Credit booms, a rapid increase in the issuance of debt to businesses or consumers, and economic booms, a period of rapid economic expansion, often go hand in hand, as do subsequent busts. The Great Depression and Great Recession are two salient examples of economic downturns that followed major credit booms, but is there necessarily a relationship between economic “overheating” or more general periods of rapid expansion and the onset of credit-fueled financial crises?
New research from the Federal Reserve finds that economic booms aren’t necessarily a harbinger of a financial crisis:
With the national unemployment rate running below 4 percent, the possibility that an overheated economy could lead to financial imbalances, which in turn could generate or amplify economic distress, has become more salient. We explore the link between indicators of financial imbalances and macroeconomic performance, focusing on the experience of the United States. Our approach involves a statistical analysis of the link between measures of economic slack and financial system vulnerability. We study bivariate time-series relationships between different measures of economic slack and systemic financial vulnerability, relying on conventional measures of the business and financial cycles. In an accompanying note, The Relationship between Macroeconomic Overheating and Financial Vulnerability: A Narrative Investigation, we follow a narrative approach to review historical episodes of significant financial imbalances and examine whether these episodes were linked to macroeconomic overheating. Neither approach highlights a strong direct link between macroeconomic overheating and increased financial vulnerability.
This abstract is from the quantitative approach to the question (you can read the narrative approach here), but the two approaches yield the same results–financial booms and busts “appear to have stemmed more from financial innovation and the development of different financial markets. Regulatory factors, policy regimes, and other external factors also appear to have played a more important role than macroeconomic overheating in inducing various financial disturbances.” These results confirm previous research finding that “bad booms,” those that end in a crisis instead of a more general decline in or slowing of output, “appears to have stemmed more from financial innovation and the development of different financial markets. Regulatory factors, policy regimes, and other external factors also appear to have played a more important role than macroeconomic overheating in inducing various financial disturbances.”
This is good news–the current economic boom (like all others before) can’t last forever, and as we pass the tenth anniversary of the financial crisis, many are concerned that the end of this period of expansion will end not only in a recession, but another collapse of the banking system.
Then again, just because the end of a boom doesn’t necessarily imply the onset of a financial crisis doesn’t mean more effective and countercyclical macroprudential policy isn’t necessary. There’s no time like the present for reforming the financial system, especially if it can be done in advance of another financial crisis.