How excess savings trigger financial crises

This essay explores how unrealized excess savings—when individuals or institutions aim to save more than others are willing or able to borrow—can destabilize an economy.

Financial savings inherently require others issue liabilities. If these liabilities are not issued, economic activity contracts, leading to underproduction and underemployment.

A Stylized Economy: Savings, Credit, and the Genesis of Money

Imagine an economy built from scratch by Elon Musk and one million participants. For money (in the form of bank deposits) to exist in this economy, credit must first be issued. Suppose someone takes out a car loan from a bank, which credits the borrower’s deposit account with the loan amount—simply creating numbers on a screen. The borrower purchases a Tesla from Elon Musk, thus introducing money, debt, and savings into the economy simultaneously.

Elon Musk now has income (a financial asset), and the borrower holds debt. Let’s assume Musk spends 20 USD and saves the remaining 80 USD. As the 20 USD circulates through the economy—eventually reaching back to the original borrower—he repays part of his loan. The rest of the money remains with Elon Musk, and the total deposit base falls to 80 USD.

Here, we observe a basic principle: without borrowing, financial saving is impossible. Elon Musk’s decision to produce more Teslas relies on his confidence that others will continue borrowing to finance their purchases. If they don’t, his savings desire goes unfulfilled, production declines, and the economy contracts. Idle resources and underutilized capacity follow.

Excess Savings and the Leverage Trap

Private debt cannot expand indefinitely, especially when wealth is concentrated. As leverage—defined as the debt-to-equity ratio—increases, default risk escalates. Borrowers may hesitate to take on more debt, and banks become reluctant to lend to highly leveraged clients.

During economic expansions, rising incomes allow borrowers to service their debts, masking underlying risks. But in downturns, as revenues fall and unemployment rises, overleveraged borrowers begin defaulting en masse. If the financial system holds enough high-risk debt, these defaults transmit from the real sector to the banking system, triggering a financial crisis.

The Spiral of Unmet Savings Demand

In a financial crisis, the system fails to generate enough private debt. Savers, afraid of default risks, hold back their funds. Ironically, most savers will never reclaim the debt they issue—because they continually save more than they spend, their net lending always grows. Their true fear isn’t non-payment, but debt destruction, which would evaporate their wealth.

When savers stop lending due to fear of defaults, they suppress the very income and output they rely on. Unmet savings demand results in falling consumption, investment, and employment—transforming a financial crisis into a full-blown economic crisis.

The Role of Public Debt as a Stabilizer

Government borrowing plays a crucial role in breaking this vicious cycle. In times of crisis, when private borrowing collapses, increased public debt can sustain aggregate demand. If the state expands spending when the private sector retrenches, it can shield the economy from the worst of the downturn.

Public debt also offers savers a safe asset, reducing systemic risk. The state’s ability to issue debt without collateral and at lower interest rates than the private sector makes it uniquely positioned to absorb excess savings. In contrast, the private sector’s capacity to generate safe assets is limited by the value of its collateral.

Conclusion: When Leverage Meets Imbalance

High leverage magnifies losses during economic downturns. For households, it means a collapse in net worth and an increased risk of default. When defaults become widespread, they erode the capital base of financial institutions and destabilize the entire system.

The financial system’s vulnerability grows when a large share of savings demand is met through risky private debt. Only by acknowledging the macroeconomic implications of excess savings and using public debt strategically can we prevent these financial imbalances from spiraling into full-blown crises.

In the next essay, we’ll examine how high leverage helped trigger the 2008 financial crisis and the lessons it holds for today’s debt-dependent global economy.