The Financial Cycle and Macroeconomics: What Have We Learnt?

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The Financial Cycle and Macroeconomics: What Have We Learnt?

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The Financial Cycle and Macroeconomics: What Have We Learnt?

Claudio Borio¹•Institutions (1)

01 Dec 2012-Social Science Research Network-

TL;DR: The authors highlighted the stylised empirical features of the financial cycle, conjectures as to what it may take to model it satisfactorily, and considered its policy implications in the discussion of policy.

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Abstract: 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 calls for a rethink of modelling strategies and for significant adjustments to macroeconomic policies This essay highlights the stylised empirical features of the financial cycle, conjectures as to what it may take to model it satisfactorily, and considers its policy implications In the discussion of policy, the essay pays special attention to the bust phase, which is less well explored and raises much more controversial issues

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Journal Article•DOI•

Rising inequality as a cause of the present crisis

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Engelbert Stockhammer¹•Institutions (1)

Kingston University¹

01 May 2015-Cambridge Journal of Economics

TL;DR: In this article, the authors argue that the economic imbalances that caused the present crisis should be thought of as the outcome of the interaction of the effects of financial deregulation with the macroeconomic effects of rising inequality.

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Abstract: The article argues that the economic imbalances that caused the present crisis should be thought of as the outcome of the interaction of the effects of financial deregulation with the macroeconomic effects of rising inequality. In this sense rising inequality should be regarded as a root cause of the present crisis. I identify four channels by which it has contributed to the crisis. First, rising inequality creates a downwards pressure on aggregate demand since poorer income groups have high marginal propensities to consume. Second, international financial deregulation has allowed countries to run larger current account deficits and for longer time periods. Thus, in reaction to potentially stagnant demand, two growth models have emerged: a debt-led model and an export-led model. Third, (in the debt-led growth models) higher inequality has led to higher household debt as working-class families have tried to keep up with social consumption norms despite stagnating or falling real wages. Fourth, rising inequality has increased the propensity to speculate as richer households tend to hold riskier financial assets than other groups. The rise of hedge funds and of subprime derivatives in particular has been linked to rise of the super-rich.

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337 citations

Cites background from "The Financial Cycle and Macroeconom..."

...First, there is a growing interest in debt-cycle and debt-deflation models (Jordá et al., 2011; Borio, 2012; Eggertsson and Krugman, 2012)....
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...First, there is a growing interest in debt-cycle and debt-deflation models (Jordá et al., 2011; Borio, 2012; Eggertsson and Krugman, 2012)....
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Journal Article•

Can It Happen Again

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D. L. Archer

01 Jan 2001-Food Technology

335 citations

Journal Article•DOI•

Interest and Prices: Foundations of a Theory of Monetary Policy

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Andrew Scott¹•Institutions (1)

London Business School¹

01 Aug 2005-Economica

333 citations

Posted Content•

Rethinking Potential Output: Embedding Information About the Financial Cycle

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Claudio Borio¹, Piti Disyatat¹, Mikael Juselius², Mikael Juselius¹, Mikael Juselius³ - Show less +1 more•Institutions (3)

Bank for International Settlements¹, Hanken School of Economics², University of Helsinki³

01 Feb 2013-Social Science Research Network

TL;DR: In this article, the authors argue that incorporating information about the financial cycle is important to improve measures of potential output and output gaps, and they show that including information about financial cycle can yield more reliable estimates of cyclically adjusted budget balances and to serve as complementary guides for monetary policy.

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Abstract: This paper argues that incorporating information about the financial cycle is important to improve measures of potential output and output gaps. Conceptually, identifying potential output with non-inflationary output is too restrictive. Potential output is seen as sustainable; yet experience indicates that output may be on an unsustainable path even if inflation is low and stable whenever financial imbalances are building up. More generally, as long as potential output is identified with the non-cyclical component of output fluctuations and financial factors play a key role in explaining the cyclical part, ignoring these factors leaves out valuable information. Within a simple and transparent framework, we show that including information about the financial cycle can yield measures of potential output and output gaps that are not only estimated more precisely, but also much more robust in real time. In the context of policy applications, such "finance-neutral" output gaps are shown to yield more reliable estimates of cyclically adjusted budget balances and to serve as complementary guides for monetary policy.

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251 citations

Cites background from "The Financial Cycle and Macroeconom..."

...As such, our contribution can be seen as an extension of the burgeoning literature on the link between financial cycles, business cycles and banking crises (eg Aikman et al (2011), Claessens et al (2011a,b), Schularick and Taylor (2011), Drehmann et al (2012), Borio and Drehmann (2009) and Alessi and Detken (2009))....
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...This combination can turbo-charge the financial cycle, especially if supported by a monetary policy focused on stabilising near-term inflation (Borio and Lowe (2002a))....
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...As such, our contribution can be seen as an extension of the burgeoning literature on the link between financial cycles, business cycles and banking crises (eg Aikman et al (2011), Claessens et al (2011a,b), Schularick and Taylor (2011), Drehmann et al (2012), Borio and Drehmann (2009) and Alessi and Detken (2009)). Guided by the intuition of a close relationship between financial factors and business fluctuations, our approach is largely empirical. We do not develop a fully fledged model, but rely on reduced-form relationships. To facilitate comparisons and illustrate the contribution of financial factors, we start from the most widely used purely statistical approach for estimating potential output – the Hodrick-Prescott (HP) filter – and extend it to incorporate information about the financial cycle. In doing so, we do not impose strong priors regarding the relationship between financial variables and potential output: we let the data speak. Financial factors are included only as possible explanatory variables that help filter out cyclical fluctuations in output. This contrasts sharply with the common practice of forcing output gaps to explain key economic variables such as inflation through the inclusion of a Phillips curve in system-based approaches. Indeed, as we show elsewhere (Borio et al (2013)), this widespread approach can lead to large biases: it does violence to the data when the information content of output gaps for inflation is limited, as is typically the case. Our approach provides a less restrictive way of incorporating economic information into statistical methods than the multivariate filters typically employed in the literature (Benes et al (2010), Boone (2000))....
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...12 In fact, stable or falling inflation is not uncommon (eg Borio and Lowe (2002a))....
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...During such times, the overhang of debt makes the task of reshuffling capital and labour harder, hindering the correction of the resource misallocations built-up during the boom (eg Hall (2012), Borio (2012))....
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Journal Article•DOI•

The Italian financial cycle: 1861–2011

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Riccardo De Bonis, Andrea Silvestrini

01 Sep 2014-Cliometrica

TL;DR: In this article, the authors investigated the main features of the Italian financial cycle, extracted by means of a structural trend-cycle decomposition of the credit-to-GDP ratio, using annual observations from 1861 to 2011.

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Abstract: In this paper, we investigate the main features of the Italian financial cycle, extracted by means of a structural trend-cycle decomposition of the credit-to-GDP ratio, using annual observations from 1861 to 2011. In order to draw conclusions based on solid historical data, we provide a thorough reconstruction of the key balance sheet time series of Italian banks, considering all the main assets and liabilities over the last 150 years. We come to three main conclusions. First, while there was close correlation between loans and deposits (relative to GDP) until the mid-1970s, over the last 30 years, this link became more tenuous and the volume of loans has increased in relation to deposits. The banks covered this “funding gap” mainly by issuing new debt securities. Second, the Italian financial cycle has a much longer duration than traditional business cycles. Third, taking into account the deviation of the credit-to-GDP ratio from its trend, an acceleration of credit preceded or accompanied a banking crisis in 8 out of the 12 episodes listed by Reinhart and Rogoff (This time is different: eight centuries of financial folly. Princeton University Press, Princeton, 2009). A Logit regression confirms a positive association between the probability of a banking crisis and a previous acceleration of the credit-to-GDP gap. However, there were also periods—such as the early 1970s—in which the growth of the credit-to-GDP ratio was not followed by a banking crisis.

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147 citations

Cites background from "The Financial Cycle and Macroeconom..."

...Borio (2012) studies the stylised features of the financial cycle and argues that ihas a longer duration and wider amplitude than the traditional business cycle....
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...Also Borio (2012) 1We wish to acknowledge the contribution of Fabio Farabullini, Miria Rocchelli and Alessandra Salvio to a previous version of this manuscript....
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...…ratio gap constitute an indicator of excessive credit growth.2 The credit-to-GDP ratio gap is defined as the deviation of bank loans – expressed as a ratio to GDP – from its long-term trend and thus is itself a measure of the financial cycle, and an indicator of financial leverage (Borio, 2012)....
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...This variable, which has often been proposed in the empirical macro literature (Borio, 2012), has a number of interesting properties: being expressed as a ratio to GDP, it is normalised by the size of the economy and facilit tes international comparison....
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References

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Journal Article•DOI•

Rules Rather than Discretion: The Inconsistency of Optimal Plans

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Finn E. Kydland, Edward C. Prescott

01 Jun 1977-Journal of Political Economy

TL;DR: In this paper, it was shown that discretionary policy does not result in the social objective function being maximized, and that there is no way control theory can be made applicable to economic planning when expectations are rational.

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Abstract: Even if there is an agreed-upon, fixed social objective function and policymakers know the timing and magnitude of the effects of their actions, discretionary policy, namely, the selection of that decision which is best, given the current situation and a correct evaluation of the end-of-period position, does not result in the social objective function being maximized. The reason for this apparent paradox is that economic planning is not a game against nature but, rather, a game against rational economic agents. We conclude that there is no way control theory can be made applicable to economic planning when expectations are rational.

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7,652 citations

"The Financial Cycle and Macroeconom..." refers background in this paper

...In this case, taking wages and prices as given, policymakers may be tempted to produce inflation in an ultimately unsuccessful effort to raise output and employment, as prices and wages catch up (Kydland and Prescott (1977))....
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...The notion, or at least that of financial booms followed by busts, actually predates the much more common and influential one of the business cycle (eg, Zarnowitz (1992), Laidler (1999) and Besomi (2006))....
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Posted Content•

The Financial Accelerator in a Quantitative Business Cycle Framework

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Ben S. Bernanke¹, Mark Gertler², Mark Gertler³, Simon Gilchrist³•Institutions (3)

Federal Reserve System¹, New York University², National Bureau of Economic Research³

01 Mar 1998-Social Science Research Network

TL;DR: This article developed a dynamic general equilibrium model that is intended to help clarify the role of credit market frictions in business fluctuations, from both a qualitative and a quantitative standpoint, and the model is a synthesis of the leading approaches in the literature.

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Abstract: This paper develops a dynamic general equilibrium model that is intended to help clarify the role of credit market frictions in business fluctuations, from both a qualitative and a quantitative standpoint. The model is a synthesis of the leading approaches in the literature. In particular, the framework exhibits a financial accelerator,' in that endogenous developments in credit markets work to amplify and propagate shocks to the macroeconomy. In addition, we add several features to the model that are designed to enhance the empirical relevance. First, we incorporate money and price stickiness, which allows us to study how credit market frictions may influence the transmission of monetary policy. In addition, we allow for lags in investment which enables the model to generate both hump-shaped output dynamics and a lead-lag relation between asset prices and investment, as is consistent with the data. Finally, we allow for heterogeneity among firms to capture the fact that borrowers have differential access to capital markets. Under reasonable parametrizations of the model, the financial accelerator has a significant influence on business cycle dynamics.

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5,370 citations

"The Financial Cycle and Macroeconom..." refers background in this paper

...And when included at all, it would at most enhance the persistence of the impact of economic shocks that buffet the economy, delaying slightly its natural return to the steady state (eg, Bernanke et al (1999))....
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Book•DOI•

This Time Is Different: Eight Centuries of Financial Folly

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Carmen Reinhart, Kenneth Rogoff

11 Sep 2009-Research Papers in Economics

TL;DR: This Time Is Different as mentioned in this paper presents a comprehensive look at the varieties of financial crises, and guides us through eight astonishing centuries of government defaults, banking panics, and inflationary spikes.

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Abstract: Throughout history, rich and poor countries alike have been lending, borrowing, crashing--and recovering--their way through an extraordinary range of financial crises. Each time, the experts have chimed, "this time is different"--claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters. With this breakthrough study, leading economists Carmen Reinhart and Kenneth Rogoff definitively prove them wrong. Covering sixty-six countries across five continents, This Time Is Different presents a comprehensive look at the varieties of financial crises, and guides us through eight astonishing centuries of government defaults, banking panics, and inflationary spikes--from medieval currency debasements to today's subprime catastrophe. Carmen Reinhart and Kenneth Rogoff, leading economists whose work has been influential in the policy debate concerning the current financial crisis, provocatively argue that financial combustions are universal rites of passage for emerging and established market nations. The authors draw important lessons from history to show us how much--or how little--we have learned. Using clear, sharp analysis and comprehensive data, Reinhart and Rogoff document that financial fallouts occur in clusters and strike with surprisingly consistent frequency, duration, and ferocity. They examine the patterns of currency crashes, high and hyperinflation, and government defaults on international and domestic debts--as well as the cycles in housing and equity prices, capital flows, unemployment, and government revenues around these crises. While countries do weather their financial storms, Reinhart and Rogoff prove that short memories make it all too easy for crises to recur. An important book that will affect policy discussions for a long time to come, This Time Is Different exposes centuries of financial missteps.

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4,595 citations

"The Financial Cycle and Macroeconom..." refers background in this paper

...17 As noted earlier, and as confirmed by broader empirical evidence, these recessions are particularly costly (eg, BCBS (2010b), Reinhart and Rogoff (2009), Reinhart and Reinhart (2010), Dell’ Arriccia (2012))....
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...The black bars denote financial crises, as identified in well known data bases (Laeven and Valencia (2008 and 2010), Reinhart and Rogoff (2009)) and modified by the expert judgment of national authorities....
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An estimated dynamic stochastic general equilibrium model of the euro area. NBB Working Paper Nr. 35

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Frank Smets, Raf Wouters

01 Oct 2002

TL;DR: In this article, a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area was developed and estimated with Bayesian techniques using seven key macroeconomic variables: GDP, consumption, investment, prices, real wages, employment and the nominal interest rate.

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Abstract: This paper develops and estimates a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area. The model incorporates various other features such as habit formation, costs of adjustment in capital accumulation and variable capacity utilisation. It is estimated with Bayesian techniques using seven key macro-economic variables: GDP, consumption, investment, prices, real wages, employment and the nominal interest rate. The introduction of ten orthogonal structural shocks (including productivity, labour supply, investment, preference, cost-push and monetary policy shocks) allows for an empirical investigation of the effects of such shocks and of their contribution to business cycle fluctuations in the euro area. Using the estimated model, the paper also analyses the output (real interest rate) gap, defined as the difference between the actual and model-based potential output (real interest rate).

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2,716 citations

"The Financial Cycle and Macroeconom..." refers background in this paper

...In this case, much of the persistence in the behaviour of the economy is driven by the persistence of the shocks themselves (eg, Christiano et al (2005), Smets and Wouters (2003))....
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Posted Content•

Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008

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Moritz Schularick¹, Moritz Schularick², Alan M. Taylor², Alan M. Taylor³, Alan M. Taylor⁴ - Show less +1 more•Institutions (4)

University of Bonn¹, Economic Policy Institute², University of California, Davis³, National Bureau of Economic Research⁴

01 Nov 2009-Social Science Research Network

TL;DR: This paper studied the behavior of money, credit, and macroeconomic indicators over the long run based on a newly constructed historical dataset for 12 developed countries over the years 1870-2008, utilizing the data to study rare events associated with financial crisis episodes.

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Abstract: The crisis of 2008-09 has focused attention on money and credit fluctuations, financial crises, and policy responses. In this paper we study the behavior of money, credit, and macroeconomic indicators over the long run based on a newly constructed historical dataset for 12 developed countries over the years 1870-2008, utilizing the data to study rare events associated with financial crisis episodes. We present new evidence that leverage in the financial sector has increased strongly in the second half of the twentieth century as shown by a decoupling of money and credit aggregates, and we also find a decline in safe assets on banks' balance sheets. We also show for the first time how monetary policy responses to financial crises have been more aggressive post-1945, but how despite these policies the output costs of crises have remained large. Importantly, we can also show that credit growth is a powerful predictor of financial crises, suggesting that such crises are

...read moreread less

2,021 citations

"The Financial Cycle and Macroeconom..." refers background in this paper

...At one end of the spectrum, like much of the extant work, one could exclusively focus on credit – the credit cycle (eg, Aikman et al (2010), Schularick and Taylor (2009), Jordá et al (2011), Dell’Arriccia et al (2012))....
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...3 If a single variable has to be chosen, then the evidence indicates that credit is the most relevant one; see, eg, Borio and Lowe (2002), Drehmann et al (2011) and Schularick and Taylor (2009)....
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