Question

Explain the self-reinforcing cycle and why it has negative implications for the economy's growth and employment?

Answer 1

The term "financial cycle" refers to the self-reinforcing interactions between perceptions of value and risk, risk-taking, and financing constraints. Typically, rapid increases in credit drive up property and asset prices, which in turn increase collateral values and thus the amount of credit the private sector can obtain until, at some point, the process goes into reverse. This mutually reinforcing interaction between financing constraints and perceptions of value and risks has historically tended to cause serious macroeconomic dislocations.

During expansions, the self-reinforcing interaction between financing constraints, asset prices and risk-taking can overstretch balance sheets, making them more fragile and sowing the seeds of the subsequent financial contraction. This, in turn, can drag down the economy and put further stress on the financial system.

Second, having grown in amplitude over the past 40 years or so,the financial cycle can be much longer than the business cycle. Business cycles as traditionally measured tend to last up to eight years, and financial cycles around 15 to 20 years since the early 1980s. The difference in length means that a financial cycle can span more than one business cycle. As a result, while financial cycle peaks tend to usher in recessions, not all recessions will be preceded by financial cycle peaks.

Financial cycle booms took place ahead of recessions in the early 1990s and the late 2000s. At the same time, the shallow recession in the early 2000s in the United States did not coincide with a financial cycle peak: while the economy slowed and equity prices tanked, the financial expansion continued as measured by credit and property prices, only to reverse a few years later, triggering the Great Recession. By contrast, in the United Kingdom, no recession took place in the early 2000s, so that the two recessions coincided with the two financial cycle peaks.

Three such changes deserve particular attention. First, financial markets were liberalised starting around that time. Without sufficient prudential safeguards, this change likely allowed greater scope for the self-reinforcing interactions at the heart of the financial cycle to play out. Second, starting roughly at the same time, inflation-focused monetary regimes became the norm. And the evolving thinking of central banks led them to gradually downplay the role of monetary and credit aggregates. This meant that central banks had little reason to tighten policy if inflation remained low, even as financial imbalances built up. Finally, from the 1990s on, the entry of China and former Communist countries into the world economy, alongside the international integration of product markets and technological advances, boosted global supply and strengthened competitive pressures. Coupled with greater central bank credibility, this arguably made it more likely that inflationary pressures would remain muted even as expansions gathered pace. It also meant that financial booms could build up further and that a turn in the financial cycle, rather than rising inflation and the consequent monetary tightening, might trigger an economic downturn.

These factors were in evidence in the run-up to the Great Financial Crisis. In many countries, short-term output volatility as well as the level and volatility of inflation fell and remained low (the so-called Great Moderation). At the same time, leverage in the financial and non-financial sectors rose. When the financial cycle turned, financial stress emerged and economies worldwide experienced a serious recession.