Financial Crises, Credit Booms, and External Imbalances

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Credit growth emerges as the single best predictor of financial instability.

There is remarkably little empirical evidence on the relative importance of global imbalances and other factors in credit boom-bust episodes in advanced economies. In Financial Crises, Credit Booms, and External Imbalances: 140 Years of Lessons (NBER Working Paper No. 16567), authors Òscar Jordà, Moritz Schularick, and Alan Taylor fill that gap as they analyze whether external imbalances, that is current account surpluses or deficits, increase the risk of financial crises.

Using a long-run cross-country dataset of 14 developed countries over 140 years (1870-2008), the authors draw interesting observations from the macroeconomic dynamics before and after crises, being careful to differentiate between global and national crises. The pre-crisis dynamics indicate that although both credit and money growth are strongly elevated before both types of financial crises, the large international crises are different from national crises in that they combine strong credit growth with an environment of low real interest rates (relative to real growth) and tame inflation. Crises also are typically preceded by somewhat larger current account deficits relative to the country's own history, but there is little evidence that big international crises can be identified by abnormal current account trends. Therefore, the initial evidence suggests that while both domestic credit and external imbalances could play a role in financial crises, the role of external imbalances may be secondary.

The authors further observe that downturns associated with financial crises lead to deeper recessions and to stronger subsequent turnarounds in imbalances than normal business cycle downturns. Indeed, deflationary tendencies are considerably more pronounced in recessions caused by a crisis than in normal recessions. Crisis recessions also display a much stronger negative impact on loan growth.

The researchers explore whether external imbalances can help to predict the occurrence of financial instability in advanced economies. They conclude that credit growth emerges as the single best predictor of financial instability. They find only limited evidence that external imbalances have played a major role in generating financial crises in the past 140 years. However, the correlation between lending booms and current account imbalances has grown much tighter in recent decades, suggesting that high rates of credit growth coupled with widening imbalances can pose important stability risks.

--Claire Brunel