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The Real Engine of the Business Cycle

A valuable lesson from the Great Recession is that credit-supply expansions play a key role in subsequent recessions. When lenders make credit more available or more affordable, households respond by taking on debt, which drives up aggregate demand – that is, until the music stops.

CHICAGO – Every major financial crisis leaves a unique footprint. Just as banking crises throughout the nineteenth and twentieth centuries revealed the importance of financial-sector liquidity and lenders of last resort, the Great Depression underscored the necessity of counter-cyclical fiscal and monetary policies. And, more recently, the 2008 financial crisis and subsequent Great Recession revealed the key drivers of credit-driven business cycles.

Specifically, the Great Recession showed us that we can predict a slowdown in economic activity by looking at rising household debt. In the United States and across many other countries, changes in household debt-to-GDP ratios between 2002 and 2007 correlate strongly with increases in unemployment from 2007 to 2010. For example, before the crash, household debt had increased enormously in Arizona and Nevada, as well as in Ireland and Spain; and, after the crash, all four locales experienced particularly severe recessions.

In fact, rising household debt was predictive of economic slumps long before the Great Recession. In his 1994 presidential address to the European Economic Association, Mervyn King, then the chief economist at the Bank of England, showed that countries with the largest increases in household debt-to-income ratios from 1984 to 1988 suffered the largest shortfalls in real (inflation-adjusted) GDP growth from 1989 to 1992.