Is the Credit Cycle a Factor in Boom and Bust Cycles?

Understanding the intricate relationship between the credit cycle and business cycle is crucial for policymakers, economists, and investors. In this article, we delve into the empirical evidence, theoretical models, and real-world implications of these interconnected cycles.

Empirical Evidence

The credit cycle is often seen as a reaction to the business cycle due to the central bank's response to economic conditions. According to empirical data, when the business cycle experiences an upturn, central banks typically lower interest rates to boost lending, encourage investment, and eventually stimulate economic growth. Conversely, during a downturn, central banks hike interest rates to curb inflation and reduce over-leveraging, thus restraining the credit cycle.

The Credit Cycle's Impact on Business Cycles

While the credit cycle is not always the sole driver of business cycles, it certainly plays a significant role. For instance, during the 2008 financial crisis, a series of credit cuts and lending restrictions contributed to the economic downturn. Historically, the boom and bust phases of the business cycle can be partially attributed to the credit cycle, with periods of high leverage preceding booms and deleveraging following busts. However, the relationship is not always straightforward.

The Complexity of the Relationship

Economists often simplify complex systems to gain actionable insights. However, when it comes to the interplay between credit and business cycles, the relationship is too convoluted to be fully captured by simple models. Despite the complexity, some models do attempt to reconcile these cycles. One such model accounts for the variations in fiscal policies, interest rates, and central bank interventions. Yet, the model's erratic nature makes it less valuable for practical applications.

The Role of Fiscal Deficit

A robust fiscal stance can dampen the impact of credit cycles on business cycles. If a government continuously injects fiscal deficits to maintain a sustainable level of public spending, it can help stabilize the economy. However, allowing fiscal deficits to cross zero could lead to speculative investment and potential instability. For instance, in periods of financial stability, increasing fiscal deficits can spur economic growth. Conversely, during downturns, reducing fiscal deficits can help prevent further economic erosion.

Monetary Policy and Its Effect on the Credit Cycle

Monetary policy, particularly low-interest-rate policies, plays a crucial role in the credit cycle. Since the 2008 financial crisis, central banks have implemented quantitative easing (QE) and near-zero interest rate policies (NIRP). These measures aim to stimulate lending and investment by lowering the cost of borrowing. However, the effectiveness of these policies has been limited, leading to the buildup of excess reserves and reduced business investment.

The Current State of the Economy

The current economic climate is characterized by low interest rates and stagnant wage growth, despite years of monetary stimulus. This situation has prompted discussions about the effectiveness of conventional monetary policies. Some economists argue that the zero lower bound on interest rates has limited the ability of central banks to stimulate the economy through traditional means. Others, known as neo-Fisherians, argue that higher interest rates could lead to higher inflation, contrasting with the views of those fitting current economic data to a Phillips curve.

Conclusion

The relationship between the credit cycle and business cycle is complex and dynamic. While the credit cycle can be a significant driver of economic booms and busts, the current state of low interest rates and economic stagnation suggests that traditional monetary policies may need to be reassessed. Future economic theory must consider the limitations of current policies and explore alternative frameworks to understand and mitigate economic cycles.