FT.com / An early warning system for asset bubbles

COMMENT: The executive summary of the report by McKinsey & Company can be found here. The research completed by the company attempts to answer two questions: 1) How can an asset bubble be detected? and 2) How can policy makers guide an economy through the painful and lengthy deleveraging process? To answer the first question, the researchers point out that debt plays a fundamental role in helping to pump up an asset class to unsustainable bubble levels. The odd thing about debt, however, is that what one company or individual can shoulder another cannot. This means that granular data needs to be collected in order to understand what levels of debt are sustainable and appropriate for different institutions. While this study is in-sample, it could provide the tools necessary to attempt to prevent asset bubbles before they become so large that the fallout and resulting deflation can have any long-term, crippling impact on the economy.

Deleveraging is, more often than not, a painful and lengthy process. The final years of an asset bubble are in general fueled by large amounts of debt. A new paradigm typically explains why this time is different. Recall the e-economy of the late 90s or an outdated, under-researched fact that says housing prices do not fall. Individuals, as well as institutions, fool themselves and underestimate the amount of risk they are taking by levering up to increase their exposure to the boom. According to the authors of the report, the deleveraging process is only beginning and will be a global phenomenon. After nearly every financial crisis a deleveraging period, lasting around six to seven years, has occurred. While this process is taking place GDP usually contracts during the first few years and then begins to recover slowly.

While deleveraging is often an arduous process, it is necessary. If government, firm and individual debt levels remain elevated there is a risk that countries around the world could fall right back into recession because the debt load becomes too heavy to service and maintain.