by Claudio Borio, Voxeu.org
Since the early 1980s, the financial cycle has re-emerged as a major force driving the macroeconomy, but economic analysis has not caught up. This column argues that macroeconomics without the financial cycle is like Hamlet without the Prince. Economic analysis and policies – monetary, fiscal, and prudential – should be adjusted to fully account for the financial cycles, but here more analytic work is needed. The question of how we address the bust and balance-sheet recession that follow the boom deserves special attention.
We thought we knew; we have since forgotten. It is high time we rediscovered the role of the financial cycle in macroeconomics. In the environment that has prevailed for at least three decades now, it is not possible to understand business fluctuations and the corresponding analytical and policy challenges without understanding the financial cycle. This perspective was largely taken for granted as far back as in the 19th century and all the way up to the Great Depression (Overstone 1857); it barely survived at the periphery of economics in the post-war period; and it has slowly been regaining ground, in modern guise, after the Great Financial Crisis. Yet, sadly, it is still far from becoming part of our intellectual furniture.1
The financial cycle: Key features
The financial cycle is best thought of as the self-reinforcing interactions between perceptions of value and risk, attitudes towards risk, and financing constraints, which translate into booms followed by busts (Borio 2012a). These interactions can amplify economic fluctuations and possibly lead to serious financial distress and economic dislocations.
A growing body of empirical work, not least that carried out at the BIS (Drehmann et al 2012), suggests that the financial cycle has several key properties.
- First, its most parsimonious description is in terms of the behaviour of private-sector credit and property prices.
Equity prices can be a distraction: they exhibit shorter cycles and tend to be more closely related to short-term fluctuations in GDP, which may leave the financial sector largely unscathed.
- Second, the financial cycle has a much lower frequency than the traditional business cycle.
Since financial liberalisation, its typical length is of the order of 16 to 20 years; by contrast, as generally conceived in academic and policy work, business-cycle frequencies are up to eight years. Figure 1 illustrates this with reference to the US, based on both frequency filters and peak-to-trough analysis.
Notes: The orange and green bars indicate peaks and troughs of the financial cycle measured by the combined behaviour of the component series (credit, credit-to-GDP ratio and house prices) using the turning-point method. The blue line traces the financial cycle measured as the average of the medium-term cycle in the component series using frequency-based filters. The red line traces the GDP cycle identified by the traditional shorter-term frequency filter used to measure the business cycle.
Source: Drehmann et al (2012).
- Third, peaks in the financial cycle tend to coincide with episodes of systemic financial distress.
For example, in a sample of seven industrial countries (Australia, Germany, Japan, Norway, Sweden, the UK and the US), all post-financial liberalisation financial-cycle peaks are associated with either full-blown crises or serious financial strains. And those banking systems that experienced stress away from the peak did so because they were exposed to cycles elsewhere (eg. Germany and Switzerland in 2008).
- Fourth, the financial-cycle regularities inform the construction of real-time leading indicators of banking crises that provide fairly reliable signals with quite a good lead – between two and four years, depending on the calibration (eg. Borio and Drehmann 2009).
Not surprisingly, such indicators are best based on the (private-sector) credit-to-GDP ratio and property prices jointly exceeding certain thresholds, which fall outside normal historical ranges. One can think of these indicators as proxies for the build-up of financial imbalances and as tools that help policymakers distinguish sustainable booms from unsustainable ones. The evidence also indicates that, during such credit booms, the cross-border component of credit tends to outpace the purely domestic one (eg. Borio et al 2011).
- Fifth, for much the same reasons, financial-cycle information also helps construct real-time estimates of sustainable output that, compared with traditional potential output estimates, are much more reliable in real time, and more statistically precise (Borio et al 2013).
Such estimates, for instance, would have shown that, during the boom that preceded the Great Financial Crisis, output in the US was growing well beyond sustainable levels. By contrast the more commonly used approaches, such as the production-function methodology, detected this pattern only well after the crisis took place, if at all.
- Finally, the financial cycle depends critically on policy regimes.
Financial liberalisation weakens financing constraints. Monetary-policy frameworks focused on short-term inflation control provide less resistance to the build-up of financial imbalances whenever inflation remains low and stable. And positive supply-side developments (eg. the globalisation of the real economy) fuel the financial boom while putting downward pressure on inflation. Not surprisingly, financial cycles have become twice as long since financial liberalisation in the early 1980s and have been especially virulent since the early 1990s (see Figure 1).
The financial cycle: Analytical challenges
Analytically, modelling the financial cycle requires capturing three key features.
- The booms should not just precede but cause the busts: busts are fundamentally endogenous, the result of the vulnerabilities and distortions built up during the boom.
- The busts should generate debt and capital stock overhangs – the natural legacy of the preceding unsustainable expansion.
- And potential output should not just be identified with non-inflationary output: as the previous evidence indicates, output may be on an unsustainable trajectory even if inflation is stable.
How could one best capture these features? Most likely, one would need to:
- Drop ‘rational’ (model-consistent) expectations.
- Allow for state-varying risk tolerance, ie. for attitudes towards risk that vary with the state of the economy, wealth, and balance sheets.
- And last but not least, capture more deeply the monetary nature of our economies: the banking sector does not just allocate given resources but creates purchasing power out of thin air. In all probability, all this may require us to rediscover the merits of disequilibrium analysis.2
The financial cycle: Policy challenges
Dealing with the financial crisis calls for policies that are more symmetrical across booms and busts. Policies need to lean against the booms and tackle the debt-asset quality problems head on during the bust. A medium-term focus is essential.
During the boom, the key question is how to address the build-up of financial imbalances.
- For prudential policy, it means containing the procyclicality of the financial system through macroprudential measures (Borio 2009).
- For fiscal policy, it means extra prudence, fully recognising the hugely flattering effect of financial booms on the fiscal accounts: potential output and growth are overestimated; financial booms are tax revenue-rich; and large contingent liabilities are needed to address the bust.
- For monetary policy, it means leaning against the build-up of financial imbalances even if short-term inflation remains subdued.
During the bust, the key question is how to address the balance-sheet recession that follows, ie. how to prevent a stock problem from becoming a persistent and serious flow problem, in the form of anaemic output and expenditures. After having stabilised the system (crisis management phase), it is necessary to move swiftly to tackle the over-indebtedness and asset-quality problems head on (crisis resolution phase).
The crisis resolution phase is critical and less well understood.
For prudential policy, it means repairing banks’ balance sheets aggressively through the full recognition of losses, asset disposals, recapitalisations subject to strict conditionality, and the reduction of operational excess capacity necessary for sustainable profitability. This is what the Nordic countries did and what Japan failed to do following the bust in their respective financial cycles in the early 1990s; it is what partly explains their subsequent divergent economic performance.
For fiscal policy, it means creating the fiscal space needed to use the sovereign’s balance sheet to support private-sector balance-sheet repair while avoiding a sovereign crisis down the road. This can be done through bank recapitalisations, including via temporary public-sector ownership and selective debt relief for the non-financial sector (eg. households). In fact, contrary to received wisdom, pump-priming – where it can be afforded – may well be less effective in a balance-sheet recession, as agents tend to save the extra money to repay debt, resulting in a low multiplier. By contrast, by relieving debt burdens and asset-quality problems, the alternative use of fiscal space could set the basis for a self-sustaining recovery.
For monetary policy, it means recognising its limitations and avoiding overburdening it. Monetary tools are blunt when overindebted sectors are unwilling to borrow, and banking system strains impair the transmission chain. As a result, when policymakers press harder on the gas pedal, the engine revs up without traction. Over time, this enhances any side effects that policy may have. These include the possibility of delaying balance-sheet adjustment, such as by facilitating evergreening; of undermining the profitability of banks, by compressing interest margins; of masking market signals; and of raising political-economy concerns, not least because of the quasi-fiscal nature of the large-scale deployment of central bank balance sheets.
The risk is that policies that do not address aggressively the balance-sheet problems can buy time but also make it easier to waste it. This can prolong weakness and delay a strong, self-sustaining recovery. Some new empirical evidence that carefully differentiates between the nature of recessions is broadly consistent with this picture (Bech et al 2012). It is as if the economy operated in a state of suspended animation.
The longer-term risk is that policies that fail to recognise the financial cycle will be too asymmetric and generate a serious bias over time. Failing to tighten policy in a financial boom but facing strong, if not overwhelming, incentives to loosen it during the bust would erode both the economy’s defences and the authorities’ room for manoeuvre. In the end, policymakers would be left with a much bigger problem on their hands and without the ammunition to deal with it – a new form of ‘time inconsistency’. The root causes here are horizons that are too short and a failure to appreciate the cumulative impact of flows on stocks. This could entrench instability in the system over successive cycles (Borio 2012b).
Macroeconomics without the financial cycle is very much like Hamlet without the Prince: a play that has lost its main character. Post-crisis, both policymakers and academics are making efforts, to varying degrees, to understand and respond to the challenges the financial cycle poses. But these efforts are still falling short of the mark. The stakes are high; the road ahead a long one.
Editor’s note: The views expressed are the author’s own and not necessarily those of the Bank for International Settlements.
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1 Well-known references go back to at least Lord Overstone (1857). Aspects of the financial cycle, with special reference to credit, were later famously refined by the likes of von Mises (1912) and Hayek (1935). In the post-war period, Kindleberger (2000) and Minsky (1982) highlighted its role in financial instability. By contrast, in the mainstream pre-crisis literature, financial factors were seen as factors that at most enhanced the persistence of the exogenous shocks that buffeted the economy (eg, Bernanke et al (1999)). Recent, mainly empirical, work stressing again the importance of credit and financial cycles includes Reinhart and Rogoff (2009), Aikman et al (2010), Claessens et al (2011) and Taylor (2012). The prevailing theoretical literature has continued to try to incorporate financial factors within the DSGE mainstream; see Gertler and Kiyotaki (2010) for a recent review; this field is expanding exponentially. For a notable exception, see Adrian and Shin (2010).
2 Borio and Disyatat (2011) elaborate on point (iii) in the context of the role (or non-role) of current-account imbalances in the Great Financial Crisis.
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