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Macroeconomics and the financial cycle

Claudio Borio from the BIS has written a widely cited paper. The Economist has linked to it and suggested that so far his advice for including the financial cycle into macroeconomics has only been followed by a few. Besides Borio, Minsky, Godley and Lavoie and Keene are also cited by The Economist. The paper by Borio (he only cites Minsky), which has been a very influential voice suggesting that capital flows were pro-cyclical and more regulation was needed before the financial crisis, is somewhat underwhelming though.

For starters the definition of the financial cycle is based on individual perceptions. In his view, financial cycles result from "self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts." Then there is the question of the theoretical features for modeling the financial cycle according to Borio. There are three that are essential according to him. First, that financial cycles have endogenous causes, second, that debt must be present, and last but not least a different measure of the output gap. The last one is really the central theoretical modification in his scheme [note that heterodox models, like Kaldor's 1940 cycle model were endogenous, and Keynes had debt in the General Theory, in chapter 19 it is central, in fact].

The new output gap measure would include financial variables. He correctly notes that output gap measures take into consideration only inflation, when ascertaining whether the economy is above the potential or not, and that "it is quite possible for inflation to remain stable while output is on an unsustainable path" [and you can have inflation without being at full employment too, I would add]. His measure of the output gap would include information about asset price inflation too (property prices and measures of credit booms) and is shown for the US and Spain as the red line below.

Note that the new output gap shows the economy growing way beyond its potential in both the US and Spain before the crisis, more than in the alternative measures using a Hodrick-Prescott filter (green) and a conventional production function (blue). He concludes that: "potential output and growth tend to be overestimated" by conventional methods. Further, his point when arguing that the cycle is endogenous is that excessive booms are the cause of the collapse, so what is needed is to smooth out the boom. The prescription is to grow less and avoid to surpass the potential level, which is supply determined and exogenous presumably (since no word on this is uttered).*

He wants then to constrain booms, and macroprudential policies should be used for that aim. Further, while noting that in balance sheet recessions (following Koo) it is important to deal with agents losses head on, he suggests that "fiscal policy is less effective than in normal recessions" and that as a result of excessive monetary expansion after the bust "the central bank’s autonomy and, eventually, credibility may come under threat." So one really needs to kill booms, since nothing much beyond re-writing debt down and acting as lender of last resort with moderation can be done after.

I have several problems with these views, even if there are some good things, beyond good intentions, in Borio's paper. In fact, I think that there is significant evidence for the notion that potential output varies with demand expansion (Kaldor-Verdoorn Law), so that if a revision of the way potential output is measured it would be in the opposite direction. Mind you, if you check the chart above it means that Spain now is close to its potential level. I guess the natural rate of unemployment in Spain is around 20% or so (slightly below the current level). Note, also, that in Latin America we have been smoothing the boom with the consequence that our crises are not milder than Asia, but we end up growing less (see the paper by Pérez and Pineda linked here).

However, in my view the biggest flaw in the approach to financial cycles proposed by Borio is the absence of any discussion of how debt-deflation (the balance sheet recessions) affect and are affected by income distribution. There is no understanding of how wage stagnation in the center was as instrumental as financial de-regulation for the collapse, as noted by Barba and Pivetti (link here) or Jamie Galbraith's last book, not by chance called Inequality and Instability. This is again something that heterodox economists have known for a while and that the mainstream still has to learn.

* The reasons for the excess in the boom are associated to excessive finance [which he calls excess elasticity of the system], as in Shin's (2011) global banking glut, and not excessive savings, since he correctly points out that "expenditures require financing, not saving."

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