Mainstream economic models ignore debt.The argument goes like this: if I lend you £1 then you have +£1 and I have -£1; and -1 + 1 = 0. Debt cancels out and can be ignored when modelling the economy. It’s all very simple and economists tell us we're stupid for not seeing it.
But consider another area where they make forecasts: weather. Rainfall is the water than falls from the atmosphere (creating a shortfall). This is balanced by a positive flow created by evaporation from open water, and transpiration from the leaves of plants. Now the net flow of water into and out of the atmosphere is zero. By the logic of economics we could safely ignore water when predicting the weather. But any idiot can see that the flaw in the logic. What happens when we have too little rain or too much in an area? We experience droughts or floods. Often a drought in one area is balanced by floods in another.
If we move back into the realm of the economy then too much debt creates floods which manifest as asset and commodity bubbles. Easy credit contributes to bubbles by making it easy for people with no assets to speculate on prices. Easy credit enables spending beyond our means, and it enables ponzi investment schemes. Once the bubble bursts a drought follows in which not enough investment capital flows into the economy to make it grow, and we have a recession. Growth ballooned from 1990 to 2007, when, pricked by the sub-prime mortgage scam, the bubble burst, and was followed by the Great Recession that is still in play.
Navigating without a compassMainstream economists and politicians had not predicted any of it. Indeed in late 2007 they were still talking in terms of an economic miracle – growth that would continue unabated forever. This was just magical thinking: the Hogwarts School of Economic Thought. When asked why they didn't predict the Credit Crunch and its consequences the answer is inevitably “We don’t know, but we’re sure that no one could have predicted it.” Which we know is wrong because at least a dozen heterodox economists and commentators did predict it. All were ignored as hapless muggles.
The simple fact is that if your weather model doesn't include water, then you can’t predict rainfall, and if you can’t predict rainfall then you can’t predict either droughts or floods. With economic models that don’t include debt, the mainstream were always incapable of predicting problems created by too much debt.
Yes, in a purely mathematical sense debt does cancel out. But it also accumulates. According to government and Office of National Statistics the situation in the UK in 2010 was like this: GDP: £1,500 billion Total private debt: £475% of GDP = £7125 billion. Total net worth: ~ £6,000 billion, with government indebtedness reducing this to £5,200 billion. Debt to asset ratio: 135%. In other words if we cashed in all the assets of the UK we’d still owe £1,925 billion.
In banking terms the UK has close to £2 trillion in unsecured loans. This level of debt is not neutral. This level of debt has a huge impact. Part of the problem is that debt incurs rent. Yes, the principle cancels out, but interest payments don’t. We don’t know what the average rate of interest is on all this debt, but let’s assume it’s 10%. That means that interest payments are about 47% of GDP. Almost half the annual income of the UK. That is very far from a neutral amount, and may well be an underestimate. If we take the population in 2010 to be 60 million, then in 2010 we all owed nearly £120,000. This is probably a bit higher now because the government is worth less.
So it turns out that a model that doesn't account for debt is worse than useless, it’s positively dangerous. A flood of debt causes long term damage to the economy, and indeed to the people who participate in the economy. We used to have regulations to prevent too much debt because this is not a new phenomenon. We have been through exactly this in 1929 and made laws to stop it happening again. Magical thinking on behalf of free market economists and politicians lead to those protections being dismantled. With predictable results: a flood of debt, a massive bubble, and a massive crash.
The Hogwarts School of Economics is still in charge and still trying “Expelliarmus” to get out of the recession. For some reason it's not working.