Steve Clemons and Richard Vague tell us that it’s all, or at least mostly, about debt. The financial crisis and the Great Recession were “caused primarily by a massive private debt buildup,” they write in a recent white paper: “How To Predict The Next Financial Crisis.” The authors will be speaking next month at a conference on the topic at the Global Interdependence Center in Philadelphia and presumably they’ll lay out the evidence in some detail. They’re certainly on solid ground when they link debt with financial crises. History is quite clear on this point. But let’s be careful here. Citing debt as the main catalyst that routinely triggers recessions across time is surely going too far.

This may sound like a subtle distinction, but it’s critical nonetheless. Financial crises and recessions often strike simultaneously, but one event has been known to arrive without the other at times. For example, the credit crunch of 1966—”the first financial crisis in the postwar period,” as Martin Wolf labeled it in Financial Crisis: Understanding the Postwar U.S. Experience—wasn’t accompanied by an economic downturn, at least not by NBER’s definition of recession. On the flip side, the brief 2001 slump was basically crisis-free in terms widespread banking troubles.
Even so, it’s essential to recognize the toxic relationship between debt and financial crises, a connection that Gary Gorton analyzed thoroughly in his recent book: Misunderstanding Financial Crises: Why We Don’t See Them Coming, which I reviewed last November. “Banks and bank debt were at the root of every one of the 124 systemic crises around the world from 1970 to 2007,” Gorton reports.
No wonder that a financial crisis can push an economy into recession. Or is it the other way around? Do recessions cause financial crises?
Analysts can be excused for not answering directly, at least not in absolute and definitive terms. The problem is that no one’s really sure what’s driving business cycles, or even if they’re a natural, inevitable part of capitalism vs. a byproduct of misguided policy and ill-advised decisions in the private sector, which is to say a phenomenon that can be “cured.” In any case, let’s not conflate a diagnosis with an explanation. It’s easy to identify events that precede and/or accompany downturns, but correlation isn’t necessarily causation—a caveat of no small import in the land of macroeconomics.
A quick example is the popular observation that consumption declines just ahead of and/or during recessions. A naïve observer could claim that falling consumption causes recessions. True, but one could just as easily ask: What causes consumption to fall? Economists have been looking for answers to such answers in the context of the business cycle for over two centuries, and it’s not obvious that we’re any wiser today than in 1819, when Sismondi first identified the alternating periods of expansions and slumps as a distinct trend in economics.
If you study the ebb and flow of the economy in history you’ll soon discover that there are few constants for identifying cause and effect in a timely manner. Perhaps the only reliable forecast is that there’s another recession out there somewhere. In my own work in trying to untangle the various factors that collectively drive the economy’s rise and fall in real time it’s clear that there’s an evolving mix of triggers that are linked with recessions. For instance, I track 14 broad economic and financial indicators and individually they present a mixed record in terms of signaling the onset of a new downturns through history. Collectively, however, they provide a richer roadmap for anticipating another drop in economic output. The record’s hardly perfect with a carefully selected lineup of indicators, but the record’s better compared to indicators in isolation throughout economic history.
This brings us back to debt and its connection with the business cycle. The simple reality is that debt is a problem, can be a problem, if the economy’s slipping into recession. That’s another way of saying that debt is far less threatening during an expansion. In fact, debt may not be a problem at all under the right conditions. Granted, there are limits to how much debt an economy can bear—even a growing economy—without pushing the macro climate into the danger zone. But deciding where those limits lie, in relative or absolute terms, is a murky business. Why? Much depends on whether the economy is growing or shrinking and how the other key variables compare at a given point in time.
It’s tempting to say that high debt causes recessions, but the empirical record offers no easy lessons. Debt levels can increase for years without the onset of recession. That implies that there are other triggers to consider for understanding the business cycle. Monetary policy, employment, consumer spending, and so on, are hardly irrelevant here. Debt is surely a factor, but it’s a contributing factor, and one with fluctuating degrees of influence through time.
Explaining the big picture from a theoretical perspective opens up another dimension of analysis, and complication. The standard Keynesian view is that slumps are a byproduct of weak/falling aggregate demand. By contrast, market monetarists emphasize that recessions are primarily due to a central bank’s willingness to let nominal gross domestic product (NGDP) fall, an explanation that assumes that monetary policy can prevent or substantially lessen the economy’s fall from expansionary grace.
Every corner of macroeconomic analysis is controversial, of course, as it has been over the past two centuries. Deciding how an economy moves away from equilibrium, or even if such a state exists, is the raw material for great debates and precious little agreement. Par for the course in macro. So when someone claims that all is explained by analyzing debt, or any one factor, sign me up as a skeptic.
No one can ignore debt when it comes to dissecting the business cycle. Sometimes it’s the elephant in the room. But assuming that’s all we need to know from here on out is assuming empirical facts not in evidence.