off limits, More like meddling in private sectors, and free enterprise with a whiff of Big Brother, private loan growth especially in housing and business is viewed as always been good for us so hands off, but this is utterly false GDP growth is influenced by private debt growth as much as or more than any other factor, runaway growth in private debt, especially when combined with high existing levels of that debt is what has caused most major economic crises of the last century. That makes it a very public issue, public policy profoundly influences private loan growth especially through direct and indirect capital requirements imposed on lenders. There is one more reason private debt is more susceptible to crisis than public debt, governments with their own currency can within reason print money to raise taxes, private businesses or individuals cannot businesses and households, more quickly reached the limits of solvency because they must generate income to service and repay debts. Many authors have done solid work in portraying the role of private debt in a crisis is Irving Fisher Hyman Minsky, Alan Taylor Morris shoe lar Rick, among others. US mortgage debt grew from 5.3 trillion in 2001 To 10 point 6 trillion in 2007 and an astonishing doubling in six years. There’s contributed to high absolute levels of private debt to GDP a level that reached 137% in 2008, in larger more developed economies when high growth in private debt is coupled with high absolute levels of private debt. It has almost always led to calamity. Since this buildup of excessive private debt occurred over several years, it should have made the prediction of the crisis and its prevention both possible and straightforward. But it wasn’t just mortgage loans, business debt to GDP picked up markedly starting in 2006 and overall private debt increased as a pace rarely seen during the last century in the United States, an increase of 20% to GDP in five years leading up to the crisis.

Our view is that roughly 18% of growth in private debt to GDP growth over five years serves as a benchmark for when lending is excessive. This is especially true when the level of growth persists for several years and it’s coupled with 150% or more in absolute private debt to GDP. When I say private debt to GDP grew 18% In five years, it means that the private debt to GDP ratio in example. 1997 was 18% greater than the private debt to GDP ratio in 1992. It takes only changes in lending policy to change values but it takes actual income to sustain those values. If lending policy pushes values beyond what can be supported by the borrower’s incomes as was the case with much of the mortgage lending in the years before the 2008 crisis, it creates unsustainable values and a false sense of wealth and confidence.

Crash of 1929

I wondered whether this was also true for the crash of 1929, a crisis, for which an endless variety of explanations has been offered, when we review the data just as in the period before the Great Recession and we saw a pronounced acceleration of lending in the mid to late to that 1920s by 1928 private loans the GDP increased almost 20% in private debt to GDP reached a towering 161%. In fact, This was the first peacetime moment in US economic history where these two twin peaks of debt were reached simultaneously, and it was perhaps a time of far less sophistication and resilience in financial markets.

Reagan’s Debt Fueled Boom

Though less pronounced, even the Reagan Revolution of the 1980s was in part the result of a simultaneous debt surge in both private and public debt that by 1987 had resulted in 90% private debt to GDP growth and 41% government debt to GDP growth in five years. As one would expect from our private debt hypothesis, this Reagan era surge in debt, brought the crash of October 1987 and the savings and loan crisis of the late 1980s and the early 1990s.

The UK

In the United Kingdom, the 2008 crisis came after it had reached 24% private credit to GDP growth in five years and a 208% total private debt to GDP. The Eurozone 18 European member states that have adopted the euro as their common currency has a combined current GDP of 13 trillion however four countries alone, Germany, France, Spain and Italy compose 70% of the Eurozone GDP. Spain’s recent crisis came when it had reached private debt to GDP growth of 49% in five years and a total private debt to GDP of 220%, France had reached 21% and 150%, Italy had reached 33% and 118% of the four countries Spain’s lending trends were by far the most egregious, notably Germany only reached 122% and had had a decline in private debt to GDP of 10%, but it had a crisis nonetheless because it was so inextricably inextricably intertwined with the other eurozone countries, Germany is also a special case because its export rate is so extraordinarily high relative to other countries. In 2012 Germany’s export to GDP were 52% and an enormous number compared to the United States 13% France is 27% and Spain’s 32% Even China which we think of as as a mass exporter only exports at a level of 27%. of the GDP. Therefore, Germany is, in many respects, just as dependent on its neighbors as they are on it, although few frame it this way. Germany’s export dependence on other countries is so high that it is more, it is to some degree, more useful to think of the Eurozone as a single entity economically at least were a portion of the rise in private debt of other eurozone countries, is to finance purchases from Germany.

China

As we’ve seen runaway private lending can lead to crisis in addition to this, in some part, because of these episodes of runaway private lending there has been a long term trend towards higher and higher levels of private debt to GDP. This is not just a trend that is happening all over the globe in China in particular, there has been started in Lehigh recent growth in private debt since the industrial revolution we have been on a more than 200 year march towards an ever higher level of debt, and it is much more private debt than public debt from write a review of its long term trend, it is clear that this is not a mere cycle or supercycle, but instead a structural element of modern economics. While it is outside of the scope of this book to address growing income inequality and the role that plays in it is important to note that this debt burden has caused a level of social stress in middle and lower income groups domestically and globally, and it remains high and troubling.

Why Private Debt is Ignored and The Focus is on Public Debt

Oddly enough, the analysis of private debt is generally relegated to a peripheral space in economic analysis, those who dismiss its importance, many of whom failed to see the impending 2008 crisis may three arguments. First for the country as a whole debt nets to zero for every ball or there’s a lender and therefore the effect of any change on the country is neutral. This view ignores a disproportionate burden of this debt on middle and lower income groups, the very consumers that we depend on to power growth. Second analysts have are comforted by the fact that interest rates are low, and the ratio of debt service to income is actually far below the crisis levels of 2008. This view ignores a significant risk of interest rates, moving higher.

Third analysts have discounted the importance of growth of private debt. When they see it results in an increase in consumer or business net worth. In fact in 2006 to seven, a period when we should have been most concerned about rising debt. Many analysts were unconcerned by the rise because they point to the fact that consumers assets and increase more than their debt. Consumer net worth was at an all time high. But when increasing debt is what leads to higher home or other asset values be where values are ultimately constrained by income and values race ahead of the income required to support those values, it will come back to Earth.

Simply stated, almost all financial crises in major countries have been caused by rapid private debt growth, coupled with high overall levels of private debt. the reverse is true as well, almost all instances of rapid debt growth, coupled with high overall levels of private debt, have led to crisises. I focus here on the 22 countries with a GDP of 500 billion or more together they constitute 81% of world GDP. The United States and China together are a third of world GDP. To put it bluntly turmoil in the United States will have a big impact on Costa Rica, but turmoil in Costa Rica won’t have much of an impact on the United States.

For these 20 largest 22 countries, there have been a total of 22 crises, where we have private debt available to analyze of these 19 crisis, these have been immediately preceded by growth of 18% in private debt to GDP in five years of the other three crisis, these two were in Germany and Switzerland in 2008. And while neither of those countries had high debt growth they were intertwined with countries that did.

There were no false positives instances where this rapid private lending growth occurred, but were not followed by some type of economic reversal. There were no other crisis, these were countries with 150% of GDP, not preceded by rapid private debt growth.

Which brings us to China. The country that now has 54% growth in five years in private debt to GDP and 182% overall private debt to GDP. And that I therefore deemed to be at risk. I discuss this more later in the chapter.

What is particularly noteworthy is the absence of other criteria to predict the risk of crisis in this group. I have long heard that such things as government debt current account deficit government deficits and a very low or declining real interest rate or currency tend to predict crises and an extensive review of 20 other criteria for the use of countries we’ve saw significantly less or no power of these other criteria to predict crisises.

For example, there are crises where real interest rates in the years immediately preceding the crisis are high and not descending, and there are periods where real interest rates are declining to very low levels and do not participate precipitate rapid loan growth and crisises.

Much has been made of the fact that the US crisis of 2008 was a result of mortgage loans and then as a result, some analysts have developed an extraordinary expertise in the details of mortgage lending, but there have been crisises where mortgages have not played a big role but some other category of lending has the key is that runaway lending is at least one category B commercial industrial real estate or consumer results in significant overcapacity and associated bad debt.

My conclusion for larger countries is this with a 100% of private debt to GDP ratio and credit boom calamity is probable After the lending boom starts a calamity may be delayed propped up for several years by continued lending, but almost inevitably the crisis will come after that things, two things happen for recovery to begin. First overcapacity must be largely as absorbed and second, those lenders need to be recapitalized so they can start lending again.

applying our private debt criteria to China, we can see its economy is at risk of the major financial crisis in the near future, a significant concern because of its size and importance in the world economy. The situation in China is alarming, the five year growth of private credit to GDP is 54% its private debt to GDP ratio stands at 182%. I hold that once a country reaches an excess credit point bad things almost always happen, but I also maintain that excessive growth in lending can continue for a number of years prior to any crisis, or adversity and in China it clearly has, however the trends in China are changing for the worse. Real GDP growth has dropped from 14% in 2007, to 7.8% in 2012, China abounds and ghost cities, gleaming places that sit virtually empty because of lack of demand and equally concerning pockets of overcapacity and other sectors throughout its economy.

Using Japan to Predict China

Japan offers guidance, it can be viewed as a Dickensian Ghost of Christmas Future for China and other economies perhaps all of them. Japan is at the very opposite end of the crisis spectrum from China. China is a country on the precipice of a potential crisis. Japan had its crisis in 1991 and is still living with the extended aftermath.

In the 1990s after a rapid rise Japan’s private debt to GDP crusted at 221%. It has been on a slow decline ever since a decline that exerts considerable deflationary pressure on the country. It still stands at a high level of 168%. In 1991, Japan’s government debt to GDP stood at only 68% it skyrocketed to 226% In the year since, in part because of its recession and in part because of because of its efforts to offset the adverse effects of its private de leveraging.

The ideal economic situation for a given country in the world is to have less capacity or supply than demand coupled with low private debt. Instead we have nearly the opposite situation in the first decade of the 2000s the United States in Europe built far too much capacity, especially in housing and incur too much private debt in the 1980s Japan built far too much capacity saddling its banks with too much private debt and too many bad loans. Well, we all have been catching up to this capacity, none has yet has less capacity than demand and all still have high private debt and now China whose industrialization and urbanization, long fuels global growth has created its own overcapacity and private debt problem, building far too much capacity in many industrial and real estate projects with easy credit that fueled the most rapid buildup of public private debt yet.

So now the majority of the globe is in this less than desirable place, no Majorie global economic player now has a pivotal combination of under capacity and low private debt to fuel productive investment and help boost global growth.

When Does the Middle Class Grow?

The size of the middle class plateaus, or shrinks when there is too much capacity and too much debt as there is presently. Stated differently inequality increases when there is high capacity and high debt. It decreases when capacity and debt are low. That is because a middle class is needed to build new capacity, corporate debt can be used to fund the building of new capacity while consumer debt can be used to fund the consumption of that capacity.

In 1950 the level of private debt in the United States was 55% of GDP, today is 156%. Our investigation has led us to conclude that the level of private debt alone is not predictive of a crisis. It takes rapid private debt growth as well, but high private debt which is often the residue.

The US and Housing

In the aftermath of runaway debt growth, makes an economy more susceptible to future crises and impedes growth homeownership through mortgages has been good, a good investment, but primarily because of the massive tax advantages. It is good but not as good as widely believed in fact it was too much of a good thing. Runaway homebuying encouraged prolifigate lending that contributed mightily to the 2008 crisis.

Net home value home minus mortgage amount is only 14% of per capita net worth in 2012, the net home value per person was $33,000 Luckily the consumer has many other assets deposits investments and pensions for a total capital, net worth of $225,000.

The United States aside homeownership, most often declines as nations get wealthier. There’s a phenomenon that is so evident that it is possible to conclude that the debt growth in excess of GDP especially private debt growth in excess of GDP is a necessary part of GDP growth, there have been no extended periods in the last 200 years where debt growth has not exceeded GDP growth. The most notable periods in which GDP growth exceeded debt growth, we’re in the calamitous aftermath of the crash of 1929 and to a lesser extent the aftermath of World War Two.

In some respects, the thesis of this book is simplicity itself, financial, or banking crisis is coming from too many bad loans, and the surest evidence of bad loans is runaway long growth, what looks like success is actually the seeds of failure. We can predict a crisis in major world economies where both the damage internally and the risk of contagion are high. We have tools to prevent these crises from happening and reduce private debt levels that are excessive.

If the past shows us the problem, it may also show us a solution in biblical Israel, they had a special name for a day when the debts were forgiven, the Jubilee. These civilizations has something to teach us when private debt rises to unsustainable levels we could do worse than turn to these ancient models of forbearance, it is private debt that matters the most.