Credit Cycles and the Economy: Introduction
Davis, E. Philip, National Institute Economic Review
The recent boom and succeeding prolonged downturn have brought very much to the fore the role of the credit cycle--the expansion and contraction of access to credit over the course of the business cycle--in driving economic activity. The sizeable costs of allowing free rein to such credit cycles are still evident in many countries. This issue of the National Institute Economic Review brings together key analyses in this area, thus aiding understanding and the development of appropriate policies and policy frameworks.
Claudio Borio (Bank for International Settlements) begins the series of articles by highlighting the deeper forces that are widely considered to underlie the current conjuncture, namely financial liberalisation, credible anti-inflationary monetary frameworks and globalisation of the real side of the economy. These have given scope for powerful financial cycles which exceed in duration and amplitude those of the business cycle. Such financial cycles mean we now have some recessions--such as the current one but also that of the early 1990s--which are characterised by greater depth and very slow recoveries owing to the need for balance sheet adjustment. Borio contends that there are two key changes to economic behaviour to be addressed, first that macroeconomic developments are taking longer to unfold, owing to the length of the financial cycle, and second that stocks of assets and debt rather than flows now dominate economic trends, building up excessively in the boom and generating damaging overhangs in the bust.
In the short term, he suggests there is a need for policies to address the current level of debt, including bank regulation directed at decisively repairing banks' balance sheets as in the Nordic countries in the 1990s, use of fiscal policy to repair private balance sheets and being aware of the dangers for monetary and financial stability from holding interest rates too low for too long.
In the longer term, he advocates not only longer policy horizons but also policies to limit financial booms (such as macroprudential buffers and embedding asset prices within monetary policy frameworks). He highlights the dangers if these policies are not adopted, notably protectionism and currency wars as well as bouts of high inflation. The impact on growth of such an adverse outcome would be seismic.
Philip Lane (Trinity College, Dublin) focuses on an aspect of the recent boom and bust that amplifies the mechanisms Borio highlights, namely the impact of financial globalisation on credit dynamics. At a basic level, banks in such an environment have a choice on the asset side between domestic and international lending and securities, while on the liabilities side banks can supplement domestic retail and wholesale deposits with much greater cross-border supply so that, even for domestic banks, lending need not be constrained. In a globalised financial system, international capital flows become pervasive influences on the behaviour of banks and hence on credit dynamics, as well as on sovereign and bank-bond markets. Besides amplitude, the composition of capital inflows also matters for fragility, such as whether inflows finance real estate or productive investment and whether there is debt that retains risk at home or an element of equity that transfers risk to foreign holders. All of these issues arise most strongly in a single currency zone such as the Euro Area, within which there is less of a constraint on current account imbalances.
Research has shown a strong link from net debt flows to domestic credit expansion in a range of countries and periods. Whereas the traditional pattern has been a 'sudden stop' in such inflows during a currency crisis, private sector reactions in the Euro Area since 2008 have been partly offset by the common liquidity policies. Complex distributive questions arise when a crisis does occur that requires multilateral resolution, even before banking union. …