By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB
It is time policymakers rediscovered the role of the financial cycle in macroeconomics. In the environment that has prevailed for at least three decades now, it is not possible to understand business fluctuations and the corresponding analytical and policy challenges without understanding the financial cycle. This calls for a rethink of modeling strategies and for significant adjustments to macroeconomic policies. This is what Claudio Borio discusses in a recent BIS WP 395 (Dec. 2012) The Financial Cycle and Macroeconomics: What have we learnt?
Understanding in economics does not proceed cumulatively. So-called “lessons” are learnt, forgotten, re-learnt and forgotten again. They do so because the economic environment changes, sometimes slowly but profoundly, at other times suddenly and violently. But they do so also because the discipline is not immune to fashions and fads.
The notion of the financial cycle, and its role in macroeconomics, is no exception. The notion, or at least that of financial booms followed by busts, actually predates the much more common and influential one of the business cycle, but for most of the postwar period it fell out of favor. Finance came to be seen effectively as a veil – a factor that, as a first approximation, could be ignored when seeking to understand business fluctuations. And when included at all, it would at most enhance the persistence of the impact of economic shocks that buffet the economy, delaying slightly its natural return to the steady state. Economists are now trying hard to incorporate financial factors into standard macroeconomic models.
The purpose of the study is to summarize what we learned about the financial cycle over the last ten years and to identify the most promising way forward. The main thesis is that macroeconomics without the financial cycle is like Hamlet without the Prince. Three themes emerge. The financial cycle is much longer than the traditional business cycle. Modeling the financial cycle correctly, rather than simply mimicking some of its features superficially, requires recognizing fully the fundamental monetary nature of our economies: the financial system does not just allocate, but also generates, purchasing power, and has very much a life of its own. The global economy, with its financial, product and input markets, is highly integrated.
There are five stylized empirical features of the financial cycle that stand out. (1.) The financial cycle is best captured by the joint behavior of credit and property prices. (2.) It is much longer, and has much larger amplitude, than the traditional business cycle. (3.) It is closely associated with systemic banking crises, which tend to occur close to its peak. (4.) It permits the identification of the risks of future financial crises in real time and with a good lead. (5.) And it is highly dependent of the financial, monetary and real-economy policy regimes in place.Modeling the financial cycle raises major analytical challenges for prevailing paradigms. It calls for booms that do not just precede but generate subsequent busts, for the explicit treatment of disequilibrium debt and capital stock overhangs during the busts, and for a clear distinction between non-inflationary and sustainable output, i.e., a richer notion of potential output – all features outside the mainstream.
More generally, the emergence of the financial cycle as a major force highlights a growing tension between “economic” and “calendar” time. The financial cycle slows down economic time, as it stretches out the period over which the relevant economic phenomena play themselves out. Financial vulnerabilities take a long time to grow and the wounds they generate in the economic tissue a long time to heal. But the horizon of policymakers does not seem to have adjusted accordingly. If anything, it has shrunk in an attempt to respond to the high-frequency vagaries of the markets. This tension can be a major source of economic damage. The short horizons of market participants and policymakers contributed in no small measure to the financial crisis. They should not be allowed to generate the next one.
