Debt/broad money supply is a key foundation of asset values and GDP flows and, because of this, wealth and debt effects (new loans create deposits) on GDP/income flows should not be considered as separate forces.
Debt in the form of money supply (bank deposits) is a foundation of both GDP flows and asset values and it is when debt, in the form defined, increases relative to GDP/national income flows that we should pay attention. Money leverages many activities, and asset values are always to a certain extent in a form of a bubble, but excess leverage, especially during periods where we have structural imbalances and frame transitions creates instability and risks to the financial system.
If you borrow to invest, for example, and if borrowing raises both demand for assets and their prices, then the impact of a decline in wealth in the event of an asset price shock will play out to greater or lesser magnitude according to leverage. Asset prices are dependent on system leverage, on the amount of money in the system and, in particular, the amount of money allocated to assets classes within the market portfolio: if the market wishes to reduce % money balances the only way this can be done, apart from transferring money to consumption, is to raise asset prices relative to money.
Moreover the flows that underpin asset values, such as GDP/national income, are also likewise leveraged to greater or lesser degree and the degree of leveraging of these flows can compound an asset price shock. Highly indebted consumers or corporations will be more exposed to asset price led or demand led shocks.
So we have leverage in the asset market (from asset focused loans, quantitative easing, low interest rates) and we have leverage of economic flows (consumer credit/deposit based lending and commercial bank lending to corporations as well as debt issued by corporations). Leverage upon leverage at extremes (asset price to GDP/income flows divergence) is what we appear to be left with. And of course let us not ignore the increased velocity of asset focused money and the loan/liquidity spirals of the shadow banking sector. All these flows are linked.
Separating out debt and wealth is like trying to separate out the balloon and the air within it, like ignoring the hand in the glove that punches you.
I write with reference to a discussion in a recent Bloomberg View article, We’re Still Not Sure What Causes Big Recessions. I have some qualms over the discussion if not for the simple fact that it also ascribes the cause of the recession to the financial system without definition:
“…..Almost everyone agrees, at this point, that the Great Recession of 2007-09 was caused by the financial system.”
The financial system, the balloon per se, did not cause the great recession. At a basic level, the many imbalances that had built up within the system (the air, the hand in the glove) were the causes of the financial crisis; they came back through the banking system as debtors defaulted on home loans, loan collateral values declined and off balance sheet vehicles came back onto bank balance sheets. What led to the imbalances was more complex.
In drafting stage…