As the Greek debt crisis winds down, world markets are reverting to business as usual without acknowledging a fundamental truth: Greece was only the beginning. Many countries have used nothing but debt to fuel their growth, laying the groundwork for a mega-sized economic collapse.
A key study by the International Monetary Fund (IMF) found that an over-indebted population is directly correlated with a volatile economy. And when I say debt, I don’t necessarily mean government debt. Plenty of growth is built on the backs of new credit cards and mortgages. If the level of private credit hits 80% to 100% of gross domestic product (GDP), there’s trouble ahead. (Source: IMF Working Paper, June 2012.)
Take Greece. What happened in that little Mediterranean nation is proof of a financial system run amok—the incessant credit creation, over-lending, and ever-higher leverage. Private debt in Greece was 115.9% of the country’s output in 2014. Government debt is a different matter because most countries can print their way out of a crisis, but how do you reduce the indebtedness of your entire population?
Shocking: This Could Lead to an Economic Collapse
Finance is a service business. It facilitates the flow of capital through the economy; it doesn’t create goods or contribute to an end product. Finance is just an intermediary.
But there’s money to be made as the economy’s middleman. Although central banks set reserves for private banks, it’s really the private banks that expand the money supply. When they decide to make a new loan, they enter a few keystrokes on some computer, and a matching deposit is made at the bank. Just like that, more money is added to the economy.
In places like Spain and Portugal, private debt hovers between 125% and 130% of GDP. Both lenders and borrowers were irresponsible to let the situation get so far out of control. But the real problem is interconnectivity—a lot of the debt has been pooled into asset-backed securities and sold to investors. (Source: World Bank Data, July 21, 2015.)
Sooner or later there will be a tipping point, a moment when too many people are unable to repay their loans. And when that happens, the country’s entire debt market will collapse as the panic feeds on itself. If this reminds you of the 2008 financial crash, it’s because they are both products of overzealous lending.
As a portion of America’s GDP, finance has grown from 4.2% in 1970 to nearly seven percent in 2012. The profits of financial firms also rose as a share of corporate America’s income, from 24% to 37%.
The pattern is reminiscent of the 1920s, when people would leave their farming jobs to come and work on Wall Street. Working for as a stock broker was the magic ticket to getting rich. Until the market crashed in 1929, which launched the country into the Great Depression. (Source: Harvard Business Review, June 2014 Edition.)
Decades have passed since, but history repeats itself. These days, many of the smartest software programmers and engineers go work on Wall Street instead of building the next Facebook or Google. Between 2009 and 2014, the number of Goldman Sachs employees with high-level programming experience jumped by 43%. (Source: Business Insider, November 14, 2014.)
Finance is the lifeblood of capitalism. But we need it to function properly. Rather than letting money flow towards the best real investments, an over-bloated financial system can distort the proper functioning of capitalism. It drives money towards short-term thinking instead of rewarding innovation and risk taking, effectively guaranteeing another economic implosion.