Hard Evi­dence: is the UK fac­ing another finan­cial cri­sis?

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Taken at face value, David Cameron’s warning this week about risks in the global economy sounds like it might be wonderfully prescient. Here’s the country’s economic chauffeur, carefully checking his instrument gauges, and sure enough, sees the same signs today that should have given us warning of the crisis of 2007-08. Time to apply the brakes.

There’s only one prob­lem: the eco­nomic dash­board that Cameron relies upon did not warn of the cri­sis before it hap­pened. Instead, that dash­board advised Cameron and other lead­ers around the world that every­thing was look­ing rosy, and that going full throt­tle was entirely safe.

The OECD’s Eco­nomic Out­look, pub­lished in May 2007, stated that its “cen­tral fore­cast remains indeed quite benign” as it pre­dicted “a strong and sus­tained recov­ery in Europe”. Some dash­board that turned out to be.

Motor skills

Politi­cians are fond of car analo­gies when talk­ing about the econ­omy, because they’ve actu­ally dri­ven cars, and they know how they work. Press the accel­er­a­tor, you go faster; hit the brake, you slow down; the tachome­ter tells you whether the engine is flat out or idle; the fuel gauge tells you whether you need to call into a petrol sta­tion. Car con­trols work because they are designed by engi­neers who actu­ally built the car in ques­tion, and the dash­board tells you all you need to know, with no seri­ous omis­sions and no dis­tract­ing false sig­nals.

But the eco­nomic dash­board that Cameron relies upon today was hor­ri­bly wrong in 2007: the sig­nals it focused upon – mainly the rate of unem­ploy­ment (low and falling), the rate of infla­tion (low), the gov­ern­ment deficit (head­ing towards a sur­plus), and the rate of inter­est (low but ris­ing to cool the econ­omy down) – gave absolutely no warn­ing of the biggest eco­nomic cri­sis in a cen­tury.

This main­stream dash­board gave no warn­ing of the cri­sis because it was built by econ­o­mists whose the­o­ries have more in com­mon with Alice in Won­der­land than with engi­neer­ing. And one Mad Hat­ter assump­tion their dash­board makes is that the level of pri­vate debt can be ignored.

Debt wish

Ques­tions for Bernanke
Ger­ald R. Ford School of Pub­lic Pol­icy, Uni­ver­sity of Michi­gan, CC BY-ND

If that sounds crazy to you, that’s because it is. Some influ­en­tial econ­o­mists argue that pri­vate debt has “no sig­nif­i­cant macro­eco­nomic effects”, to quote Ben Bernanke. Only mav­er­icks who fol­low the then-ignored but now famous Amer­i­can econ­o­mist Hyman Min­sky dis­agree, and regard the level and growth of pri­vate debt as vital eco­nomic indi­ca­tors.

I am one of those mav­er­icks, and the signs I saw back in 2005 led me to be one of the hand­ful of econ­o­mists who did warn of the cri­sis before it hap­pened.

Since then, the Amer­i­can phil­an­thropist Richard Vague – who made his for­tune in bank­ing – has exam­ined all major eco­nomic crises since 1850, and con­cluded that the two key signs of an immi­nent cri­sis are pri­vate debt exceed­ing 1.5 times GDP and that ratio ris­ing by 17 per­cent­age points or more over five years. Both those sig­nals were clearly “flash­ing red” in 2007.

Signals, noise

Pri­vate debt in Britain rose from 135% of GDP in 2000 to 180% when the cri­sis began in August 2007 – a 45% rise in less than eight years. In the US, it rose from 125% to 160% – a 35% rise. Both these lev­els and the rates of change were unsus­tain­able: the growth in pri­vate debt had to stop, and when it did, I expected that the biggest eco­nomic cri­sis since the Great Depres­sion would fol­low – which is what actu­ally hap­pened.

So what are those reli­able but neglected indi­ca­tors telling us today? In the US, pri­vate debt fell from 1.7 times GDP in 2010 to 1.45 times in 2014. It’s been ris­ing since 2012 and was now grow­ing at 5% of GDP per year in mid-2014, which is spurring eco­nomic growth – but the head­room for con­tin­ued credit-dri­ven growth is lim­ited because the aggre­gate level is still so high. We are nudg­ing back closer to Vague’s dan­ger zone.

US Pri­vate Debt Level & rate of change
Fed­eral Reserve Flow of Funds

In the UK, pri­vate debt peaked at more than twice GDP in 2010. It has fallen to 170% today, but between 2012 and 2014 it rose – stim­u­lat­ing eco­nomic growth. Now it is falling again – by as much as 5% of GDP a year. That implies that a credit con­trac­tion – how­ever wel­come it might be in stop­ping at least one warn­ing light flash­ing – is likely to reduce British eco­nomic growth in the near future.

So Cameron is right to worry, but he’s wor­ry­ing about the wrong thing: pan­ick­ing about a ris­ing level of gov­ern­ment debt, when at 91% of GDP, it’s 80 per­cent­age points below the level of pri­vate debt. If Cameron thinks reduc­ing gov­ern­ment spend­ing when pri­vate credit is con­tract­ing is good eco­nomic pol­icy, then he’s ignor­ing the biggest car crash in eco­nomic his­tory – the Euro­pean Union, where gov­ern­ment aus­ter­ity turned the cri­sis into a sec­ond Great Depres­sion.

The key indi­ca­tor I use to antic­i­pate where the econ­omy is headed is the accel­er­a­tion of pri­vate debt. Just as the rate of change of pri­vate debt indi­cates what’s going to hap­pen to the level of eco­nomic activ­ity, the accel­er­a­tion of debt indi­cates whether activ­ity is likely to rise or fall. That indi­ca­tor, which was trend­ing up from mid-2010 until mid-2012, has been headed down ever since. Debt accel­er­a­tion was strongly neg­a­tive as of mid-2014, run­ning at minus 10% of GDP.

That, com­bined with Richard Vague’s indi­ca­tor that crises occur when pri­vate debt exceeds 150% of GDP (tick at 170% in mid-2014) and has grown by 20 per­cent­age points or more over five years (in fact it’s shrunk by 30 per­cent­age points since 2010), points to stag­na­tion rather than cri­sis being the likely out­come for the UK econ­omy.

In this sce­nario, an attempt to pare gov­ern­ment spend­ing back could make the stag­na­tion worse – just as it has done across the Chan­nel.

Author pro­vided

All in all, I would rec­om­mend Cameron gets his eco­nomic dash­board fixed, or he risks steer­ing the UK in the direc­tion of Europe.

Hard Evi­dence is a series of arti­cles in which aca­d­e­mics use research evi­dence to tackle the trick­i­est pub­lic pol­icy ques­tions.

The Conversation

Steve Keen has received research fund­ing from the Insti­tute for New Eco­nomic Think­ing (www.ineteconomics.org) and has con­sulted to the Governor’s Woods Foun­da­tion (www.govwoods.org). He is affil­i­ated with IDEA Eco­nom­ics (www.ideaeconomics.org).

This arti­cle was orig­i­nally pub­lished on The Con­ver­sa­tion.
Read the orig­i­nal arti­cle.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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  • TruthIs­ThereIs­NoTruth

    One very impor­tant thing the gov­ern­ment has on their dash­board which the analy­sis pro­posed in this arti­cle does not is the cost of debt. Pri­vate debt is an aggre­ga­tion of mil­lions of indi­vid­u­als who on their own do not influ­ence inter­est rates or credit spread. Col­lec­tively they do but for the gov­ern­ment this is a vital, per­haps the most impor­tant con­sid­er­a­tion. Some­one has to buy the bonds and while the US can buy it’s own bonds effec­tively, I don’t know if other coun­tries includ­ing Britain have this lux­ury.

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  • Willy2

    Mr. Keen,

    There’s — IMO — a good sign that the UK is head­ing for finan­cial trou­ble. The BoE has warned that the BoE will raise (short term) inter­est rates. That’s for me a clear sign the BoE acknowl­edges that the UK is in trou­ble.

    I would point to the fact that Turkey raised inter­est rates in early jan­u­ary of this year to defend the cur­rency. Not sur­pris­ingly for a coun­try with a Cur­rent Account of ~ 6.5% of GDP.

    I don’t know the num­bers for the UK but the mere fact that the BoE has men­tioned the words “Rais­ing inter­est rates” makes me VERY sus­pi­cious. The same story applies to the US. Janet Yellen also has said the FED will raise rates in 2015. And that on its own is very remark­able because the FED Always fol­lows (short term) rates as set by a force called “Mr. Mar­ket”.

    Do the FED & BoE see things the ordi­nary econ­o­mist is over­look­ing ?