Almost 12 years have passed from the big crash of 2007-2008, one of the biggest negative shocks on the economy after the great depression that followed 1929.
Following several bailouts and significant measures to stimulate economic growth and get out of the financial crisis, causing the levels of debt in the economy to rise, we managed to have an economic recovery that resulted in a great decade both for economic growth and financial markets.
Despite the negative impact of coronavirus, as of the first months of 2021, there are signs that the economy is starting to recover and many expect a new period of economic prosperity.
Some foresee a new economic boom, others are seeing the worst recession ever seen and a big stock market crash. There are good points for both arguments.
Surely financial markets are optimistic about the future, at least this is what they are pricing.
In this article, I’d like to talk about debt in the economy, its role in driving economic growth and generating financial crisis, debt cycles, the long-term debt cycle, and what we could expect for the future.
Economy and Recession Cycles
Is the economy actually recovering or is it just one part of the story?
There is an ideal concept in economics called equilibrium, a condition in which economic forces are balanced: supply, demand, prices are stable and economic variables remain unchanged without external influences.
Although the idea of equilibrium might be appealing and is certainly useful to frame the economic cycle, in the real world there is no such thing and history speaks clearly about that.
The closest thing to equilibrium that we can think of today is a steady growth of the economy with a low and stable inflation rate, that is what central banks are generally pursuing.
However, even if we had a similar situation in the last decade (2010-2020), we would be naive investors to expect that to be the norm.
The alternating of expansions and recessions along with the business cycle is natural, it’s just part of how things work and later we are going to touch on how debt plays a crucial role in this mechanism.
No wonders here. Since the beginning of capitalism, we are able to see a sequence of ups and downs in the economy, periods of growth followed by times of recession.
Of course, there are no written rules, however, a closer look at the past shows the alternation of different economic periods that typically last in the order of decades.
In the last decade, we had a nice level of economic growth and low inflation. In order to understand whether a situation like this is sustainable, it’s useful to understand and analyze the main drivers of economic growth.
What Are The Drivers of Future Economic Growth?
We all talk about economic growth and how it’s important for how our economy to work properly, but we don’t usually take the time to reflect on what’s causing the growth.
Sticking to the basics, the three main factors that drive economic growth are:
Although capital and labor are fundamental factors, just by adding more capital and more labor the additional output obtained will eventually decline, according to the law of diminishing returns.
It’s safe to say that the main driver of economic growth is productivity.
It necessarily has to be technological progress because, in a world of finite resources, it allows us to produce more with the same inputs, increasing both the efficiency of capital and the value-added per worker.
When it comes to economic growth, a useful distinction that is often overlooked is the time frame over which the growth takes place.
If in the long run, the main driver of economic growth is productivity, over shorter periods of time the levels of debt and their sustainability play a crucial role in creating booms and busts in the economy.
Debt Cycles, Recessions, and Economic Growth
When talking about the sources of economic growth there is a very wide range of variables that could be considered. Factors like capital, technologies, labour, investments, interest rates and their relationships all play crucial role in the economy.
For the purpose of this article, I’d like to focus your attention on these three drivers of the economic growth:
- Short-term debt cycle
- Long-term debt cycle
The chart below offers an intuitive representation:
Productivity is the factor that ultimately drives the long-term economic growth, it is represented here as a straight line that grows over time. The larger wave represents the long-term debt cycle and the smaller waves reflect the short-term debt cycle.
Credit plays a huge role in driving the economic growth with serious implications on the economy and our society. In short period of times (5–7 years), the increasing amount of credit makes it possible to drive consumption levels higher than income levels, fostering the expansion of the economy until it reaches its maximum level.
The credit expansion generates a huge amount of debt in the system, that is the result of the behavior of buying on credit and increased businesses investments.
At some point the cycle inverts, lower levels of credit lead to lower consumption and the economy slows down. There is nothing surprising about that, this process is part of how the economy works and will continue to occur.
What is more surprising is our incredible ability to forget that fact during economic good times.
Credit is a really important factor for the economy to grow and prosper, it is a crucial variable of the current system. To put it extremely simple:
Higher Credit → Higher consumptions → The economy will do better
We can see that today, it is exactly what happened after the 2008 crash: an unprecedented monetary expansion that fuelled what is now considered a healthy economic growth (according to the news).
Monetary policy played a big role in supporting the recovery after the crash and that was possible because of the role of credit and debt in the system. Surely monetary policy has real effect in driving short term movement of the economy, but this system works until the economy can’t accept higher level of debt.
While credit is a powerful tool that helps the economy to grow, at some point people and businesses will reach their maximum. Higher interest rates will increase debt payments and rate of defaults, the aggregate demand for products and services will drop and the economy will slow down. Given how the system works a recession is inevitable, the question is only when.
Where are we today?
Short-Term Debt Cycle
Consumer credit represents the debt that a person incurs when purchasing a good or service using credit cards, lines of credit or some loan.
Take a look at this chart, showing the total amount of consumer credit in the US over recent years:
Today, consumer credit is up more than 45% in comparison to 2008 before the market crash and the following recession.
How long and how much credit levels can go up?
If you consider this from a long-term perspective, you clearly see that this trend is unsustainable.
I am not making predictions about when things may happen, but when the markets start to price the risk associated with the probability of a recession, it is really likely that we are going to see substantial declines in financial markets and stocks evaluations and this could be one of the triggers for a future recession.
Long-Term Debt Cycle
The fluctuations of the overall debt in the economy over the years can be represented by the long-term debt cycle. These cycles are much longer and typically last around 50 years, they begin at low levels of debt in the economy and end at very high levels of debt.
Suppose that you were born in 1960, except some small recessions along the way and two big market crash, you have seen only economic growth and prosperity, a huge growth in overall production.
You can get the idea by looking at this chart of the GDP over the years:
When you live in those circumstances, you don’t realistically consider a dramatically different scenario. After a short period of crisis, you reasonably expect a fresh wave of economic growth.
The point is that there are limits to an economic growth financed by a combination of debt and monetary expansion. When these limits are reached, the upward phase of the long-term debt cycle comes to its end, the overall amount of debt in the system comes back to lower levels in a process called deleveraging.
Deleveraging means an overall reduction of debt levels by all the economic operators (banks, consumers, businesses…), a scenario that has a huge negative impact on economic growth.
The question is: how much of this economic growth measured by GDP has solid fundamentals?
As you can see from the chart above relative to the total amount of consumer credit in the US , the level of consumer credit has increased alarmingly, roughly 10 times higher than it was 45 years ago.
One of the main driver (if not THE driver) of the huge economic growth of the last 20 years is high consumer credit, made possible by low interest rates. And that trend shows a strong acceleration following the two major crisis of 2000 and 2008.
Stop here and try to think: What happens when this trend reverses?
The good scenario is the one that sees a normal recession where stocks drop, bad businesses go bankrupt, but there is enough room to further stimulate growth, probably with another monetary expansion. (In this soft-landing scenario, long-term investors are presented with really good buying opportunities for good businesses that are temporarily undervalued by the market).
The bad scenario is the one that is going to wipe out the huge pile of debt accumulated in the last 45 years, correcting the excesses in the economy. If the long-term debt cycle is over, we may well see 20–30 years of a great depression scenario. In this situation everyone has reached his debt ceiling and there is no room to further stimulate the economy through easy money.
Higher interest rates coupled with the high level of debt make the debt unsustainable, putting a huge burden on the government and the people: default rates increases, confidence in the economy goes away and uncertainty rises, the aggregate demand drops and the cycle strengthens, paving the way for a big recession.
Nobody expects a great depression scenario, but if you look at the overall level of debt in the system by governments, consumers and businesses, we meet the requirements for a full-scale economic collapse.
We tend focus on the short-term news like the FED announcements on interest rates, the number of new jobs created, international trade, the level of GDP, etc. forgetting to consider a long-term view based on how the economy works and how people behave.
The massive monetary expansion that came after the 2007–2008 crash fostered an enormous debt assumption by consumers and especially governments (deficit) that lead to economic growth. This increased the total amount of debt in the system is putting a burden on the entire economy: it makes the system more fragile and the debt has to be repaid in the future (IF and HOW it will be paid back deserve a dedicated article).
It is exactly what the old-fashioned theory of the economic cycle says: we are now in times of economic expansion stimulated by monetary policy. What comes after huge expansion times?
Every time that there is a scenario that could be a bubble we say that “this time is different”, providing all sort of explanation to justify that history no longer applies because of changes in technology, economy and society.
It was said so many times over the course of history and usually had never been the case, maybe this time could really be different, indeed it could be much worse than ever before.