1) The document analyzes historical data from 14 advanced economies over 140 years to identify trends leading up to financial crises. It finds that periods of high credit growth and leverage often precede crises and result in long, slow recoveries, especially when combined with high public debt. 2) Five facts are presented: advanced economies have experienced more frequent crises since the 1970s as financial sectors grew rapidly independent of the real economy; crises are deflationary and depress economic growth; unprecedented leverage in the banking sector now compared to the past; emerging markets insure against currency crises while developed markets benefit; and demographic changes may undermine long-term liquidity. 3) Five lessons recommend macroprud

1. Islamic Capital Markets
FN5630
Article Report: The Great Leveraging
(Group 2)
Prepared for: Prof. Dr. Obiyathulla Ismath Bacha
Prepared by: Murhasniyah Mukhtar (0800754)
Thaqif b. Kamaruzdin(1100286)
Mirra Nabila Mohd Sukri (1200045)

2. Introduction
Conventional Macroeconomic theory, in the aftermath of the 2008 global financial crisis, has been
thrown into wreckage sorting mode yet again. This scenario begs the question of “how far can theory take
us?” With that in mind, it is the premise of the paper that the only reliable source of explanation can be
from a Historical point of view where the evidence is considered empirically to understand what has
happened and quite possibly, as history tends to repeat itself, what will happen in the future.
5 Facts as well as 5 Lessons has been found to be significant in an attempt to grasp the overall
situation in which we live in today, post the 2008 global financial crisis. It has been found that, what is
happening now has indeed occurred before. Although the evidence, form 14 “advanced economies” over
the period of 140 years points to a much larger scale of financialization with more serious implications
seeing as the world is more integrated as a “global village” making easy contagion effects to spread,
causing major negative implications to the global economy. It is therefore an imperative for policymakers
to consider the evidence presented below.
The 5 Facts and 5 Lessons
Fact 1: Crises almost forgotten, now they are back.
Up until the recent 2008 global financial crisis, “advanced economies” seemed to have forgotten
about crises in general. Perhaps this pseudo sense of security came from the fact that for the period after
World War 2 and post The Great Depression of the 1930’s, advanced economies increased regulation and
supervision, which followed a period of high growth and expanding real resources, accompanied by low
leverage, modest but positive inflation and no financial crises at all! For 30 years from the 1940’s to 1970’s.
However, caution is needed as no research has been done to verify the causality of this period. Did it come
at a cost post 1970’s?
Fact 2: Consequences: Crises are depressing and deflationary
It has been found that recessions are bad and even worse when combined with financial crises
and worse when both are combined with Global Financial Crises. Financial crises lead to strong setbacks
in rates of growth of loans, which hinders business operations and establishment. Inflation falls more
during a combination of recession and crises than just recession alone due to the low growth.
Fact 3: Extreme Leverage: Size of Banking Sector is Unprecedented

3. The title “The Age of Money” ex-ante 1970’s was given due to, broad money (M2), was expending
at more or less the same rate of credit. Leverage it seems, was kept at reasonable levels that it provided
liquidity but not ballooning to the point that would jeopardize the economy should a recession occur.
Ex-post 1970’s, it was observed that a decoupling of loans from M2 took place. Banking assets on
the balance sheet exploded to triple that of GDP while loans doubled. This financialization was accelerated
by more interbank lending which saw private debt outweigh public debt. Deemed the “Age of Credit”, ex-
post 1970’s saw the emergence or rather acceleration of a “Paper Economy”, where the financial sector
grows independent of the real sector. This increase in risk tolerance is perhaps due to the “confidence”
that post 1930’s Great Depression, the central bank would bail out any failing banks in an attempt to avoid
similar catastrophes.
Fact 4: Global asymmetry: EM’s buy insurance, DM’s sell it
Theoretically, the integration of economies from the developed and emerging markets would
bring about downhill investment evening out the asymmetries of wealth by creating an optimum situation
where deficit units (EM’s) would receive the capital they needed to develop and surplus units (DM’s)
would get a return on the investment, so the Globalist claim.
In reality, while it may be true that private capital has been flowing downhill, official capital has
been flowing uphill, especially ex-ante 1997s Asian Financial Crisis in a bid to hedge against future currency
crisis that might cause unacceptable ramifications to sovereign and political stability in what has been
termed “The Great Reserve Accumulation” . As a result the downhill flow has been offset and in addition,
caused interest rates in the DM to be artificially low due to the euphoric demand for “safe assets”. US
10yr yields are at 1.5%.
Fact 5: Savings Glut: short run panic v. long run demography
From fact 4, a unique structural shift has taken place. The “safe assets” are on the official side,
while, the risky assets are held on the private side. Excess/artificial liquidity from the low interest rates
has encouraged businesses to lever up and take risky positions based on the “perceived” security of cheap
capital. The short run panic from EM’s has caused DM’s to over extend themselves.
In the long run however, DM’s have an ageing demographic as baby boomers retire and begin
consuming their savings thus reducing deposits effecting the money multiplier effect and thus reduced

4. liquidity and raising interest rates. The implication is, leveraged risky assets will become expansive to
maintain and thus exist the possibility of default on a massive scale.
Lessons 1 & 2:
3 variables (Credit Growth, C.A Deficit and Public Debt) were tested to find their significance as
an indicator of financial crises. It was found that credit growth was very significant as a predictor of
financial crises. This view is further back up by Babecký et al (2012) and Frankel and Saravelos (2010).
However Babecký et al (2012) does differ with Taylor (2012) regarding C.A Deficit and Public Debt,
asserting that they are late indicators whereas Taylor (2012) finds that C.A Deficit is not as good as credit
growth as an indicator while Public Debt was found to be insignificant (ex-Greece today).
Lessons 3, 4 &5:
There exist a strong relationship between the growth of credit on the upswing and the subsequent
severity of the collapse of GDP on the downswing. Output, consumption, investment, lending, money,
inflation, credit and long term investments all suffer negatively plus any recovery (normalization) will take
longer. Jorda et al (2013) and Kannan (2012) conclude similar findings but the latter ads that a reliance on
external credit will slow down recovery even more.
An economic recession with/or financial crises when combined with large public debt will
experience significantly worse conditions the larger the public debt. It seems counties with better fiscal
position will be more able to withstand a recession with/or financial crises at least without having to resort
to austerity measures. Reinhart and Rogoff (2012) and Gartner (2013) both find that with the addition of
large public debt, the recovery will be fragile and slow to ensue.
To sum it up, excess credit will make a recession with/or financial crisis worse with a slow recovery
process. When combined with large public debt the result could be catastrophic, extending the recovery
period and making it more fragile to shocks. However Taylor (2012) finds that credit buildup, though
significant, is rarely monitored by the macro-prudential authorities and banks risking inept policies.
This is concerning, as the historical evidence suggest, should the “Age of Credit continue, it is very
likely that the world will continue to expand leverage due to artificially low interest rates and when
combined with reckless policy making, put economies at risk the larger the leverage and public debt.

5. Nothing has been seen on par with The Great Depression, although The Global Financial Crisis of
2008 serves as a reminder. The empirical/historical evidence would suggest that should the lessons of
2008 not be headed, we are likely to repeat history or supersede it with an unprecedented Depression
forthcoming. A grim picture indeed.
Policy Recommendations
As far as policies go, Taylor’s Rule (1993) provides guidance as to when the Fed should adjust
interest rates to stabilize the economy in the short-term and still maintain long-term growth. Accordingly,
the Fed should have raised interest rates in times of high inflation/ full employment and vice versa. This
was in contrast with the Greenspan era (1987-2006) where interest rates were continuously cut for the
period even as inflation and employment began to rise because tightening interest rates would risk a
slowdown. However the low rates caused businesses to overhazardly increased capacity unlike
Greenspan’s presumption that firms would regulate themselves. The low rates also contributed to
another bubble being formed in housing sector with ramifications coming full circle in 2008.
Accordingly, credit growth should be monitored by the macro-prudential authorities and central
banks as it is currently not. In times of high credit growth, banks should be directed to increase fractional
reserves as it would reduce the multiplier effect and therefore reduce credit growth. It also goes without
saying that public debt ideally should reduce because that would eliminate the need to sell T-bills to EM’s
so that interest rates would not be artificially low. Of course, reducing public debt is easier said than done
should deficits persist.

6. Bibliography
Babecký, J. (2012). Banking, Debt, and Currency Crises Early Warning Indicators For Developed
Countries. European Central Bank Working Papers. No 145.
Frankle, J. A., & Saravelos, G. (2010). Are Leading Indicators of Financial Crises Useful for Assessing
Country Vulnerability? Evidence from the 2008-09 financial Crisis. NABER Working Papers.
Reinhart, C., & Rogoff, K. (2012). Public Debt Overhangs: Advanced- Economy Episodes Since 1800.
Journal of Economic Perspectives, 69-86.
Taylor, A. M. (2012). The Great Leveraging. BIS Working Papers.