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An Early Warning System for Asset Bubbles New research from the McKinsey Global Institute shows that the right tools could have identified the recent global credit bubble years before the crisis broke.

An Early Warning System for Asset Bubbles

by Susan Lund and Charles Roxburgh, McKinsey Global Institute

New research from the McKinsey Global Institute shows that the right tools could have identified the recent global credit bubble years before the crisis broke.

As policy makers and business leaders gather in Davos, Switzerland, this week, much of their conversation will no doubt focus on how to drive a global economic recovery. Yet they should spend just as much time and energy discussing how to prevent the next devastating financial crisis—specifically, how to spot and prick asset bubbles as they are inflating.

For many years, some of the world’s most prominent central bankers said doing so was impossible. However, new research from the McKinsey Global Institute (MGI) shows that rising leverage is a good proxy for an asset bubble—and that the right tools could have identified the recent global credit bubble years before the crisis broke. We urge policy makers to develop these tools and use them to ensure a more stable financial system, thereby avoiding more of the widespread pain and suffering caused by the current crisis.

To spot a bubble, we need to know how much debt is too much.

Our new MGI report, Debt and deleveraging: The global credit bubble and its economic consequences, details how debt rose rapidly after 2000 to very high levels in mature economies around the world. But to spot a bubble, we need to know how much debt is too much. Some households, businesses, and governments can carry high levels very easily, while others struggle with lesser amounts.

The answer lies not in the level of debt alone but in the sustainability of debt. If borrowers cannot service their debt, they will go through a process of debt reduction, or deleveraging. We see today, for example, that many debt-burdened households are deleveraging—voluntarily and involuntarily—by saving more and paying down debt, or by defaulting. To understand the sustainability of current debt levels, we looked at borrowing within individual sectors and subsectors of individual economies and at more granular factors such as the recent growth rate of leverage, borrowers’ ability to service the debt under normal conditions, and borrowers’ vulnerability to a disruption in income or a spike in interest rates.

Our analysis is far from perfect. The data we would ideally want are not wholly available. Still, the results show that borrowers in ten sectors within five mature economies have potentially unsustainable levels of debt, and therefore have a high likelihood of deleveraging. Half of the ten are the household sectors of Spain, the United Kingdom, and the United States, and to a lesser extent Canada and South Korea—reflecting the boom in mortgage lending during recent housing bubbles. Three are the commercial-real-estate sectors of Spain, the United Kingdom, and the United States—reflecting loans made during commercial property bubbles. The remaining two are portions of Spain’s corporate and financial sectors, both of which thrived during that country’s real-estate bubble, which is now deflating.

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