Good times before the bust, as portrayed here by Robert Redford and Mia Farrow in The Great Gatsby (AP)

Former Fed Chairman Alan Greenspan, discussing the financial crisis of 2008, wrote that “financial bubbles occur from time to time, and usually with little or no forewarning.”

That’s misleading at best. The 2008 collapse was predictable. And, more generally, major financial crises of this type can be seen well in advance—and prevented—if you know what to look for. In fact, there’s a fairly simple formula that predicts such crises with a high amount of confidence. And it suggests that the world economy remains in more peril than is generally appreciated.

This conclusion comes from an examination of financial crises around the world, dating back to the 19th century, that I conducted with my colleagues and summarize in my new book The Next Economic Disaster. The logic behind our conclusion can be seen in the diagrams below.  

Take a look at this graph:

Crisis of 2007-2008: U.S. GDP, Public Debt, and Private Debt (in Billions)

Note that, in the years prior to the crisis, the line representing federal government debt roughly parallels the line representing GDP; federal debt wasn’t growing dramatically as a fraction of GDP. So the big post-crisis standoff between Democrats and Republicans over the federal debt wasn’t focused on the big problem.

What was the big problem? Look at the line representing private debt. It clearly is not parallel to the GDP line and, indeed, reflects a rapid growth of private debt relative to GDP.

By itself this isn’t shocking. We all know that a growth in home mortgages preceded the crash, and home mortgages are one kind of private debt—along with other consumer borrowing and borrowing by businesses. What’s more surprising is what we found when we looked at lots of other financial crises around the world, dating back to the 19th century: Though most of these crises aren’t thought of as being fundamentally caused by excessive private debt, the fact is that they were preceded by the same kind of runup in private debt that the U.S. saw prior to 2008. 

Just to take one example, look at this data from Japan prior to its financial crisis of 1991. 

Japan Crisis of 1991: GDP, Public Debt, and Private Debt (in Millions of Yen)

Look familiar? Time and again, that’s the story we found: A major financial crisis is preceded by a runup in private debt relative to GDP. In fact, there seems to be only one other ingredient required for a crisis: that the absolute level of private debt is high to begin with. We found that almost all instances of rapid debt growth coupled with high overall levels of private debt have led to crises.

To put a finer point on it: For major economies, if the ratio of private debt to GDP is at least 150 percent, and if that ratio grows by at least 18 percent over the course of five years, then a big crisis is likely in the offing. 

Until the moment of reckoning, things may seem wonderful. Rapid private-debt growth fueled what were viewed as triumphs in their day—the Roaring Twenties, the Japanese “economic miracle” of the ’80s, and the Asian boom of the ’90s—but these were debt-powered binges that brought these economies to the brink of economic ruin.

What’s alarming is that, of the two ingredients for an economic crisis—high private debt and rapid private-debt growth—one is still with us even after the 2008 collapse. Private debt in the U.S., relative to GDP, stands at 156 percent. That’s lower than the 173 percent it reached in 2008, but it’s still nearly triple the level—55 percent—it was at in 1950. Indeed, across the globe there has been a steep climb in the ratio of private debt to GDP over that period.

The situation in China is particularly alarming. Look at this graph, which shows  changes in the ratio of private debt to GDP and the ratio of public debt to GDP:

Ratio of Chinese Private and Public Debt to GDP

Applying our private-debt early-warning criteria to China, we can see that its economy is at risk of a major financial crisis in the near future—a significant concern because of its size and importance to the world economy. China's five-year growth in private credit to GDP is near 60 percent. Its private debt to GDP ratio stands is approaching 200 percent. (As always, data on China's economy must be considered provisional: The numbers for China include “shadow lending” but are somewhat difficult to pin down, and I have seen differing numbers for the current level of private debt in China that range from 167 percent to 200+ percent. But in all cases, the recent five-year private debt to GDP growth trends are above 40 percent.) To be sure, China, by virtue of the government’s large role in the economy, its fiscal assets, and other distinctive features, could forestall the day of reckoning a few years yet. Still the broader picture—extremely high private-debt levels—is alarming.