Taken at face value, David Cameron’s warning this week about risks in the global economy sounds like it might be wonderfully prescient. Here’s the country’s economic chauffeur, carefully checking his instrument gauges, and sure enough, sees the same signs today that should have given us warning of the crisis of 2007-08. Time to apply the brakes.

There’s only one prob­lem: the eco­nom­ic dash­board that Cameron relies upon did not warn of the cri­sis before it hap­pened. Instead, that dash­board advised Cameron and oth­er lead­ers around the world that every­thing was look­ing rosy, and that going full throt­tle was entire­ly safe.

The OECD’s Eco­nom­ic Out­look, pub­lished in May 2007, stat­ed that its “cen­tral fore­cast remains indeed quite benign” as it pre­dict­ed “a strong and sus­tained recov­ery in Europe”. Some dash­board that turned out to be.

Motor skills

Politi­cians are fond of car analo­gies when talk­ing about the econ­o­my, because they’ve actu­al­ly dri­ven cars, and they know how they work. Press the accel­er­a­tor, you go faster; hit the brake, you slow down; the tachome­ter tells you whether the engine is flat out or idle; the fuel gauge tells you whether you need to call into a petrol sta­tion. Car con­trols work because they are designed by engi­neers who actu­al­ly built the car in ques­tion, and the dash­board tells you all you need to know, with no seri­ous omis­sions and no dis­tract­ing false sig­nals.

But the eco­nom­ic dash­board that Cameron relies upon today was hor­ri­bly wrong in 2007: the sig­nals it focused upon – main­ly the rate of unem­ploy­ment (low and falling), the rate of infla­tion (low), the gov­ern­ment deficit (head­ing towards a sur­plus), and the rate of inter­est (low but ris­ing to cool the econ­o­my down) – gave absolute­ly no warn­ing of the biggest eco­nom­ic cri­sis in a cen­tu­ry.

This main­stream dash­board gave no warn­ing of the cri­sis because it was built by econ­o­mists whose the­o­ries have more in com­mon with Alice in Won­der­land than with engi­neer­ing. And one Mad Hat­ter assump­tion their dash­board makes is that the lev­el of pri­vate debt can be ignored.

Debt wish



Ger­ald R. Ford School of Pub­lic Pol­i­cy, Uni­ver­si­ty of Michi­gan, CC BY-ND

If that sounds crazy to you, that’s because it is. Some influ­en­tial econ­o­mists argue that pri­vate debt has “no sig­nif­i­cant macro­eco­nom­ic effects”, to quote Ben Bernanke. Only mav­er­icks who fol­low the then-ignored but now famous Amer­i­can econ­o­mist Hyman Min­sky dis­agree, and regard the lev­el and growth of pri­vate debt as vital eco­nom­ic indi­ca­tors.

I am one of those mav­er­icks, and the signs I saw back in 2005 led me to be one of the hand­ful of econ­o­mists who did warn of the cri­sis before it hap­pened.

Since then, the Amer­i­can phil­an­thropist Richard Vague – who made his for­tune in bank­ing – has exam­ined all major eco­nom­ic crises since 1850, and con­clud­ed that the two key signs of an immi­nent cri­sis are pri­vate debt exceed­ing 1.5 times GDP and that ratio ris­ing by 17 per­cent­age points or more over five years. Both those sig­nals were clear­ly “flash­ing red” in 2007.

Signals, noise

Pri­vate debt in Britain rose from 135% of GDP in 2000 to 180% when the cri­sis began in August 2007 – a 45% rise in less than eight years. In the US, it rose from 125% to 160% – a 35% rise. Both these lev­els and the rates of change were unsus­tain­able: the growth in pri­vate debt had to stop, and when it did, I expect­ed that the biggest eco­nom­ic cri­sis since the Great Depres­sion would fol­low – which is what actu­al­ly hap­pened.

So what are those reli­able but neglect­ed indi­ca­tors telling us today? In the US, pri­vate debt fell from 1.7 times GDP in 2010 to 1.45 times in 2014. It’s been ris­ing since 2012 and was now grow­ing at 5% of GDP per year in mid-2014, which is spurring eco­nom­ic growth – but the head­room for con­tin­ued cred­it-dri­ven growth is lim­it­ed because the aggre­gate lev­el is still so high. We are nudg­ing back clos­er to Vague’s dan­ger zone.



Fed­er­al Reserve Flow of Funds

In the UK, pri­vate debt peaked at more than twice GDP in 2010. It has fall­en to 170% today, but between 2012 and 2014 it rose – stim­u­lat­ing eco­nom­ic growth. Now it is falling again – by as much as 5% of GDP a year. That implies that a cred­it con­trac­tion – how­ev­er wel­come it might be in stop­ping at least one warn­ing light flash­ing – is like­ly to reduce British eco­nom­ic growth in the near future.

So Cameron is right to wor­ry, but he’s wor­ry­ing about the wrong thing: pan­ick­ing about a ris­ing lev­el of gov­ern­ment debt, when at 91% of GDP, it’s 80 per­cent­age points below the lev­el of pri­vate debt. If Cameron thinks reduc­ing gov­ern­ment spend­ing when pri­vate cred­it is con­tract­ing is good eco­nom­ic pol­i­cy, then he’s ignor­ing the biggest car crash in eco­nom­ic his­to­ry – the Euro­pean Union, where gov­ern­ment aus­ter­i­ty turned the cri­sis into a sec­ond Great Depres­sion.

The key indi­ca­tor I use to antic­i­pate where the econ­o­my is head­ed is the accel­er­a­tion of pri­vate debt. Just as the rate of change of pri­vate debt indi­cates what’s going to hap­pen to the lev­el of eco­nom­ic activ­i­ty, the accel­er­a­tion of debt indi­cates whether activ­i­ty is like­ly to rise or fall. That indi­ca­tor, which was trend­ing up from mid-2010 until mid-2012, has been head­ed down ever since. Debt accel­er­a­tion was strong­ly neg­a­tive as of mid-2014, run­ning at minus 10% of GDP.

That, com­bined with Richard Vague’s indi­ca­tor that crises occur when pri­vate debt exceeds 150% of GDP (tick at 170% in mid-2014) and has grown by 20 per­cent­age points or more over five years (in fact it’s shrunk by 30 per­cent­age points since 2010), points to stag­na­tion rather than cri­sis being the like­ly out­come for the UK econ­o­my.

In this sce­nario, an attempt to pare gov­ern­ment spend­ing back could make the stag­na­tion worse – just as it has done across the Chan­nel.

Author pro­vid­ed

All in all, I would rec­om­mend Cameron gets his eco­nom­ic dash­board fixed, or he risks steer­ing the UK in the direc­tion of Europe.

Hard Evi­dence is a series of arti­cles in which aca­d­e­mics use research evi­dence to tack­le the trick­i­est pub­lic pol­i­cy ques­tions.

Steve Keen has received research fund­ing from the Insti­tute for New Eco­nom­ic Think­ing (www.ineteconomics.org) and has con­sult­ed to the Gov­er­nor’s Woods Foun­da­tion (www.govwoods.org). He is affil­i­at­ed with IDEA Eco­nom­ics (www.ideaeconomics.org).

This arti­cle was orig­i­nal­ly pub­lished on The Con­ver­sa­tion.

Read the orig­i­nal arti­cle.