The return of the bear

The most egregious cheerleader for asset price inflation was Alan Greenspan. That's why I've marked Greenspan on Figure 1 and Figure 4: if his rescue of Wall Street after the 1987 Stock Market Crash hadn't occurred, it is quite possible that the unwinding of this speculative debt bubble could have begun twenty years earlier.

Figure 4: US Private Debt to GDP since 1920

A mini-Depression would have resulted, as deleveraging drove aggregate demand below aggregate supply, but it would have been a much milder event than both the Great Depression and what we are experiencing now. The debt to GDP ratio in 1987 was slightly lower than at the start of the Great Depression (159 versus 172 per cent), inflation was higher (4.5 per cent versus half a per cent), and the "automatic stabilizers" of government spending and taxation would have attenuated the severity of the drop in aggregate demand.

Instead, Greenspan's rescue-and the "Greenspan Put" that resulted from numerous other rescues-encouraged the greatest debt bubble in history to form. This in turn drove the greatest divergence between asset and consumer prices that we've ever seen.

The crisis began in late 2007 because rising asset prices require not merely rising debt, but accelerating debt. The great acceleration in debt that the Federal Reserve encouraged and the US financial system eagerly financed, ended in 2008 (see Figure 5). From 1950 till 2008, the Credit Accelerator-the ratio of the acceleration in private debt to GDP-averaged 1.1 per cent. In the depths of the downturn, it hit minus 26 per cent. With the motive force of accelerating debt removed, asset prices began their long overdue crash back to earth.

Figure 5: Acceleration of Debt and the Bear Market Rally

However the share market rebounded again because, partly under the influence of government and Central Bank policy, private debt accelerated once more even though, in the aggregate, private debt was still falling. The annual Credit Accelerator turned around from minus 26 per cent in 2010 to plus 3 per cent in early 2011.

Figure 6: Private debt accelerated even though the level was still falling

This in turn fed into the stock market, causing one of the biggest year-on-year rallies ever seen (see Figure 7). But it could not be sustained because, if debt continued to accelerate, then ultimately the level of debt relative to income would again start to rise. With all sectors of the US economy maxed out on credit (apart from the Government itself), this wasn't going to happen. The impetus from the Credit Accelerator thus ran out, and the Stock Market began its plunge back toward reality.