Leverage, Business Cycles, and Crises

A stronger increase in ... bank credit-to-GDP in the boom tends to lead to a deeper subsequent downturn.

In When Credit Bites Back: Leverage, Business Cycles, and Crises (NBER Working Paper No. 17621), authors Oscar Jorda, Moritz Schularick, and Alan Taylor analyze data from 14 advanced economies going back to 1870 that include nearly 200 recession episodes and find that the credit-intensity of the boom that precedes a downturn matters for the path of the recession. In other words, a stronger increase in financial leverage, measured by the rate of growth of bank credit-to-GDP in the boom, tends to lead to a deeper subsequent downturn.

The authors track the effects of leverage on key macroeconomic variables including investment, lending, interest rates, and inflation. They find that the effects of leverage are particularly pronounced when the recession coincides with a financial crisis, but that there are similar effects in normal recessions. The aftermath of leveraged booms is associated with somewhat slower growth, investment spending, and credit growth than usual. If the recession coincides with a financial crisis, these effects are compounded and typically accompanied by pronounced deflationary pressures.

The authors also show that the economic costs of crises vary considerably and depend on the run-up in leverage during the preceding boom. A leverage build-up during the boom seems to heighten the vulnerability of economies to shocks, which suggests that financial factors play an important role in the business cycle.

--Lester Picker