Private sector debt will likely cause the next crisis

This month of course saw the 10^th anniversary of the collapse of Lehmann Brothers, which precipitated one of the only two global financial crises of the past 150 years. The late 2000s and the early 1930s are the only times when capitalism itself has trembled on the edge of the precipice.

It was in early November 2008 that the Queen put her famous question about the crisis to the academics of the London School of Economics: “Why did nobody notice it?”.

The answer is simple. In the models of the economy at the time, finance did not matter. Mainstream economists did not notice the massive financial imbalances in the economy because in their models, any problems these imbalances might create were assumed away.

It is hard to believe. But it is true.

All scientific models have to make simplifications of reality to be of any use. But orthodox macroeconomics took a step too far. It assumed that the workings of the whole economy could be explained by analysing the theoretical behaviour of just a single decision maker. In the jargon, this is the “representative agent”.

This agent was extremely clever, and could solve hard mathematical problems. This, indeed, was one of the attractions of these kinds of models to economists. They go by the splendid name of “dynamic stochastic general equilibrium models”, or just plain “DSGE” to their friends.

But at its most basic, the problem with the models was that there was only one decision maker in them. Having just two, a “creditor” and a “debtor” for example, would have helped a lot.

A huge scramble has developed within macroeconomics over the past decade to incorporate finance into their models. Key contributions to this research are discussed in the latest issue of the Journal of Economic Perspectives. Bizarre though they may seem, even DSGE models now recognise the potential importance of financial factors in causing crashes.

A particularly interesting paper in the journal is by Atif Mian of Princeton and Amir Sufi of Chicago. Their focus is considerably wider than the crisis of the late 2000s in the United States. They quote empirical studies across some 50 countries with data going back to the 1960s. A rise in household debt relative to the size of the economy is a good predictor that GDP growth will slow down.

With Rickard Nyman, a computer scientist at UCL, I applied machine learning algorithms to data on both public and private (households and commercial companies) sector debt in both the UK and America. We find that the recession of 2008/09 could have been predicted in the middle of 2007. Perhaps the most striking result is that public sector debt played little role in causing the crisis. The driving force was the very high levels of private sector debt.

A critic might say that this is simply a case of generals fighting the last war. True, we don’t know whether a completely different nasty event lies around the corner. But at long last, economists appreciate the fundamental important of debt and finance in Western economies.