Home / Opinion / Global economics: Why financial cycles matter

The first cracks appeared a decade ago. US subprime mortgage defaults began to pick up in the summer of 2007. Most policymakers saw it as a problem restricted to one part of the global financial system. What happened later is now well known. The contagion spread rapidly because of excess leverage, complex derivatives and sheer mismanagement. The North Atlantic financial crisis of September 2008 almost brought down the world economy.

Much has happened since. Yet the global economy has still not recovered from the effects of the financial crisis. The latest data does show signs of a cyclical bounce, but the underlying structural problems have not disappeared. The standard view is that the world is now suffering from secular stagnation. Potential growth has fallen because of weak effective demand on the one hand and lack of technological progress on the other. The role of the financial system as a source of economic instability has once again been swept under the carpet.

However, there has been a parallel narrative about the financial bubble and its aftermath, though it has received far less attention than it deserves. The Bank for International Settlements (BIS) has always had an alternative view that could be described as neo-Austrian rather than New Keynesian. Claudio Borio, head of the monetary and economic department of BIS, in a recent speech again threw light on some important issues. Borio argued that the persistent low growth in much of the world economy is not because of secular stagnation but the financial sector drag. There are several important lessons to be learnt from the BIS view.

First, there is a financial cycle that often does not move in sync with the business cycle. The financial cycle tends to be much longer than the business cycle—15-20 years rather than 8-10 years, according to several studies cited by Borio. So policymakers have to be sensitive to financial conditions being out of line with the underlying economic conditions.

Second, loose monetary policy in the years leading to the financial crisis led to both excess leverage as well as the misallocation of capital. Monetary policy cannot be oblivious to financial stability issues, despite the recent attempts to design macro prudential frameworks to manage that set of problems.

Third, most of the policy response after 2009 has focused on demand stimulus. Not enough attention has been paid to balance-sheet repair. Most standard economic models focus on an output gap but pay too little attention to the way capital is misallocated. China is an excellent example of this.

Fourth, and this is a technical point, the equilibrium rate of interest that is so crucial to much of modern monetary thinking is, in the current global situation, not negative but actually positive. What this means in practical terms is that monetary policy in many countries is too loose.

The upshot is that the post-2009 policy response, aimed at boosting aggregate demand through fiscal expansion and low interest rates, has its limitations unless the structural issues on the supply side are also dealt with. In other words, structural slowdowns cannot be tackled with demand stimulus alone. They require structural reforms.

The BIS view leads to one conclusion that is very relevant for our times. The overdependence on monetary expansion to deal with what is actually a structural problem in the world economy has led policymakers to focus on closing output gaps while they have been relatively more sanguine about other risks. And these risks are evident: excess credit growth, rising property prices, increasing debt service ratio and frothy asset markets. These could be the forerunners of another financial crisis in the future.

Demand stimulus through aggressive fiscal and monetary expansion did have a role to play in the immediate aftermath of the crisis, when economic activity had almost fallen off a cliff. But depending almost exclusively on these tools has created a new set of financial frailties.

This editorial has described the BIS view that Borio represents as neo-Austrian. Yet it is interesting that Borio concluded his speech with a hat tip to an innovative Marxist thinker: “Extricating ourselves from the current condition will require a rare mix of what Antonio Gramsci once called ‘pessimism of the intellect and optimism of the will’: pessimism to assess the challenges ruthlessly, and optimism to overcome them. Ensuring that policymakers firmly capture the financial cycle on their radar screen is a prerequisite for a successful response."

Have policymakers been excessively dependent on monetary policy after the financial crisis? Tell us at

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