The people hardest hit by a financial crisis often are those who had nothing to do with causing it: millions of hard-working Americans who live paycheck to paycheck.
If we better understand financial crises, I hope we can completely sidestep or reduce the damage that they bring — damage that lingered for years after the 2008 crisis that profoundly influenced the 2016 election.
History tells us that by monitoring growth in private debt relative to GDP, regulators and policymakers can have a reliable and sensible early warning system for financial calamity.
Many have proclaimed that financial crises cannot be predicted, but this resignation betrays those millions who do not cause the crises but are badly damaged by them. Our ability to predict financial crises should have profound policy implications.
Data analysis of the years preceding the 43 largest financial crises over the last 200 years shows that financial crises, also known as banking crises, happen when a large number of a country’s lenders fail or have to be rescued. These crises have happened a lot. In the U.S. alone, the financial system came crashing down in 1792, 1819, 1837, 1857, 1873, 1884, 1893, 1907, 1914, 1929, 1987 and 2008.
These crises happen in all sorts of circumstances:
- with and without a gold standard;
- with and without a current account deficit;
- with and without securitizations;
- as part of a wider multi-country crisis or standing alone; and
- in diverse sectors, including residential real estate, commercial real estate and railroads.
Notably, for major countries, government debt is typically not a factor until after the crisis. Instead, the common theme is a very rapid increase in private-sector lending.
The pattern is almost always the same. In the few years preceding each crisis, there was rampant, runaway lending using blatantly compromised lending standards.
In 2008 for example, mortgage lenders had extended billions upon billions of dollars in loans without requiring down payments or checking employment, income or assets of the borrower.
In the 1850s, railroads were pushing preferred stock on unwitting farmers, providing them loans with no money down but secured by their farms — even though those railroads had no earnings to pay the preferred dividend.
In the 1830s, U.S. bank loans increased a whopping three-fold in five years, concentrated in state banks that had virtually no regulatory oversight. The list goes on and on.
Why do these lending booms happen? Lenders are almost always predisposed to grow loans as a way to increase their incomes and advance their careers. In certain periods, that tendency accelerated, and the very act of lending caused asset prices to rise, which encouraged even more lending.
In the early 2000s, the vast increase in mortgage lending meant there were far more buyers than sellers for homes, and prices skyrocketed. Only later when lenders realized this caused an oversupply of housing did they curtail their lending, and then prices came tumbling down.
A lending boom leads to a crash because it drives problematic overcapacity. Mortgage lending before 2008 led to acres of unneeded houses. When wildly optimistic forecasts of demand failed to materialize, many loans went bad, crippling the borrowers and lenders.
Home builders had to lay off workers and remain idle for years while demand caught up to supply; and the bad news cascaded into the rest of the economy.
Stock market crashes are a result rather than a cause of these financial crises. In each, overlending had happened for years before the stock market implosion.
Here’s the billion-dollar question: How can we tell if private loan growth is problematic? By looking at that growth with respect to GDP.
Our rough metric is that if private-sector loans — the sum of individual and business loans — increase by 15 to 20 percent with respect to GDP in under five years, the chances of a financial crisis are very high.
In the U.S. from 2002 to 2007, growth in private debt relative to GDP was 18 percent, a level only reached two other times since World War I: the years leading to the Great Depression and the years before the savings and loans crisis of the late 1980s.
I’m pleased to share that loan growth in the U.S. today has not again reached these troubling levels. However, in Asia, especially China and its economic satellites, loan growth is at very concerning levels, and that portends troubles that U.S. policymakers and regulators should be mindful of.
It is my firm belief that predicting financial crises should be our duty. We owe it to the American people.
Richard Vague is a managing partner of Gabriel Investments and author of "A Brief History of Doom." He is a former U.S. State Department’s Advisory Committee member on International Economic Policy.