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A credit boom is driven by a rapid expansion of credit to the private sector accompanied by rising asset prices. Following the boom phase, these prices collapse and a credit crunch arises, with access to financing falling below levels typical of normal times. The unwinding of the boom phase brings a considerably reduction in investment and a fall in consumption, whereupon an economic recession may follow. Recession following the burst of the episode may be short-lived, with GDP growth resuming within a year. In the financial sector of the economy the recovery is slower and credit may remain depressed for several periods. Credit contracts more sharply than GDP and the cost of borrowing may remain higher than in normal times.
A boom–bust cycle is also associated with the existence of bubbles in the stock market that may lead to a period of accelerated investment and excessive borrowing. After the buildup there is a stock market crash which is often attributed to speculative behavior and Herd behavior on the part of investors. All these studies share the following findings. During the build up of the boom there is rapid expansion in credit to the private sector, GDP, consumption and investment also grow above their rates observed during tranquil times. The non-tradable sector of the economy, that is economic activities produced only for domestic consumption, experiences faster growth, and the real exchange rate appreciates. During the boom banks extended more credit to the non-tradable sector of the economy, and there is a surge of capital flows into the country. Capital inflows tend to be 4% above its long run trend in the year previous to the crisis; similarly the price of housing is 15% above its trend one year before the bust.
In developing countries credit tends to be denominated in foreign currency increasing the debt burden of borrowers during the bust phase. It has been argued that the currency mismatch of the non-tradable sector can amplify the effects of the decline in economic activity during the bust phase. The reason is that the non-tradable sector uses the value of its production, its physical capital or any other asset as a guarantee to access financing from a bank; however more often than not, the collateral put forth by firms is denominated in domestic currency while its liabilities to the bank are denominated in foreign currency, thus during the bust, production diminishes and the foreign currency value of its collateral plummets, and the firm maybe forced to default on its debt. This mechanism helps explain why banks' loan portfolio deteriorates heavily during a bust, opening the possibility of a banking or financial crisis.
Evidence over the past 40 years in developing and developed countries document several regularities observed during credit booms. First, the length of the boom phase ranges between 6 to 7 years, and the episodes are often observed in different countries around the same period and are not limited to a single region. GDP and consumption rise 2 to 4% above its trend, while investment rises 18%. Output in the non-tradable sector rises 6.5% and the real exchange rate appreciates roughly 9%. Also capital flows increase up to 3.5 percentage points with respect to GDP, and the current account as a share of GDP declines about 2.5 percentage points more than in normal times. Stock markets also thrive during the boom phase and equity and housing prices rise considerably, for example in the Financial crisis (2007-present) the Case–Shiller index, measuring the real price of housing in the US, shows that between early 2000 and August 2007 housing prices had a cumulative increase of 125% .
During the downswing of the cycle consumption and investment fall, output in the non-tradable sector declines, the real exchange rate depreciates and asset and housing prices fall below trend. Investment is the component of GDP that suffer the most pronounced swings during the bust; for example after the Argentinean crisis, investment to GDP ratio fell by 5.5 percentage points in Argentina and by 6.1 percentage points in Chile. The contraction in GDP tends to be short lived, however when the bust is accompanied with a financial crisis the effects can be much large; after the 1997 Asian financial crisis, GDP in Thailand, Indonesia and Philippines fell by more than 10%, in the aftermath of the Argentine crisis GDP collapsed by roughly 23%.
Even though not all episodes of rapid credit growth end up in a bust, when they do the adjustment tends to be very disruptive. For example, output and consumption fall 4% below trend, investment falls about 18%, the real exchange rates depreciates suddenly by an average of 4% within one year. Output in the non-tradable sector drops 3% below its pre-boom value. Other indicators of the bust phase include, a sharp deterioration of the quality of banks portfolio with a sudden increase in non-performing loans and rapid deleveraging by financial institutions. The latter implies that financial institutions try to rise capital and improve their capital adequacy in periods where capital is scarcer forcing them to liquidate assets through fire sales. In open economies, the external accounts adjusts sharply; in the 1994 economic crisis in Mexico the current account went from a deficit of 8 percent of GDP to zero within a year. The average adjustment is approximately a jump from a current account deficit of 2.5% of GDP to a surplus of 1.5% of GDP.
The adjustment in the current account reflects the consumption cost associated to the bust as well as the reallocation of resources that takes places after the bust. During the boom phase the heightened desire for investment and consumption tends to move resources into the growing non-tradable sector of the economy. Since the bust depresses the non-tradable sector, both labor and capital shift back towards the tradable sector. This reallocation can be costly, for example if the skills workers need to enter the tradable sector are different than those employed in no-tradable sector, which can produce longer unemployment spell and losses in total factor productivity.
The phrase "boom and bust" was applied to the United Kingdom in the early 1990s. The "boom" period had come in the second half of the 1980s, when the economy grew rapidly and unemployment fell from a record of nearly 3,300,000 in 1984 to 1,600,000 by the end of 1989. However, the Conservative government led by Margaret Thatcher (and then John Major from November 1990) increased interest rates to tackle rising inflation, and by the end of 1990 the economy was in recession and unemployment was creeping back upwards, turning the "boom" into a "bust". Britain had joined the European Exchange Rate Mechanism in October 1990 before leaving it on Black Wednesday in September 1992, when interest rates had briefly peaked at 15%. Britain's departure from the exchange rate mechanism enables interest rates to be reduced. Within a year, inflation was falling, but unemployment was now above 2,000,000 and rising. The recession in Britain was officially declared over in April 1993, by which time it had lasted for a record of nearly three years. This marked the end of that "boom and bust" era in the British economy. A strong economic recovery followed, with low unemployment and inflation, and it would be 16 years before the economy entered another recession.
Boom–bust episodes have been largely documented in emerging economies. During the nineties, countries like Mexico, Argentina, Malaysia, Turkey, Colombia, Indonesia, Korea and Peru all experienced boom–bust cycles with the consequent collapse in GDP, consumption, non-tradable output sector contraction, capital flow reversals, limited or costly access to capital markets and sharp real exchange rate fluctuations.
In emerging markets the phenomenon of a boom–bust cycle has also been linked to episodes of sudden stops in capital flows and output drops. Following the 1998 Russian economic crisis, the seven largest Latin American countries saw their investment rates plummet from an average of 7.4% per year in the five years prior to the crises to -4.1% in the year to follow. After the crisis ended investment rates resumed their growth at rate of 10% per year. The same episode had a different effect on the emerging economies of Asia. In that region investment dropped from an average rate of 6.06% to -37% in the year after the crisis and resumed at an average annual rate of 6% in the following five years.
Not even among emerging markets the response of economic variables during a boom–bust episode is the same. Some countries are more vulnerable than other due to their particular domestic conditions. Some examples include the extent of liability dollarization which increases the vulnerability of the balance sheet of leveraged agents in the case of a devaluation;
Swings in output, consumption and investment are consistent with traditional theories of the business cycle, but the magnitudes of these movements are not. Proponents of the Real Business Cycle Theory would argue that demand needs to be very sensitive to movements in output in order to generate a large credit expansion. However, the evidence suggests that periods with fast output growth are not always accompanied with a credit boom, meanwhile a credit boom usually brings about an acceleration of output. Alternatively, unexpected improvements in a country terms of trade can lead to a boost in consumption and investment generating the rapid expansion we observe during the boom phase. However, there is no evidence of significant movements in terms of trade during the build up of the credit booms.
A different view on the origin of the boom–bust episodes emphasizes the role of external factors. For example, large capital inflows like a surge in foreign direct investment or a sudden increase in short term portfolio investment. If domestic banks can finance their operations with foreign capital, when these resources are easily available banks have the incentive to increase credit in the economy. When the capital flow veers direction suddenly, banks can no longer access cheap financing from foreign sources credit or it is forced to repay its obligations to external lenders and therefore the supply of credit to the economy falls and a credit crunch ensues. Under these view, capital flows are procyclical because borrowing increases during good times and falls in bad times, making the country vulnerable to experience growth in investment and consumption that result in a sudden bust when capital flows reverse. Regardless of its appeal the external view does not offer an explanation of why capital flows behave so wildly, and some argue that these surges of foreign capital are the reflection of a deeper change in the domestic conditions of the recipient country or region.
A third possible explanation for the nature and the characteristics of boom–bust cycles emphasizes the role of financial frictions. For example, costs in acquiring information from borrowers due to moral hazard or adverse selection problems may have amplifying effects on the economy. To alleviate the effect of these frictions, banks may offer contracts that require borrowers to use part of their own capital as collateral for the loan. During an expansionary phase households and firms net worth rise with rising asset prices, if households uses their net worth as collateral they can access credit with relative ease, and as a consequence they can increase the ratio of their debt obligations to net worth (leverage). At the onset of the bust phase, the decline in asset prices negatively affects households net worth limiting access to credit and through a financial accelerator mechanism take the economy into a recession. The existence of collateralized borrowing generates an externality problem in which individual borrowers do not take into account the effect of their actions into the value of the assets that determine their own collateral, like in the case of housing. During good times borrowers acquire too much debt than what is socially desirable, and when the value of their collateral falls they do not have enough resources to pay off their obligations and can trigger general turmoil in the financial system.
A fourth explanation based on the experience of many Latin American and Eastern European countries led to the view that economic reform and financial deregulation maybe the culprit of boom–bust cycles. Efforts to control inflation in Latin America, specially those in which the nominal exchange rate was used as main policy tool, backfired producing an initial expansion in output followed by a recession. The failure of the stabilization programs was in part due to a lack of credibility that lead people to anticipate a future reverse of policy.
Hyman Minsky offered a related theory, (the financial instability hypothesis), where financial regulations, practices and norms naturally relax as a boom goes on, due to general exuberance, regulatory capture, or intellectual decline among the regulators and other actors in the system. This allows more fraudulent and unsound credit to be extended, (Ponzi credit), inflating the bubble and deepening the ensuing crash. Bankers and regulators then swear that they will implement better systems and remember lessons of history, which are nevertheless routinely forgotten on a roughly seventy year cycle.
Still another explanation of the boom–bust episodes goes back to John Maynard Keynes. Keynes argued that changes in investor’s expectations about respect to the state of the economy. These animal spirits that drive sudden changes in consumers’ and investor’s optimism can have implications for the behavior of aggregate economic variables like output and consumption. In good times, optimism is contagious, investors are willing to take more risk and households are willing to consume more. This approach to explain boom and bust cycles require some form of irrational behavior in which agents based their decision on the basis of ‘sentiments’ and can be fooled consistently. In the economic literature these ideas have been captured in models with "Sun Spots" in which the economy is driven to a bad equilibrium outcome by factors not related to the underlying conditions of the economy.