2 Financial cycles and the macroeconomy

This box discusses the relationship between financial cycles, the

macroeconomy and potential output. The financial cycle can be thought of as
economic fluctuations that are amplified by – or stem directly from – the financial
system. It typically manifests itself as a co-movement between credit aggregates and
asset prices with a possible impact on real economic developments as well. While
cyclical fluctuations in real economic variables do not always correspond to financial
cycles, when they do, the resulting business cycles can be much more pronounced,
with troughs often accompanied by financial crises. There is a growing body of
literature which claims that, in such cases, the estimation of potential output can
benefit from including information about the financial cycle. 6 Without such
information, potential output may be overestimated in the boom period and
underestimated during the bust phase.

Economic theory points to a potential role for the financial system over the
business cycle. Financial factors have been regarded as a possible driving force
behind business cycle fluctuations since at least the time of the Great Depression. 7
More recent general equilibrium approaches also emphasise the role of financial
frictions in output fluctuations. 8 According to these approaches, the financial system
can both act as an amplifier of shocks and be the source of shocks that trigger
business cycle fluctuations in the first place. The balance sheets of households,
firms and banks can give rise to various pro-cyclical mechanisms (such as the
financial accelerator). For example, demand shocks can be amplified through
corresponding changes in the value of collateral (such as residential or commercial
property) and the real value of nominally fixed debt. These theoretical considerations
suggest that credit and asset price-driven cyclical fluctuations can be expected to
yield higher peaks and lower troughs than normal business cycles, possibly with
more prolonged periods of boom and bust.

There is growing empirical evidence for a role of the financial system in

business cycle fluctuations. While not all business cycle fluctuations are driven by
the financial system, or go hand-in-hand with financial booms and busts, there is
evidence that the most severe fluctuations are typically associated with the build-up
and unravelling of financial imbalances. 9 A comprehensive macrofinancial historical
database covering 17 advanced economies over the last 150 years suggests that

6
Borio, C., Disyatat, P. and Juselius, M., “Rethinking potential output: Embedding information about the
financial cycle”, BIS Working Papers, No 404, Bank for International Settlements (BIS), 2013; Borio, C.,
Disyatat, P. and Juselius, M., “A parsimonious approach to incorporating economic information in
measures of potential output”, BIS Working Papers, No 442, BIS, 2014.
7
Fisher, I., “The Debt-Deflation Theory of Great Depressions”, Econometrica, Vol. 1(4), 1933, pp. 337-
57.
8
See, for example, Kiyotaki, N. and Moore, J., “Credit cycles”, Journal of Political Economy, Vol. 105,
1997, pp. 211-248; Gertler, M. and Karadi, P., “A Model of Unconventional Monetary Policy”, Journal of
Monetary Economics, Vol. 58(1), 2011, pp. 17-34; Bernanke, B.S., Gertler, M. and Gilchrist, S., “The
financial accelerator in a quantitative business cycle framework”, in Taylor, J. and Woodford, M. (eds.),
Handbook of Macroeconomics, Vol. 1, Part C, 1999, pp. 1341-1393; Iacoviello, M., “House Prices,
Borrowing Constraints, and Monetary Policy in the Business Cycle”, The American Economic Review,
Vol. 95(3), 2005, pp. 739-764.
9
See, for example, Rogoff, K., “Debt supercycle, not secular stagnation”, VoxEU.org, Centre for
Economic Policy Research, 2015.

ECB Economic Bulletin, Issue 1 / 2017 – Boxes

Financial cycles and the macroeconomy 24
financial and business cycles tend to co-move and be in the same phase significantly
more often than not. 10 It is also found that the correlation of output, consumption and
investment growth with credit growth has strengthened substantially over recent
decades, in parallel with an unprecedented increase in mortgage lending. There is
also evidence that credit and asset price variables are relatively important in
explaining real economic fluctuations at the global level. 11 These findings suggests
that economic expansions associated with strong credit growth are driven more by
cyclical (as opposed to structural) factors than are other upturns.

The path of potential output may be overestimated in credit-driven booms.

Standard tools for potential output estimation which do not take into account the role
of the financial system in business cycle fluctuations may provide an overly optimistic
assessment of the supply side of the economy during financial booms. This is
particularly true when nominal variables give weaker signals about the overheating
of the economy, such as when inflation expectations are well anchored. While the
availability of financing and low risk aversion in the expansion phase of the business
cycle can boost underlying productivity growth by enabling more innovation, credit-
driven expansion can also give rise to capital misallocation. Such episodes often
entail significant increases in residential property investment, owing to the ability to
collateralise this asset type via mortgage borrowing, with capital being concentrated
disproportionately in relatively low-productivity projects and activities (such as
housing and property development). 12 Moreover, since residential property is
included in typical measures of the capital stock, production function-based
methodologies which use these data have a tendency to overestimate the productive
capacity of the economy. 13 As an illustration, the chart below shows potential output
measures for the euro area, calculated using three different methodologies, including
one that assumes a link between the financial cycle and real economic fluctuations.
The latter method yields a lower path for the level of potential output in the pre-crisis
boom years and a higher path in the post-2008 period than the methods that are not
informed by financial variables. However, all three methods imply a slowdown in
potential output growth after 2008.

10
Jorda, O., Schularick, M. and Taylor, A.M., “Macrofinancial History and the New Business Cycle Facts”,
NBER Macroeconomics Annual, Vol. 31, National Bureau of Economic Research, 2016.
11
Dées, S., “Credit, asset prices and business cycles at the global level”, Working Paper Series, No
1895, ECB, April, 2016.
12
However, capital misallocation is not necessarily confined to real estate type assets. For more detail,
see Cecchetti, S.G. and Kharroubi, E., “Why does financial sector growth crowd out real economic
growth?”, BIS Working Papers, No 490, BIS, 2015.
13
The overestimation of potential output can lead to overly optimistic assessments of the fiscal policy
stance and debt sustainability of countries experiencing financial cycle driven booms which may limit
fiscal space and thus add to the drag on output in the event of a financial crisis. See Borio, C.,
Lombardi, M. and Zampolli, F., “Fiscal sustainability and the financial cycle”, BIS Working Papers, No
552, BIS, 2016.

ECB Economic Bulletin, Issue 1 / 2017 – Boxes

Financial cycles and the macroeconomy 25
Chart
Real GDP and different measures of potential output in the euro area
(EUR trillions; quarterly data)
real GDP
trend 1: Hodrick-Prescott
trend 2: macroeconomic information only
trend 3: macroeconomic and financial information
2.6

2.5

2.4

2.3

2.2

2.1

2.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Sources: Eurostat and ECB staff calculations. 14

Notes: Trend 1 refers to a measure derived using the two-sided Hodrick-Prescott filter with the standard smoothing parameter for
quarterly data (1600). Trend 2 refers to an estimate derived from a small unobserved components model that decomposes real GDP
into trend and cyclical components with the help of reduced-form macroeconomic relationships such as Okun’s law and a Phillips
curve.Trend 3 refers to the same model augmented with a financial cycle component which is estimated as a common latent factor
driving fluctuations in a number of financial variables, such as real credit growth to households and non-financial corporations, real
growth rate of M3 and real growth rate of residential property prices. As potential output is an unobservable variable, all methods carry
a high degree of uncertainty.

Severe downturns following credit-driven booms can have a negative impact

on potential output. While economic downturns, such as the recent Great
Recession, can arguably give rise to cleansing effects with a beneficial impact on
future productivity growth, the reallocation of resources towards more productive
uses may be hindered by supply constraints in the financial system. In particular,
high non-performing loan (NPL) ratios, coupled with inadequate insolvency and bank
resolution, can tie up capital in low-productivity firms and make acquisitions and the
entry or expansion of innovative and potentially highly productive firms less likely to
happen. 15 Nominally fixed debt that has been accumulated in the boom period,
coupled with collateral that has lost value during the bust, can limit the options for
otherwise healthy firms to obtain external financing for productive investment
projects – particularly when the lower bound on nominal interest rates is binding. The
ensuing long process of repairing private sector balance sheets can further weaken
domestic demand and lead to persistently high unemployment rates. With long
periods of high unemployment, there is a greater chance of labour market hysteresis
effects, particularly in rigid, overregulated labour markets. The reallocation process
itself may introduce a temporary dip in potential output if, for example, the acquisition
of resources that were locked in low-productivity activities is hampered by high
barriers to entry.

14
For a similar approach, see Melolinna, M. and Tóth, M., “Output gaps, inflation and financial cycles in
the United Kingdom”, Staff Working Paper, No 585, Bank of England, 2016.
15
See Adalet Mcgowen, M., Andrews, D. and Millot, V., “The Walking Dead? Zombie Firms and
Productivity Performance in OECD Countries”, Economics Department Working Papers, No 1372,
OECD, 2016.

ECB Economic Bulletin, Issue 1 / 2017 – Boxes

Financial cycles and the macroeconomy 26
The negative supply-side effects of financial bust episodes are not necessarily
persistent and depend on the policy context. While credit constraints and other
financial imperfections may well put a significant drag on economic growth during a
recovery period, their impact on resource allocation might be expected to diminish
over time. Therefore estimates of potential output that do not take these possible
features into account may yield an overly pessimistic view of the supply-side
potential during recoveries from financial crises. Therefore, at present, both the
cyclical recovery and supply-side capacity of the economy could benefit from
adequate insolvency and resolution policies and an effective workout of NPLs,
particularly in the context of accommodative monetary policy.

ECB Economic Bulletin, Issue 1 / 2017 – Boxes

Financial cycles and the macroeconomy 27