What does credit do after it has finished the job it was designed for? The supply of credit ought to stop at funding productive activity. But the reality is different. Surplus credit fuels dangerous asset price inflation and funds profligate governments. As leverage increases, so too does the risk of crisis and recession.
Credit, otherwise known as debt or loans, is not necessarily monstrous. It can be a most helpful economic beast of burden, carrying resources to the places where they can be best used. Loans from households to businesses fund helpful investments, and loans from rich older households to poor younger ones help spread property, especially houses and cars, more equitably. Even loans to governments can be a useful alternative to taxes.
However, credit too easily goes astray and there is no natural force to rein it in. Without firm regulatory guidance, credit seems to expand indefinitely, until the financial system explodes. That has been the pattern since the end of the Second World War.
Academics Moritz Schularick and Alan M. Taylor showed in a 2012 paper that the ratio of bank credit to GDP in developed economies fell during the Great Depression and then expanded steadily and rapidly. Combining the 14 countries studied, the ratio surpassed the previous pre-Depression peak of about one by 1970, and started the 2008 crisis at just below two.
Their work does not directly include government debt, but that has also increased, from 60 percent of GDP in the G7 countries in 1990 to 83 percent just before the crisis, according to the International Monetary Fund, and 122 percent this year.