Two directors of Mckinsey Global Institute, Charles Roxburgh and Susan Lund opined in an article that appeared in the Financial Times that policymakers and business leaders in should spend time and energy discussing how to prevent the next devastating financial crisis – specifically, how to spot and prick asset bubbles as they are inflating.
For many years, some of the world’s most prominent central bankers said this was impossible. However, new research from the McKinsey Global Institute shows that rising leverage is a good proxy for an asset bubble – and that the right tools could have identified the recent global credit bubble years before the crisis broke. Our new MGI report, Debt and deleveraging: The global credit bubble and its economic consequences, details how debt rose rapidly after 2000 to very high levels in mature economies around the world. But to spot a bubble, we need to know how much debt is too much. Some households, businesses and governments can carry large amounts very easily, while others struggle with lesser amounts.
The answer lies not in the level of debt alone, but in the sustainability of debt. If borrowers cannot service their debt, they will go through a process of debt reduction, or deleveraging. We see today, for example, that many debt-burdened households are deleveraging – voluntarily and involuntarily – by saving more and paying down debt, or by defaulting.
The results show that borrowers in 10 sectors in five mature economies have potentially unsustainable levels of debt, and therefore have a high likelihood of deleveraging. Half of the 10 are the household sectors of Spain, the UK and the US, and to a lesser extent South Korea and Canada – reflecting the boom in mortgage lending during recent housing bubbles. Three are the commercial real estate sectors of Spain, the UK and the US – reflecting loans made during commercial property bubbles. The remaining two are portions of Spain’s corporate and financial sectors, both of which thrived during that country’s real estate bubble, which is now deflating.
These findings confirm that the credit bubble was global in nature and fuelled primarily by borrowing related to real estate. More importantly, we see that this type of analysis could have identified the emerging bubble years ago, when its existence was still being debated.
If these tools had existed and been used in 2006, they would have signalled the growth of credit bubbles. And by pinpointing the sectors and countries, the data would have helped regulators identify the specific sources of the growing problem and address them in a targeted way. For example, they could have required tighter lending standards or bigger margin requirements in specific credit markets that appeared to be overheating.