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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.