 So debt is good. Bank credit helps to grow the economy. But how exactly does that work? Well, imagine an entrepreneur who borrows say 1 million euros in order to have a car factory built. Then the total debt of the economy increases by 1 million and the borrowed money is used to pay the builders who build a factory and And it's used to pay factory workers who make the cars, so the new money is now income to workers and builders and it circulates in the economy. Money creation in this example is not just debt creation. It also helps increase the total income or the gross domestic product, the GDP. In this example, both debt and income rise. If that is all that debt could ever do, then why are we in a debt crisis? The quick answer is of course that there can be too much debt. This means we have so much debt compared to our income that it can no longer be repaid out of income without problems. This is the situation for many firms, households, governments, indeed for many entire economies. But when you stop to think about it, it's actually strange. How can there be too much debt? If each euro in debt is at least one euro of income for someone else? In that case, the ratio of debt to income does not grow. Let's call this ratio the debt burden, a number that tells us how much debt there is relative to income. When all debt is used to generate income, the debt burden will not go up. It cannot go up because there cannot be too much debt. All of it is spent in such a way that it provides us with the income that we can use to repay the debt. All is well, financially speaking. Now, to understand how a debt crisis develops, we need to make a distinction between different types of debt. Between debt that helps to grow the economy and debt that does not, because debt can also be used in other ways than to increase income. For example, if I go to the bank for a house loan or mortgage to buy an existing house, then this increases my debt and the total debt in the economy. But it does not lead to more income because no goods and services have been produced. It just pushes up house prices a bit and therefore all house owners may feel a bit wealthier. But no wages or profits have been generated in the economy. And here is the problem. Most bank credit today is used in this way. Most bank credit is used not to help producing goods and services, but to finance transactions in housing, land, commercial property and financial products and to push up their price. This price increase is a capital gain on assets. But there is no income or profit from production of goods and services. Borrowing to invest in existing assets grows our debt, but not our future income. That means the debt burden goes up. The entrepreneur, remember, who was investing borrowed money into building a factory, was using the loan in such a way that it provides him with a future stream of income from which he can repay the debt, including interest. If the business plan is solid, there will not be a debt problem for the entrepreneur or for the economy. On the contrary, the loan will make it possible for him to increase his profit and create jobs and so help grow the economy. But in our house example, the mortgage does not lead to income creation. So the debt has to be repaid out of the income of whoever bought the house and took the mortgage. Part of income, therefore, say part of a monthly salary, now needs to be used to repay the debt with interest. So that money has to be subtracted from the money people can spend on goods and services in the economy. And the interest that the bank receives is also not income to anyone else. Mostly, it is simply recycled into new loans. The tricky thing is, we don't tend to worry about it. Mortgage lending causes house prices to go up. So we see an increase in our wealth, which is the value of what we own, including our house. It goes up even more than the debt does, so we feel fine about that. But wealth is not income. In the economy, income does not go up due to mortgage lending, but debt does go up. And the ratio of debt to income, the debt burden, is rising all the time. To see this, just think of an example. In a market with 100 identical houses, each value at 1,000 euros, what happens if for some reason there is a price increase so that I take out the mortgage to buy one house for 1,200 euros? Well, that transaction will set the market price. Each house owner who wants to know the current value of his house will look at the latest transaction. The valuation of his house will go up by 200 euros. And if this happens for every house, that's 100 times 200 euros, which is a total of 20,000 euros. And house values are part of people's wealth, remember? So that's how rich they think they are. Which means that my mortgage of 1,200 euros has led to an increase in total wealth of 20,000 euros. 99 people are now richer, not because their income has gone up, but because of debt creation by one person and his bank. So here we found what that can do apart from increasing income. It can increase wealth if it is used not to invest in production, but to invest in existing assets, in houses or land or shares or whatever financial products. In fact, once this starts, people may start feeling so much richer that they think it is safe and attractive to borrow even more. Getting an additional mortgage to invest in a booming housing market seems a good idea, or perhaps the mortgage can be increased a bit to pay for that new car. So you easily get a process that reinforces itself. Debt increases wealth, which increases debt, which increases wealth and so on and so on. Meanwhile, remember the debt ratio. Debt is rising, income is not. So the debt ratio or the debt burden is going up all the time, so it's more difficult to repay debt from income. Is that actually a problem? With so much wealth, surely there's another way to repay debts if you have to, not out of income, but by selling some assets. This idea is just the reason that people will borrow without a worry while asset prices are rising. They think they can always sell assets to pay their debts if they have to. Asset values are rising faster than debts after all. So this market is not self-correcting the way we like to think about markets with demand and supply. There is no tendency to equilibrium the way we learn about it in economics textbooks. If the price for carrots goes through the roof, you will want to eat other things. So prices go up, demand goes down and then the price falls back again. There is a tendency towards equilibrium, but with houses things are different. If prices go up, everyone wants to own a house to share in the capital gains. So demand for houses goes up more than supply. And with falling asset prices, everyone wants to get rid of assets. So supply increases more than demand. This instability is even bigger if borrowing can quickly inflate the market. Money can be created instantaneously at the keystroke and be poured into the market. Something that can never happen in the market for carrots. And this is the reason why market economies have always had booms and bubbles in their asset markets, which can grow really large and destructive. And the biggest asset market in each economy is the property market for land and houses. And most credit that banks today create is mortgage credit. You can see how powerful that combination is. It's been quite a story. But now we can start seeing how credit and debt harm the economy instead of helping it. During the boom, there are three harmful effects, which tend to go unnoticed. One is when asset prices rise quickly, banks will want to invest more in asset markets and less in the production of goods and services, which gives lower returns. Another effect is when the debt burden increases, more and more of our household income is going to debt repayment. And this means less money is available for purchasing goods and services. In both ways, the economy suffers from a financial boom, though this will be masked by the abundant purchasing power that debt itself provides. And finally, with rising asset markets, there will be big gains for those who already own assets, the rich, and much smaller gains for those who need to borrow in order to obtain assets, the middle classes. So a financial boom will increase inequality, which is also bad for economic growth. And it all started with this simple distinction. Is credit used to support the production of goods and services? Or is it used to invest in and inflate asset markets? This difference is not a distinction you will find in economics textbooks or even in advanced macroeconomic models. In fact, the absence of this distinction is a key reason why the credit crisis and all that followed came as such a surprise to most economists. On the one hand, we have credit going to the economy of goods and services, where it pays for wages and profits. On the other hand, credit going to property and asset markets, pushing up asset prices. The first type grows the economy and is mostly helpful. The second type of credit may help the economy but also increases the debt burden and it introduces new risk and it's harmful at high levels. So now we've looked at the boom and its harmful effects, but while the boom is bad enough already, what about the bust?