Why financial crises accelerate?

Over-leveraged borrowers imperil the financial system in economic downturns.

The bottom 50% of the population has lost almost all their wealth. They maintained their spending by raising debt.

In normal times, whether the source of spending is income or debt, does not matter. Nonetheless, debt magnifies output deviations in crises.

To maintain expenditure without creating new debt, authorities will have to transfer income into low and mid income groups.

Over-leveraged borrowers are default-prone

The financial system stabilized in the aftermath of the World War II. As observed in the HBS visual above, the stable period had lasted until 1980s. During the time, banking crises almost ceased to exist. By 1980s, they replenished and have been accelerating since then. What might have been triggering financial crises?

Source: Harvard Business School (HBS), https://www.hbs.edu/behavioral-finance-and-financial-stability/data/Pages/global.aspx

One of the major sources of the fragility in the financial system is indebtedness. Debt served by a higher portion of income renders borrowers oversensitive to income deviations. Over-leveraged borrowers cannot tolerate income losses without cutting expenses. Massive layoffs in a recession thus plunge expenditure. Because someone's spending is someone else's income, a slump in aggregate expenditure is followed by a slump in domestic income.

Borrowers could compensate their income losses via additional debt. Nevertheless, banking sector would be reluctant to expand credits while delinquencies magnified by income losses jeopardize bank capitals. Indeed, expanding credits would lower delinquencies if all banks did so. In the absence of collection action, each bank is apt to shrink credits to preserve their equities. Banks are aware that they will fall one by one as borrowers allocate a higher portion of their income to loan installments. Their strategy is enduring until the government steps in.

Could indebtedness be blamed for financial crises? To figure it out, the debt-to-GDP ratios of household and corporate sectors are shown on the graphs. In 1980s both ratios spiked. The household sector ratio had continuously risen until 2010 when macro prudential measures restrained household leveraging. The corporate sector ratio has been fluctuating in a upward trend. When both ratios are evaluated together, private sector has been breaking new leverage records since 1980s. Over-leveraged borrowers have been imperiling the financial system in economic downturns.

The root cause of financial crises

The surge in indebtedness results from income inequality. As observed in the graph, the top 1% of the US population has been gaining a larger share in income distribution since 1980s. Groups losing their share of income have lost their wealth as well. In 1990s, the wealth share of the bottom 90% had melted. In the aftermath of the global financial crisis, the top 1% also gained share from the next 9% of the population. Overall, the top 1% has grown its share of wealth by 8% in the last 30 years.

The bottom 50% of the population has lost almost all their wealth. They maintained their expenditure by raising debt. That is, the top 1% lended the wealth that they have gained from the rest of the population. In normal times, whether the source of spending is income or debt, does not matter. Nonetheless, debt magnifies output deviations in crises. Therefore, authorities had to restrain household leverages in the aftermath of the 2008 financial crisis.

Once the COVID-19 crisis is over, corporate leveraging will also be restrained. Constraining all private debt will prompt a lower level of spending. To maintain the current level of expenditure without creating new debt, authorities will have to transfer income into low and mid income groups. As long as income distribution favors the top 1%, income transfers will have to be permanent.

One last issue to be addressed is the safe asset problem. Unless demand for safe assets is satisfied, constraining the asset supply would induce an asset price bubble. Central bank digital currency would attenuate the demand for safe asset by allowing savers to hold accounts at the central bank.

Conclusion

It is not the growing savings glut but its store as debt which renders the financial system fragile. Either leverage constraints on all debt or the isolation of savings from the financial system through central bank digital currency would dampen the debt-to-GDP ratio. Once borrowers become less sensitive to income deviations, they could preserve spending in bust times and their odds of default would be significantly lower. A lower delinquency risk would alleviate the sensitivity of banks to negative output growths. Borrowers could overcome a mild contraction of credits without cutting spending. The financial system would hence elude recessions without taking fatal losses.