Publication - How distinct are financial cycles from business cycles? - By Gerhard Rünstler
One foundation for developing new macroprudential policy in addition to traditional macroeconomic stabilisation policy is that financial cycles differ from business cycles.
This article identifies properties of credit and housing cycles, shows how they relate to GDP cycles, and compares the reliability of real-time estimates.
Financial cycles and macroprudential policy
Systemic instability during the financial crisis led policymakers to develop macroprudential approaches to financial supervision and regulation. An important aspect of those macroprudential policies is “taming” the financial cycle (e.g. Bank of England, 2009). If the properties of financial cycles are sufficiently different from those of regular business cycles, then monetary and fiscal policy are imperfect instruments for addressing them and the case for macroprudential policy as a separate third stabilisation policy is strengthened. Moreover, calibrating macroprudential policy measures will depend on the properties of financial cycles.
In this respect, credit volumes and house prices are two key financial cycle variables, as historical evidence suggests that many financial crises have been preceded by credit and housing booms (Jorda et al., 2014). Whilst empirical work by central bank researchers has started to document how their behaviour differs from business cycles, the emerging stylised facts have by no means been digested by the scientific economics community.
Drehmann et al. (2012) report that house price and credit cycles are considerably longer than business cycles. While business cycles are usually assumed to be between two and eight years in length, the study finds that financial cycles range from eight to 20 years. Drehmann et al. thus conclude that business and financial cycles are “distinct phenomena”. However, the results emerge partly by construction, as the study pre-specifies rather than estimates the length of cycles. Schüler et al. (2015) use a more flexible approach for determining cycle length, present composite financial cycle indicators that also include bond and equity prices, and cover a wider set of euro area countries. They find significant cross-country heterogeneity in the length and amplitude of financial cycles across the euro area countries. Claessens et al. (2012) report that turning points occur more often in GDP than in house prices and credit volumes, but major recessions still coincide with troughs in the financial series. Their regression analysis adds that financial disruptions make recessions longer and deeper. Beyond that, limited attention has so far been paid by the literature to co-movements between financial and business cycles, and widely used macroeconomic theories do not reflect most of the above facts.
This article summarises the analysis of Rünstler and Vlekke (2016), who use a model-based multivariate time-series approach to estimate the cyclical components in credit volumes, house prices and GDP.[2] The approach goes beyond the aforementioned studies based on univariate band-pass filters in three respects. First, it allows for the key properties of financial cycles, such as their length and persistence, to be estimated. Second, it enables the degree of co-movement between the business cycle and financial cycles to be estimated at different cycle lengths. Finally, as macroprudential policymakers have to assess potential measures with real-time indicators of financial cycles (which are based on past data only), the study also examines the uncertainty of real-time estimates. The quarterly data used cover the United States and five major European economies (France, Germany, Italy, Spain and the United Kingdom) from 1973 to 2014.
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