Leveraging and De-leveraging
By Arnold Kling
The claim isn’t that leverage cycles explain all recessions, but rather that they can help explain why some recessions–often those that also include a financial crash–can turn out to be so severe. The U.S. data on borrowing certainly suggests that leverage went through a leverage cycle. Here are two graphs from FRED, the ever-useful website run by the St. Louis Fed. The first shows total bank credit in proportion to GDP. Total bank credit was about 45% of GDP, give or take a bit, from 1975 through the mid-1990s. But then it starts rising, hitting 50% of GDP by about 2002, and then shooting up to about 67% of GDP by 2009. It has dropped since then, but is still above 60% of GDP. But when leverage rises this fast, it has “bubble” written all over it.
The theory that de-leveraging makes for a deep recession is not in the textbooks. However, I have been predicting that the theory will become popular.