Leverage is risky. Purchasing assets with borrowed money can amplify small movements in prices into extraordinary gains or crippling losses, even default. From the mid-1980s to the Great Recession, an unusually rapid increase in the ratio of credit to GDP, or leverage, across the developed world was overshadowed by an equally unusual decline in inflation rates and output volatility. As such, this period is often called the Great Moderation. However, underneath the apparent calm, leverage continued to build. The pressure mounted up along financial fault lines, and in time struck violently in the form of the 2008 global financial crisis. The aftershocks are still being felt today, as policymakers continue to grapple with the resulting economic damage and discern how best to prevent future financial tremors.
This Economic Letter explores the channels through which advanced economies have increased their debt and the consequences that this leverage has had for the business cycle. The rapid increase in credit-to-GDP ratios since the mid-1980s was just the final phase of a long historical process. The run-up started at the end of World War II and was shaped by a long boom in mortgage lending. One of the startling revelations has been the outsize role that mortgage lending has played in shaping the pace of recoveries, whether in financial crises or not, a factor that has been underappreciated until now.
A historical rise of leverage
Research by Schularick and Taylor (2012) showed that bank lending in advanced economies quadrupled in the second half of the 20th century, from about 30% of GDP in 1945 to about 120% of GDP right before the 2008 global financial crisis. In newer work, Jordà, Schularick, and Taylor (2014) show that this sharp increase has primarily resulted from the rapid growth of loans secured by real estate. The share of mortgage loans in banks’ total lending portfolios averaged across 17 advanced economies including the United States has roughly doubled over the past century—from about 30% in 1900 to about 60% in 2014. The evolution of this share since 1880 is shown in Figure 1. The most dramatic increase occurred since the mid-1980s.