Boom and bust

Boom and bust

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A credit boom-bust cycle is an episode characterized by a sustained increase in several economics indicators followed by a sharp and rapid contraction. Commonly the boom is driven by a rapid expansion of credit to the private sector accompanied with rising prices of commodities and stock market index. Following the boom phase, asset prices collapse and a credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...

 arises, where access to financing opportunities are sharply reduced below levels observed during normal times. The unwinding of the bust phase brings a considerably large reduction in investment and fall in consumption and an economic recession may follow.

The recession following the burst of the episode is oftentimes short-lived, GDP and consumption growth usually resume within a year. In the financial sector of the economy the recovery is slower and credit remains depressed for several periods. Credit falls more sharply than GDP and the cost of borrowing remains higher compared to normal times.

A boom-bust cycle is also associated with the existence of bubbles
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...

 in stock market that lead to a period of accelerated investment and over borrowing. After the buildup there is a stock market crash
Stock market crash
A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors...

 which is often attributed to speculative behavior
Stock market bubble
A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation....

 and Herd behavior
Herd behavior
Herd behavior describes how individuals in a group can act together without planned direction. The term pertains to the behavior of animals in herds, flocks and schools, and to human conduct during activities such as stock market bubbles and crashes, street demonstrations, sporting events,...

 on the part of investors. All these studies share the following findings. During the build up of the boom there is rapid expansion in credit to the private sector, GDP, consumption and investment also grow above their rates observed during tranquil times. The non-tradable sector of the economy, that is economic activities produced only for domestic consumption, experiences faster growth, and the real exchange rate appreciates. During the boom banks extended more credit to the non-tradable sector of the economy, and there is a surge of capital flows into the country. Capital inflows tend to be 4% above its long run trend in the year previous to the crisis; similarly the price of housing is 15% above its trend one year before the bust.

In developing countries credit tends to be denominated in foreign currency increasing the debt burden of borrowers during the bust phase. It has been argued that the currency mismatch of the non-tradable sector can amplify the effects of the decline in economic activity during the bust phase. The reason is that the non-tradable sector uses the value of its production, its physical capital or any other asset as a guarantee to access financing from a bank; however more often than not, the collateral put forth by firms is denominated in domestic currency while its liabilities to the bank are denominated in foreign currency, thus during the bust, production diminishes and the foreign currency value of its collateral plummets, and the firm maybe forced to default on its debt. This mechanism helps explain why banks' loan portfolio deteriorates heavily during a the bust, opening the possibility of a banking or financial crisis
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...

.

Evidence over the past 40 years in developing and developed countries document several regularities observed during credit booms. First, the length of the boom phase ranges between 6 to 7 years, and the episodes are often observed in different countries around the same period and are not limited to a single region. GDP and consumption rise 2 to 4% above its trend, while investment rises 18%. Output in the non-tradable sector rises 6.5% and the real exchange rate appreciates roughly 9%. Also capital flows increase up to 3.5 percentage points with respect to GDP, and the current account
Current account
In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...

 as a share of GDP declines about 2.5 percentage points more than in normal times. Stock markets also thrive during the boom phase and equity and housing prices rise considerably, for example in the Financial crisis (2007-present)  the Case–Shiller index
Case–Shiller index
The Standard & Poor's Case–Shiller Home Price Indices are constant-quality house price indices for the United States. There are multiple Case–Shiller home price indices: A national home price index, a 20-city composite index, a 10-city composite index, and twenty individual metro area...

, measuring the real price of housing in the US, shows that between early 2000 and August 2007 housing prices had a cumulative increase of 125% .

During the downswing of the cycle consumption and investment fall, output in the non-tradable sector declines, the real exchange rate depreciates and asset and housing prices fall below trend. Investment is the component of GDP that suffer the most pronounced swings during the bust; for example after the Argentinean crisis
Argentine economic crisis (1999-2002)
The Argentine economic crisis was a financial situation, tied to poilitical unrest, that affected Argentina's economy during the late 1990s and early 2000s...

, investment to GDP ratio fell by 5.5 percentage points in Argentina and by 6.1 percentage points in Chile. The contraction in GDP tends to be short lived, however when the bust is accompanied with a financial crisis
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...

 the effects can be much large; after the 1997 Asian financial crisis, GDP in Thailand, Indonesia and Philippines fell by more than 10%, in the aftermath of the Argentine crisis
Argentine economic crisis (1999-2002)
The Argentine economic crisis was a financial situation, tied to poilitical unrest, that affected Argentina's economy during the late 1990s and early 2000s...

 GDP collapsed by roughly 23%.

Even though not all episodes of rapid credit growth end up in a bust, when they do the adjustment tends to be very disruptive. For example, output and consumption fall 4% below trend, investment falls about 18%, the real exchange rates depreciates suddenly by an average of 4% within one year. Output in the non-tradable sector drops 3% below its pre-boom value. Other indicators of the bust phase include, a sharp deterioration of the quality of banks portfolio with a sudden increase in non-performing loans and rapid de-leveraging by financial institutions. The latter implies that financial institutions try to rise capital and improve their capital adequacy
Capital requirement
Capital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...

 in periods where capital is scarcer forcing them to liquidate assets through fire sale
Fire sale
A fire sale is the sale of goods at extremely discounted prices, typically when the seller faces bankruptcy or other impending distress. The term may originally have been based on the sale of goods at a heavy discount due to fire damage...

s. In open economies, the external accounts adjusts sharply; in the 1994 economic crisis in Mexico
1994 economic crisis in Mexico
The 1994 Economic Crisis in Mexico, widely known as the Mexican peso crisis, was caused by the sudden devaluation of the Mexican peso in December 1994....

 the current account went from a deficit of 8 percent of GDP to zero within a year. The average adjustment is approximately a jump from a current account deficit of 2.5% of GDP to a surplus of 1.5% of GDP.

The adjustment in the current account
Current account
In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...

 reflects the consumption cost associated to the bust as well as the reallocation of resources that takes places after the bust. During the boom phase the heightened desire for investment and consumption tends to move resources into the growing non-tradable sector of the economy. Since the bust depresses the non-tradable sector, both labor and capital shift back towards the tradable sector. This reallocation can be costly, for example if the skills workers need to enter the tradable sector are different than those employed in no-tradable sector, which can produce longer unemployment spell and losses in total factor productivity
Total factor productivity
In economics, total-factor productivity is a variable which accounts for effects in total output not caused by inputs. If all inputs are accounted for, then total factor productivity can be taken as a measure of an economy’s long-term technological change or technological dynamism.If all inputs...

.

The phrase "boom and bust" was applied to the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...

 in the early 1990s. The "boom" period had come in the second half of the 1980s, when the economy grew rapidly and unemployment fell from a record of nearly 3,300,000 in 1984to 1,600,000 by the end of 1989.However, the Conservative
Conservative Party (UK)
The Conservative Party, formally the Conservative and Unionist Party, is a centre-right political party in the United Kingdom that adheres to the philosophies of conservatism and British unionism. It is the largest political party in the UK, and is currently the largest single party in the House...

 government led by Margaret Thatcher
Margaret Thatcher
Margaret Hilda Thatcher, Baroness Thatcher, was Prime Minister of the United Kingdom from 1979 to 1990...

 (and then John Major
John Major
Sir John Major, is a British Conservative politician, who served as Prime Minister of the United Kingdom and Leader of the Conservative Party from 1990–1997...

 from November 1990) increased interest rates to tackle rising inflation, and by the end of 1990 the economy was in recession and unemployment was creeping back upwards, turning the "boom" into a "bust". Britain had joined the European Exchange Rate Mechanism
European Exchange Rate Mechanism
The European Exchange Rate Mechanism, ERM, was a system introduced by the European Community in March 1979, as part of the European Monetary System , to reduce exchange rate variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union and the introduction of...

 in October 1990 before leaving it on Black Wednesday
Black Wednesday
In politics and economics, Black Wednesday refers to the events of 16 September 1992 when the British Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism after they were unable to keep it above its agreed lower limit...

 in September 1992, when interest rates had briefly peaked at 15%. Britain's departure from the exchange rate mechanism enables interest rates to be reduced.Within a year, inflation was falling, but unemployment was now above 2,000,000 and rising.The recession in Britain was officially declared over in April 1993, by which time it had lasted for a record of nearly three years. This marked the end of that "boom and bust" era in the British economy.A strong economic recovery followed, with low unemployment and inflation, and it would be 16 years before the economy entered another recession.

The emerging economies experience


Boom bust episodes have been largely documented in emerging economies. During the nineties, countries like Mexico, Argentina, Malaysia, Turkey, Colombia, Indonesia, Korea and Peru all experienced boom-bust cycles with the consequent collapse in GDP, consumption, non-tradable output sector contraction, capital flow reversals, limited or costly access to capital markets and sharp real exchange rate fluctuations.

In emerging markets the phenomenon of a boom-bust cycle has also been linked to episodes of sudden stops
Sudden stop (economics)
A sudden stop in capital flows is defined as a sudden slowdown in private capital inflows into emerging market economies, and a corresponding sharp reversal from large current account deficits into smaller deficits or small surpluses. Sudden stops are usually followed by a sharp decrease in output,...

 in capital flows and output drops. Following the 1998 Russian economic crisis, the seven largest Latin American countries saw their investment rates plummet from an average of 7.4% per year in the five years prior to the crises to -4.1% in the year to follow. After the crisis ended investment rates resumed their growth at rate of 10% per year. The same episode had a different effect on the emerging economies of Asia. In that region investment dropped from an average rate of 6.06% to -37% in the year after the crisis and resumed at an average annual rate of 6% in the following five years.

Not even among emerging markets the response of economic variables during a boom-bust episode is the same. Some countries are more vulnerable than other due to their particular domestic conditions. Some examples include the extent of liability dollarization
Domestic liability dollarization
Domestic liability dollarization refers to the denomination of banking system deposits and lending in a currency other than that of the country in which they are held...

 which increases the vulnerability of the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...

 of leveraged agents in the case of a devaluation
Devaluation
Devaluation is a reduction in the value of a currency with respect to those goods, services or other monetary units with which that currency can be exchanged....

;

Explanations


Swings in output, consumption and investment are consistent with traditional theories of the [business cycle], but the magnitudes of these movements are not. Proponents of the Real Business Cycle Theory
Real business cycle theory
Real business cycle theory are a class of macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by real shocks. Unlike other leading theories of the business cycle, RBC theory sees recessions and periods of economic growth as the efficient response to...

 would argue that demand needs to be very sensitive to movements in output in order to generate a large credit expansion. However, the evidence suggests that periods with fast output growth are not always accompanied with a credit boom, meanwhile a credit boom usually brings about an acceleration of output. Alternatively, unexpected improvements in a country terms of trade
Terms of trade
In international economics and international trade, terms of trade or TOT is /. In layman's terms it means what quantity of imports can be purchased through the sale of a fixed quantity of exports...

 can lead to a boost in consumption and investment generating the rapid expansion we observe during the boom phase. However, there is no evidence of significant movements in terms of trade during the build up of the credit booms.

A different view on the origin of the boom-bust episodes emphasizes the role of external factors. For example, large capital inflows like a surge in foreign direct investment
Foreign direct investment
Foreign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...

 or a sudden increase in short term portfolio investment
Hot money
Hot money is a term that is most commonly used in financial markets to refer to the flow of funds from one country to another in order to earn a short-term profit on interest rate differences and/or anticipated exchange rate shifts...

. If domestic banks can finance their operations with foreign capital, when these resources are easily available banks have the incentive to increase credit in the economy. When the capital flow veers direction suddenly, banks can no longer access cheap financing from foreign sources credit or it is forced to repay its obligations to external lenders and therefore the supply of credit to the economy falls and a credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...

 ensues. Under these view, capital flows are procyclical
Procyclical
Procyclical is a term used in economics to describe how an economic quantity is related to economic fluctuations. It is the opposite of countercyclical. However, it has more than one meaning.-Meaning in business cycle theory:...

 because borrowing increases during good times and falls in bad times, making the country vulnerable to experience growth in investment and consumption that result in a sudden bust when capital flows reverse. Regardless of its appeal the external view does not offer an explanation of why capital flows behave so wildly, and some argue that these surges of foreign capital are the reflection of a deeper change in the domestic conditions of the recipient country or region.

A third possible explanation for the nature and the characteristics of boom-bust cycles emphasizes the role of financial frictions. For example, costs in acquiring information from borrowers due to moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

 or adverse selection
Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...

 problems may have amplifying effects on the economy. To alleviate the effect of these frictions, banks may offer contracts that require borrowers to use part of their own capital as collateral for the loan. During a expansionary phase households and firms net worth rise with rising asset prices, if households uses their net worth as collateral they can access credit with relative ease, and as a consequence they can increase the ratio of their debt obligations to net worth (leverage). At the onset of the bust phase, the decline in asset prices negatively affects households net worth limiting access to credit and through a financial accelerator
Financial accelerator
The financial accelerator in macroeconomics refers to the idea that adverse shocks to the economy may be amplified by worsening financial market conditions...

 mechanism take the economy into a recession. The existence of collateralized borrowing generates an externality
Externality
In economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...

 problem in which individual borrowers do not take into account the effect of their actions into the value of the assets that determine their own collateral, like in the case of housing. During good times borrowers acquire too much debt than what is socially desirable, and when the value of their collateral falls they do not have enough resources to pay off their obligations and can trigger general turmoil in the financial system.

A fourth explanation based on the experience of many Latin American and Eastern European countries led to the view that economic reform and financial deregulation maybe the culprit of boom-bust cycles. Efforts to control inflation in Latin America, specially those in which the nominal exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

 was used as main policy tool, backfired producing a initial expansion in output followed by a recession. The failure of the stabilization programs was in part due to a lack of credibility that lead people to anticipate a future reverse of policy.

Still another explanation of the boom-bust episodes goes back to John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

. Keynes argued that changes in investor’s expectations about respect to the state of the economy. These animal spirits
Animal spirits (Keynes)
"Animal spirits" is the term John Maynard Keynes used in his 1936 book The General Theory of Employment, Interest and Money to describe emotions which influence human behavior and can be measured in terms of consumer confidence. Trust is also included or produced by "animal spirits"...

 that drive sudden changes in consumers’ and investor’s optimism can have implications for the behavior of aggregate economic variables like output and consumption. In good times, optimism is contagious, investors are willing to take more risk and households are willing to consume more. This approach to explain boom and bust cycles require some form of irrational behavior in which agents based their decision on the basis of ‘sentiments’ and can be fooled consistently. In the economic literature this ideas have been captured in models with "Sun Spots"
Sunspots (economics)
In economics, the term sunspots usually refers to an extrinsic random variable, that is, a random variable that does not directly affect economic fundamentals...

 in which the economy is driven to a bad equilibrium outcome by factors not related to the underlying conditions of the economy.

See also

  • Economic bubble
    Economic bubble
    An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...

  • Austrian School
    Austrian School
    The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

  • Financial crisis (2007–present)
  • Argentine economic crisis (1999–2002)
  • 1998 Russian financial crisis
  • 1997 Asian financial crisis
  • 1994 economic crisis in Mexico
    1994 economic crisis in Mexico
    The 1994 Economic Crisis in Mexico, widely known as the Mexican peso crisis, was caused by the sudden devaluation of the Mexican peso in December 1994....

  • Sudden stop (economics)
    Sudden stop (economics)
    A sudden stop in capital flows is defined as a sudden slowdown in private capital inflows into emerging market economies, and a corresponding sharp reversal from large current account deficits into smaller deficits or small surpluses. Sudden stops are usually followed by a sharp decrease in output,...

  • Financial Crisis
    Financial crisis
    The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...

  • Real estate (property) bubble
    Real estate bubble
    A real estate bubble or property bubble is a type of economic bubble that occurs periodically in local or global real estate markets...