Macroeconomics and the financial cycle: Hamlet without the Prince?

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Recently, the financial cycle has re-emerged as a key driver of the macroeconomy, but economic analysis has not caught up. Claudio Borio argues, in a recent VOXEU communique (Feb. 2^nd), macroeconomics without the financial cycle is like Hamlet without the Prince. Economic analysis and policies – monetary, fiscal, and prudential – should account for the financial cycles, but more work is needed. The question to address the bust and balance-sheet recession that follow the boom deserves special attention.

Since 1980, it is difficult to understand business fluctuations and the corresponding policy challenges without understanding the financial cycle. This perspective was taken for granted from the 19th century and to the Great Depression; it barely survived in the post-war period; and it has been regaining ground, after the Great Financial Crisis.

The financial cycle is best viewed as the self-reinforcing interactions between perceptions of value and risk, attitudes towards risk, and financing constraints, which translate into booms followed by busts. These interactions can amplify economic fluctuations and possibly lead to serious financial distress and economic dislocations.

Recent BIS research suggests the financial cycle has several properties. First, its most parsimonious description is in terms of the behavior of private-sector credit and property prices; second, the financial cycle has a much lower frequency than the traditional business cycle; third, peaks in the financial cycle tend to coincide with episodes of systemic financial distress; fourth, the financial-cycle regularities inform the construction of real-time leading-indicators of banking crises that provide fairly reliable signals; fifth, financial-cycle information also helps construct real-time estimates of sustainable output that are much more reliable; and finally, the financial cycle depends critically on policy regimes.

Financial liberalization weakens financing constraints. Monetary-policy frameworks focused on short-term inflation control provide less resistance to the build-up of financial imbalances whenever inflation remains low and stable. And positive supply-side developments (e.g. globalization) fuel the financial boom while putting downward pressure on inflation. Financial cycles have become twice as long since financial liberalization (1980s) and have been especially virulent since the early 1990s.

Modeling the financial cycle requires capturing three key features: the booms should not just precede but cause the busts: busts are fundamentally endogenous; second, the busts should generate debt and capital stock overhangs – the natural legacy of the preceding unsustainable expansion; and, potential output should not just be identified with non-inflationary output: as the previous evidence indicates, output may be on an unsustainable trajectory even if inflation is stable.

The models need the following information: first, drop 'rational' (model-consistent) expectations; second, allow for state-varying risk tolerance; and last, capture more deeply the monetary nature of our economies: the banking sector does not just allocate given resources but creates purchasing power out of thin air.

During the boom, the key question is how to address the build-up of financial imbalances: first for prudential policy, it means containing the procyclicality of the financial system through macroprudential measures; second, for fiscal policy, it means extra prudence, fully recognizing the hugely flattering effect of financial booms on the fiscal accounts and large contingent liabilities are needed to address the bust; and third, for monetary policy, it means leaning against the build-up of financial imbalances even if short-term inflation remains subdued.

During the bust, the key question is how to address the balance-sheet recession that follows and becomes a serious flow problem, in the form of anemic output and expenditures.  The next step is crisis resolution and stabilization phase is critical and less well understood.  This phase is less understood in policy implementation: first for prudential policy, it means repairing banks’ balance sheets aggressively through the full recognition of losses, asset disposals, recapitalizations subject and reducing excess capacity necessary for sustainable profitability; second, for fiscal policy, it means creating the fiscal space needed to use the sovereign’s balance sheet to support private-sector balance-sheet repair while avoiding a sovereign crisis down the road; and third, for monetary policy, it means recognizing its limitations, risks and avoiding overburdening it.

The longer-term risk is that policies that fail to recognize the financial cycle will be too asymmetric and generate a serious bias over time. Failing to tighten policy in a financial boom but facing strong incentives to loosen it during the bust would erode both the economy’s defenses and the authorities’ room for maneuver. In the end, policymakers would be left with a much bigger problem on their hands and without the ammunition to deal with it – a new form of 'time inconsistency'. The root causes here are horizons that are too short and a failure to appreciate the cumulative impact of flows on stocks. This could entrench instability in the system over successive cycles.

Macroeconomics without the financial cycle is like Hamlet without the Prince: a play that has lost its main character. Post-crisis, both policymakers and academics are making efforts to understand and respond to the challenges the financial cycle poses. But these efforts are still falling short of the mark. The stakes are high; the road ahead a long one and a challenge for risk management.

www.voxeu.org/article/macroeconomics-and-financial-cycle-hamlet-without-prince