On June 29, 2014, the
Bank for International Settlements (BIS) has published its annual
report for 2013. A central topic of this report was the distinction
between business and financial cycles.
What are business
and financial cycles?
Business cycles are
characterized by output fluctuations, i.e. the amount of what an
economy produces. They can last between one and eight years.
Financial cycles, as you
might expect, are characterized by financial fluctuations. Key
factors are not only of financial nature and include
- output growth;
- employment;
- industrial production;
- consumption;
- credit aggregates;
- credit spreads;
- equity prices;
- property prices;
- risk premia;
- credit default rates.
On average, financial
cycles can last between 15 and 20 years. They are often driven by
financial booms in which surging asset prices and rapid credit growth
reinforce each other, often in connection with prolonged
accommodative monetary and financial conditions as well as financial
innovation.
To illustrate the
distinction, here is how the BIS analyzes the business and financial
cycles of the U.S. economy since 1970.
Why is the
difference important?
The problem is that
financial cycles often develop largely undetected and end up in
banking crisis.
As a matter of fact,
during financial cycles,
- households, firms, and governments accumulate debt based on optimistic expectations about their future income, asset prices and the ease with which they are able to access credit;
- banks overestimate the solidity of their assets, the solvency of their borrowers, and their own ability to refinance themselves by rolling over short-term debt;
- capital and labor are allocated across different sectors but don't match the composition of sustainable demand.
In addition, financial
cycles are often synchronized across economies, as many of their
drivers have an important global component (for example as regards
liquidity conditions).
Finally, peaks in
financial cycles are typically followed by deeper and longer
recessions and slower recoveries, compared to business cycle peaks.
This is why monetary and
fiscal policy needs to go beyond managing business cycles. It has to
address the longer-term build-up and run-off of macroeconomic risks
that characterize the financial cycle. Put differently, politicians
cannot exclusively address immediate problems (namely employment and
inflation) at the cost of creating a bigger one down the road.
A central problem here is
to avoid debt accumulation over successive business cycles. In other
words, debt cannot be the main engine of growth.
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