Economic Booms - Explanations

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 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 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 or a sudden increase in short term portfolio investment. 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 ensues. Under these view, capital flows are procyclical 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 or adverse selection 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 an 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 mechanism take the economy into a recession. The existence of collateralized borrowing generates an externality 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 was used as main policy tool, backfired producing an 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.

Hyman Minsky offered a related theory, (the financial instability hypothesis), where financial regulations, practices and norms naturally relax as a boom goes on, due to general exuberance, regulatory capture, or intellectual decline among the regulators and other actors in the system. This allows more fraudulent and unsound credit to be extended, (Ponzi credit), inflating the bubble and deepening the ensuing crash. Bankers and regulators then swear that they will implement better systems and remember lessons of history, which are nevertheless routinely forgotten on a roughly seventy year cycle.

Still another explanation of the boom–bust episodes goes back to John Maynard Keynes. Keynes argued that changes in investor’s expectations about respect to the state of the economy. These 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 these ideas have been captured in models with "Sun Spots" in which the economy is driven to a bad equilibrium outcome by factors not related to the underlying conditions of the economy.