Debt Mania and Debt Phobia

Debts owed by nations

Every new crisis seemed to hatch a new way of thinking about debt, depending on who is lending, who is borrowing, for how long, and many other factors.

• Mexico's "tequila crisis" of the mid-1990s started with short-term bonds.  This led to focus on the dangers of short-term debt.
• The Asian financial crisis started with debt to foreigners, and foreign loans became the new obsession.

The best predictor of these meltdowns:  five straight years of rapid growth in private-sector debt.  

A decade after the global financial crisis, the Bank of International Settlements, the IMF and other international authorities concurred the most consistent precursor of major credit crises going back to the "tulip mania" in 17th century Holland was that private-sector debt - borrowing by corporations and individuals - had been growing faster than the economy for a significant length of time.

The authorities also reached another surprising conclusion:  the clearest signal of coming trouble is the pace of increase in debt, not the size of the debt.  

• Size matters, but pace matters more.  
• Government debt play a role but usually rises later, after trouble starts in the private sector.  
• A sharp increase in private debt is the leading indicator.

The key issue is whether debt is growing faster or slower than the economy.   

• A country in which private credit has been growing much faster than the economy for 5 years should be placed on watch for a sharp slowdown in the economy and possibly for a financial crisis as well.

Thailand in 1997

From the prime minister to farmers gets swept up in the mania for cheap loans. 

A housewife borrows to invest in "four million of anything."  

By 1997, private debt amounted to 165% of GDP in Thailand, but debts of that size would not necessarily have signaled a crisis if the debt had not been growing at an unsustainable pace.

• Over the previous 5 years, private debt had been growing at an annual pace more than twice as fast as the roaring Thai economy and had rise by 67% points as a share of GDP.  

To anticipate coming trouble, the number to watch:  the five-year increase in the ratio of private credit to GDP.

Successful nations avoid debt manias

Successful nations avoid debt manias and are often best positioned for sustained growth after a period of retrenchment.  

• The upside to the rule is that if private credit has been growing much slower than the economy for 5 years, the economy could be headed for recovery, because banks will have rebuilt deposits and will feel comfortable lending again.  
• Borrowers, having reduced their debt burden, will feel comfortable borrowing again.  

That is the normal cycle anyway. 

Debt phobia can be almost as destructive

 After particularly severe credit crises, lenders and borrowers may be paralyzed for years by debt phobia, which can be almost as destructive as debt mania.