by Don Alexander, MBA
Associate, RSD Solutions Inc.
www.RSDsolutions.com
info@RSDsolutions.com
Credit booms encourage investment and consumption and can contribute to long-term financial growth. However, some end up in costly balance sheet dislocations, and, others, in devastating financial crises with costly consequences. These risks have long been recognized. Yet, there is little consensus about how to manage the risks and when policy should intervene.
The IMF explores some of these issues in a Staff Discussion paper on Credit Booms that looks at past events with the objective of assessing policy effectiveness policies to reduce the risk or limiting its consequences. There is no policy panacea for credit booms.
Credit booms are often triggered by financial reform, capital inflows from capital account liberalizations, and followed by periods of strong economic growth. They are often characterized by weak regulation and loose policy. Not all booms are bad as some produce long-term periods of steady growth. Only a third of boom cases end up in financial crises, but others can be followed by extended periods of below-trend economic growth. It is difficult to tell “bad” from “good” booms in real time, but bad booms tend to be larger and last longer (balance sheet).
Monetary policy is in principle the natural lever to contain a credit boom, but some occur in low-inflation environments, a conflict may emerge with its primary objective. Given its time lags, fiscal policy is ill-equipped to timely stop a boom. Consolidation during the boom years can help create fiscal room to support the financial sector or stimulate the economy. Finally, macroprudential tools have at times proven effective in containing booms and in limiting their consequences of busts through buffers they build, but can cause distortions.
Prolonged credit booms are a harbinger of financial crises and have real costs. While only a minority of booms end up in crises, those that do can have long lasting and devastating real effects if left unaddressed. Yet it appears to be difficult to identify bad booms as they emerge, and the cost of intervening too early and running the risk of stopping a good boom therefore has to be weighed against the desire to prevent financial crises.
The optimal macroprudential policy response to credit booms, as well as the optimal policy mix, will likely depend on the type of credit boom. Policy coordination, across different authorities and across borders, may increase the effectiveness of monetary tightening and macroprudential policies. Cooperation and a continuous flow of information among national supervisors, especially regarding the activities of institutions that are active across borders, are crucial. Equally important is the coordination of regulations and actions among supervisors of different types of financial institutions. Whether and how national policymakers take into account the effects of their actions on the financial and macroeconomic stability of other countries is a vital issue, calling for further regional and global cooperation in the setup of macroprudential policy frameworks and the conduct of macroeconomic policies.
The failure to understand credit booms and busts can have devastating and costly consequences for risk management.
For more information on this, follow the link: www.imf.org/external/pubs/ft/sdn/2012/sdn1206.pdf
