The financial cycle and macroeconomics: What have we learnt?
Authors: C. Borio
Publication Year: 2012
Journal: BIS Economics Working Paper
The economic literature recognizes that on the macroeconomic scale, cycles of booms and busts are a reoccurring pattern. The economy appears to follow a cyclical pattern. Set against this background, the article summarizes the findings of recent literature pertaining the features, the behaviors and the interaction of two very important cycles: the business cycle and the financial cycle. The financial cycle is defined as the “self-reinforcing interactions between value and risk, attitudes risk and financing constraints”. It is typically much longer and of larger amplitude than the business cycle. After a period of deregulation in the 1980’s its cyclicality and magnitude has increased. The business cycle is typically defined as the fluctuations of aggregate economic activity (GDP). The study of the macroeconomic interactions of these cycles are important to understand, forecast and react to financial crises. From the existing literature, the author derives five stylized facts: Firstly, the financial cycle is best described by property and credit prices. Secondly it is long and large in amplitude. Thirdly, its peaks coincide with systemic banking crises. Fourthly, it can be used to forecast future financial crises. Fifthly, it is dependent on the policy regime in place. Borio emphasizes, that the management of crises must be addressed from a systemic point of view. Essential elements are to monitor systemic risk and the buildup of buffers in good times, which can be accessed during a crisis. These ideas are studied and applied in the field of macroprudential policy. In academics, researchers now try to include more financial features in macroeconomic models.
Relation with the adaptive cycle literature The interaction of the business- and the financial cycle mirror different layers of complex adaptive cycles within the panarchy. The business cycle is herein the smaller, faster system and the financial cycle the larger, slower system. In addition the financial cycle as a global scope, while the business cycle has a regional and/or domestic scope. These features resemble very closely the structure of cross-scale nested adaptive cycles within the panarchy. Their interactions are dynamic and disturbances in either layer can cause crisis in other layers. As pointed out by the author, it appears that peaks in the financial cycle are closely related to financial crises. This phenomenon it can be linked to the κ-phase of the adaptive cycle. After an extended period of growth where connectedness and potential of the system is the highest, small disturbances can bring about the crisis. In the financial world, the connectedness can be seen in the increasing counter-party risk exposure when trading financial derivatives (e.g. mortgage backed securities). As the panarchy-literature points out, that the more connected as system is, the less its resilience to shocks. The mortgage crisis of 2007/2008 demonstrates this feature impressively. A crash in the relatively (to the global financial market) small American subprime mortgage market was able to trigger a major financial- and real economy crisis all around the world. Many banks went bankrupt and businesses had to lay-off personnel (Κ to Ω transition). Hence in this case the crisis originated from the larger, slower financial cycle, wreaking havoc in the smaller business cycle. Currently the financial system is readapting and new policies are enforced (e.g. the European banking supervision and Basel III).