To avoid another economic downturn like we’ve had, we need to know the cause of very bad recessions. Economists today point to too much credit, according to N.C. State University’s Mike Walden.
“This is one area … where we do have some answers. And I really think it makes common sense. And the answer is really too much credit. We have seen in our history very bad recessions after a period of time in which there was massive credit expansion. For example, in the 1930s, the recession, actually depression, then followed massive credit expansion in 1920s.
“And of course our current situation followed massive credit expansion in the decade of the 2000s. And, and again I think this should make sense to most people that if they over-extend themselves and then some of their assumptions that they made in taking on that credit don’t work out — like they lose their job — that could lead to a big massive downturn.
“These downturns can also occur due to policy. For example, if the Federal Reserve looks at the expansion of credit and says, ‘Well, we’re worried about credit becoming too widespread. We want to cut it back.’ What the Federal Reserve can do is actually increase interest rates, which if they do it too aggressively can actually bring on this downturn. And there’s some evidence that that was behind our current situation. The Federal Reserve started aggressively increasing interest rates in 2004. And obviously we have the start of the recession in 2007.
“So, keeping your eye on credit and the extent to which credit is being used very aggressively can be a good clue to whether we’re going to have some economic problems.”