Credit Booms and Financial Instability

Recurrent episodes of financial instability have more often than not been the result of credit booms gone wrong.

In Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008 (NBER Working Paper No. 15512), researchers Moritz Schularick and Alan Taylor analyze the long-run behavior of money, credit, and macroeconomic indicators. They assemble a new annual dataset for the years 1870-2008 covering 12 countries: the United States, Canada, Australia, Denmark, Germany, Italy, the Netherlands, Norway, Spain, Sweden, and the United Kingdom. With this data, they show that leverage in the financial sector has increased strongly in the second half of the twentieth century, as demonstrated by a decoupling of money and credit aggregates. There has also been a decline in safe assets on banks' balance sheets. Monetary policy responses to financial crises have been more aggressive post-1945, but despite these policies, the output costs of crises have remained high.

The authors point to the value of long-run comparative data for identifying patterns in the links between financial markets and real activity. In their analysis, two distinct eras of finance capitalism emerge: the first, from 1870 to 1939, in which money and credit were volatile but maintained a roughly stable relationship to each other and to the size of the economy, except for the period of the Great Depression when the relationship collapsed. The second is the post-World War II era, when the huge growth in the use of credit and increasingly complex forms of leverage, along with a steady decline in bank-held "safe" assets such as government securities, led to an unprecedented level of risk throughout the credit system up to 2008.

A contributing factor in the post-1945 experience may have been a belief that central banks would step in as the lender of last resort to prevent the collapse of a nation's currency, as well as regulators' "hands-off" approach to the credit system. But the authors observe that the behavior of credit aggregates is the single best predictor for the likelihood of future financial instability.

The government's implicit back-stopping of the financial sector may have prevented a periodic deleveraging of that sector. The result was a virtually uninterrupted growth of credit and leverage through 2008, a development that contributed to the severity of the current crisis. "The long-run record shows that recurrent episodes of financial instability have more often than not been the result of credit booms gone wrong, most likely due to failures in the operation and/or regulation of the financial system," the authors write. "In terms of lessons for policymakers and researchers, history demonstrates that they ignore credit at their peril."

-- Frank Byrt