You are here

The real engine of the business cycle

Mar 11,2018 - Last updated at Mar 11,2018

By Amir Sufi and Atif Mian

CHICAGO — Every major financial crisis leaves a unique footprint. Just as banking crises throughout the nineteenth and twentieth centuries revealed the importance of financial-sector liquidity and lenders of last resort, the Great Depression underscored the necessity of counter-cyclical fiscal and monetary policies. And, more recently, the 2008 financial crisis and subsequent Great Recession revealed the key drivers of credit-driven business cycles.

Specifically, the Great Recession showed us that we can predict a slowdown in economic activity by looking at rising household debt. In the United States and across many other countries, changes in household debt-to-GDP ratios between 2002 and 2007 correlate strongly with increases in unemployment from 2007 to 2010. For example, before the crash, household debt had increased enormously in Arizona and Nevada, as well as in Ireland and Spain; and, after the crash, all four locales experienced particularly severe recessions.

In fact, rising household debt was predictive of economic slumps long before the Great Recession. In his 1994 presidential address to the European Economic Association, Mervyn King, then the chief economist at the Bank of England, showed that countries with the largest increases in household debt-to-income ratios from 1984 to 1988 suffered the largest shortfalls in real (inflation-adjusted) GDP growth from 1989 to 1992.

Likewise, in our own work with Emil Verner of Princeton University, we have shown that US states with larger household-debt increases from 1982 to 1989 experienced larger increases in unemployment and more severe declines in real GDP growth from 1989 to 1992. In another study with Verner, we examined data from 30 countries over the past 40 years, and showed that rising household debt-to-GDP ratios have systematically resulted in slower GDP growth and higher unemployment. Recent research by the International Monetary Fund, which used an even larger sample, confirms this result.

All told, the conclusion that we draw from a large body of research into the links between household debt, the housing market, and business cycles is that expansions in credit supply, operating primarily through household demand, are an important driver of business cycles generally. We call this the “credit-driven household demand channel”. An expansion in the supply of credit occurs when lenders either increase the quantity of credit or decrease the interest rate on credit for reasons unrelated to borrowers’ income or productivity.

In a new study, we show that the credit-driven household demand channel rests on three main conceptual pillars. First, credit-supply expansions, rather than technology or permanent income shocks, are the key drivers of economic activity. This is a controversial idea. Most models attribute macroeconomic fluctuations to real factors such as productivity shocks. But we believe the financial sector itself plays an underappreciated role through its willingness to lend.

According to our second pillar, credit-supply expansions affect the real economy by boosting household demand, rather than the productive capacity of firms. Credit booms, after all, tend to be associated with rising inflation and increased employment in construction and retail, rather than in the tradable or export-oriented business sector. Over the past 40 years, credit-supply expansions appear to have largely financed household spending sprees, not productive investment by businesses.

Our third pillar explains why the contraction phase of the credit-driven business cycle is so severe. The main problem is that the economy has a hard time “adjusting” to the precipitous drop in spending by indebted households when credit dries up, usually during banking crises. Even when short-term interest rates fall to zero, savers cannot spend enough to make up for the shortfall in aggregate demand. And on the supply side, employment cannot easily migrate from the non-tradable to the tradable sector. On top of that, nominal rigidities, banking-sector disruptions and legacy distortions tend to make post-credit-boom recessions more severe.

Our emphasis on both the expansionary and contractionary phases of the credit cycle accords with the perspective of earlier scholars. As the economists Charles P. Kindleberger and Hyman Minsky showed, financial crises and credit-supply contractions are not exogenous events hitting a stable economy. Rather, they should be viewed as at least partly the result of earlier economic excesses — namely, credit-supply expansions.

In short, credit-supply expansions often sow the seeds of their own destruction. To make sense of the bust, we must understand the boom, and particularly the behavioral biases and aggregate-demand externalities that play such a critical role in boom-bust credit cycles.

But that leaves another question: What sets off sudden credit-supply expansions in the first place? Based on our reading of historical episodes, we contend that a rapid influx of capital into the financial system often triggers an expansion in credit supply. This type of shock occurred most recently in tandem with rising income inequality in the US and higher rates of saving in many emerging markets, what former US Federal Reserve Chair Ben Bernanke described as the “global savings glut”.

Although we have focused on business cycles, we believe the credit-driven household demand channel could be helpful in answering longer-run questions, too. As the Federal Reserve Bank of San Francisco’s Òscar Jordà, Moritz Schularick, and Alan M. Taylor have shown, there has been a long-term secular increase in private — particularly household — credit-to-GDP ratios across advanced economies. And this trend has been accompanied by a related decline in long-term real interest rates, as well as increases in within-country inequality and across-country “savings gluts”. The question now is whether there is a connection between these longer-term trends and what we know about the frequency of business cycles.

 

Amir Sufi, professor of Economics and Public Policy at the University of Chicago Booth School of Business, is the co-author of House of Debt. Atif Mian is professor of Economics, Public Policy and Finance at Princeton University, director of the Julis-Rabinowitz Centre for Public Policy and Finance at the Woodrow Wilson School, and co-author of House of Debt. Copyright: Project Syndicate, 2018.
www.project-syndicate.org

up
140 users have voted.

Comments

ONCE AGAIN, THANKS TO HATEM FOR TAKING SOME TIME TO OFFER HIS OPINION. HE IS CORRECT IN HIS VIEWS WHICH SADLY APPLIES ONLY IN THE WESTERN WORLD WHERE THERE ARE AT LEAST CHECKS AND BALANCES. REGORDING THE MIS-USE PUBLIC OF FUNDS AND PROPERTIES, I DO NICK-NAME THE WEST AS ORGANISED CHAOS. HOWEVER, IN DEVELOPING COUNTRIES, IT IS A DOUBLE TRAGEDY BECAUSE OF STATE SANTIONED CORRUPTION, LOOTS AND THE POLICE STATE MODEL OF GOVERNANCE WHICH IS A CLASSICAL STATE OF DIS-ORGANISED CHAOS. BEFORE MR HATEM CAN TALK ABOUT MODERN ECONOMIC THEORY, HE SHOULS FIRST ADDRESS HOW TO FIX THE LEAKY TRESSUREY SET UP BY DICTATORS AND HEARTLESS STRONG MEN THAT RULE ALMOST ALL DEVELOPING COUNTRIES.

I don't see any fundamental problems arising as a result of credit expansion provided that three tangential elements are congruent with the expansion. 1) Equity either from ownership of real estate or other forms of known securities ( i.e. mutual funds) 2)Income generating sources such as wages, salaries, dividends, rental income, and so on. 3) A balance between income and debt ratio. This last point is detrimental to the debtor's abilities to maintain their credit in good standing without resorting to default status. Most solvency cases arise as a result of our inabilities to meet our debt payments obligations particularly when the credit obtained was based on a higher interest rate due to lack of adequate collaterals to protect lenders from defaulting debtors. The cycles of boom and but are bound to happen irrespective of the presence or absence of credit expansion.The 2008 global economic meltdown proved that most of the people that were offered credit didn't have the abilities to repay their debts due to lack of securities, inflated real estate price, debt to income ratio wasn't taken into consideration when banks expanded their generous lending offers.It took ten additional years and trillions of additional dollars pumped into the economy along with governmental absorption of bad debts and banks subjecting themselves to stress test all in the name of giving the economy another opportunity at recovering from its slump. Luckily , a global depression was averted in the last minute and was converted into a deep recession that we are still feeling its aftershock until our present day.

THE REAL ENGINE IS TO STOP ALL FORMS OF STATE SPONSORED LOOTS THAT ARE STOCK-PILLED IN THE WEST.

Add new comment

CAPTCHA
This question is for testing whether or not you are a human visitor and to prevent automated spam submissions.
14 + 6 =
Solve this simple math problem and enter the result. E.g. for 1+3, enter 4.

Newsletter

Get top stories and blog posts emailed to you each day.