Financial Cycles & Macroeconomics Borio JBF (2014)

Borio: “…We do not necessarily know more today than we did yesterday … so-called ‘lessons’ are learnt, forgotten, re-learnt and forgotten again. Concepts rise to prominence and fall into oblivion … because the discipline is not immune to fashions and fads.” “The notion of financial booms and busts actually predates … the more common and influential one of the business cycle”

The Financial Cycle Definition Self-reinforcing interactions between perceptions of value & risk [prevailing riskiness of the economy], attitudes towards risk [risk aversion], & financing constraints translating into booms followed by busts amplifying output fluctuations Thanks Stancho !

Financial Cycle 1st of 5 Stylized Facts Variables proxying financial cycle: Credit/GDP vs. historical norm (a rough measure of leverage) Property prices vs. historical norm (a rough measure of steep return to norm) Co-vary: credit finances construction & purchase of housing Must focus on small set of variables to replicate the mutually reinforcing interaction between financing constraints and perceptions of value & risks

Financial Cycle 2nd of 5 Stylized Facts Financial cycle has lower frequency than business cycle (ca. 16 years in industrialized nations) Business cycle: 1 – 8 years

Financial Cycle 3rd of 5 Stylized Facts Financial Cycle Peaks linked to Financial Crises (crises away from peaks are due to foreign cycles) Black vertical lines Show bank crisis start dates

Financial Cycle 4th of 5 Stylized Facts Predicts financial distress with good lead time

Financial Cycle 4B of 5 Stylized Facts Levels Growth Rates Cross-border credit outgrows domestic credit in finance cycle booms Direct: foreign bank loans to domestic non-financial borrowers Indirect: foreign loans to domestic banks which lend to domestic non-financial borrowers

Financial Cycle 5th of 5 Stylized Facts Length & amplitude of financial cycle depends on policy regime Financial : liberalization eases financing constraints Monetary: inflation targeting regime => low inflation gives BNB no reason to fight financial cycle boom Real-economy : low inflation, credit & asset P booms more frequent with globalization Financial cycle longer & higher amplitude may be due to financial deregulation

Borio: Need New Macro Models Financial boom precedes crisis but does it cause it ? Include debt and capital stock overhang In boom, debt allows increased spending on assets In bust, debt forces agents to cut spending Rethink concept of potential output (economy at YFE will stay there absent shocks without inflation) But recently output on too-high path while inflation stable

Borio: How to Modify Models ?? Jettison model-consistent (rational) expectations: agents can’t understand model of economy “heterogeneous & fundamentally incomplete knowledge is a core characteristic of economic processes” Allow risk attitudes to vary with economy’s SON to naturally amplify financial booms & busts Capture the monetary nature of the economy

What’s a Monetary Economy ? 1. Banking system doesn’t only transfer real resources, but also generates nominal purchasing power If deposits produced loans little problem in allocating resources But loans creating deposits (may) create an excess (part of MS) 2. Dilute discipline’s heavy focus on eqbm

Monetary Economy Borio: saving is same as funding only in non-monetary economies Saving IS unspent income while financing is the access to (also borrowed) funds E.g. in economy without investment, saving = 0 but firms still need to fund gap (buying input to revenue receipt) Gross (not net) capital flows finance credit booms; US boom funded domestically and from EU (nations with CA < 0 ) Net inflows are gross inflows less gross outflows

US BOP Accounts 2011 ($ Billions)

where’s Bernanke ? murky link between CA surplus & interest rates He doesn’t buy Bernanke’s savings glut: CA surplus nations (e.g. China) funded U.S. credit boom, cutting world interest rates Saving & Investment affect “natural interest rate” not market interest rates Natural interest rate: non-observable eqbm determined by real factors Market rates (influenced by policy rates & yield curve) may deviate from natural rates for long periods Borio: Natural rate an unlikely cause for imbalances leading to 2008 crisis

Dealing with Credit Booms Dell’ariccia et al FCCC 11

The Good & the Bad of Credit Booms Good: Increases investment & consumption Good: Contributes to financial deepening Bad: May lead to crisis or sub-trend growth Credit booms arise out of financial reform capital inflow surges strong economic growth Bad are likely to be larger & last longer, but can’t really tell difference bad vs. good booms

When does Credit Boom End in Credit Bust? Fast credit expansion brings vulnerability: Lax lending standards Excessive leverage Asset price bubbles Credit booms may go unnoticed: Inflation targeting central banks ignore M aggregates (may overlook credit boom) Regulators’ focus on individual banks may lead to ignore aggregate credit dynamics Professional consensus: M Policy too blunt to correct asset P bubbles often coming with credit booms

Dell’arricia Study Details Cross country with focus on bank credit (large share of overall credit) => ignore bond markets, trade credit, etc Use data available to policymakers at the time, not revisions coming post-decision Compare credit/GDP in each year and country to trend between years t – 10 and t. Define as boom if : Deviation from trend > (1.5 x std dev) with annual credit/GDP growth rate > 10% OR Annual credit/GDP growth > 20% Sample 170 countries with 175 boom episodes

Typical Credit Boom Median boom 3 years; Credit/GDP grows 13% p.a. (5 x all-year median growth) Most booms in middle-income (also high-income) nations More booms in undeveloped financial systems (median credit/gdp at start of boom is 19% vs. 30% for entire sample)

More countries suffer credit boom since deregulation of 1980s

Bernanke & Gertler’s Financial Accelerator In upturn Rising borrower creditworthiness & collateral values Lenders supply more credit & may loosen lending standards Greater credit allows greater investment and consumption with another round of collateral value rise Downturn, the opposite happens

Performance In Credit Booms Faster GDP growth Fast-rising Asset P Inflation subdued Real exchange rate appreciates CA deficit (=> KFA surplus due to foreign bank fund inflows)

Question 1 on Long Term Research uses credit/GDP to measure financial development that helps GDP growth 1. Does credit boom bring permanent financial deepening ? Some bring crises with sharp drop in credit/GDP 40% bring permanently higher credit/GDP level (eqbm?) (FIG 3 : credit growth in boom positively related to long term financial deepening 1970-2010)

Question 2 Is financial deepening via a credit boom the same as through gradual growth? Positive correlation between # years nation’s been in credit boom Real GDP per capita growth since 1970

The Bad Side 33% of booms followed within 3 years by banking crisis

Bad Side 2 States with greater booms during expansion also suffered larger delinquencies during bust

Bad Side 3 Credit booms preceded many of largest banking crises of last 30 years

Bad Side 4 60% of booms bring below-trend growth (by 2.2%) over next 6 years Nations with bigger credit/GDP changes had deeper recessions Credit boom predicts well “credit-less recovery” (1/3 lower average growth)

Find 3 factors linked to start of Credit Boom 33% of booms follow financial reform to increase financial deepening Capital inflow surges (often due to liberalization) increase funds in banks Booms start during or after strong economic growth Many countries can be affected simultaneously Financial liberalization occurs in several nations simultaneously Capital inflows occur due to global liquidity conditions

Some Nations Are More Susceptible Those pegging exchange rate (precludes M policy to deal with boom) Those expanding M policy (low borrowing cost inflates asset P) Those with poor bank supervision

Credit Boom Can Bring Deepening or Crisis Define Bad if followed by banking crisis within 3 years or brings recession or below-trend growth What’s there about boom to predict if it turns into crisis or long sub-par GDP growth? Find BAD booms: Are larger and last longer Usually start with high credit/GDP Sometimes related to: Higher inflation larger CA deficits, lower quality bank supervision faster growing asset P