Thursday, November 13, 2014

BIS Annual Report 2013 - Why we should care about financial cycles

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.