When Credit Bites Back: Leverage, Business Cycles, and Crises

Abstract

This paper studies the role of leverage in the business cycle. Based on a study of nearly 200 recession episodes in 14 advanced countries between 1870 and 2008, we document a new stylized fact of the modern business cycle: more credit-intensive booms tend to be followed by deeper recessions and slower recoveries. We find a close relationship between the rate of credit growth relative to GDP in the expansion phase and the severity of the subsequent recession. We use local projection methods to study how leverage impacts the behavior of key macroeconomic variables such as investment, lending, interest rates, and inflation. The effects of leverage are particularly pronounced in recessions that coincide with financial crises, but are also distinctly present in normal cycles. The stylized facts we uncover lend support to the idea that financial factors play an important role in the modern business cycle.Keywords: leverage, financial crises, business cycles, local projections.JEL Codes: C14, C52, E51, F32, F42, N10, N20.Oscar Jordà (Federal Reserve Bank of San Francisco and University of California, Davis) e-mail: oscar.jorda@sf.frb.org; ojorda@ucdavis.edu Moritz Schularick (Free University of Berlin) e-mail: moritz.schularick@fu-berlin.de Alan M. Taylor (University of Virginia, NBER, and CEPR) e-mail: alan.m.taylor@virginia.edu * The authors gratefully acknowledge financial support through a grant of the Institute for New Economic Thinking (INET) administered by the University of Virginia. Part of this research was undertaken when Schularick was a visitor at the Economics Department, Stern School of Business, New York University. The authors wish to thank, without implicating, David Backus, Philipp Engler, Michele Lenza, Javier Suarez, Richard Sylla, and Paul Wachtel for discussion and comments. In the same way, we also wish to thank participants in the conference "Financial Intermediation and Macroeconomics: Directions Since the Crisis," held at the National Bank of Belgium, December 9-10, 2011. The views expressed herein are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.All of the major landmark events in modern macroeconomic history have been associated with a financial crisis. Students of such disasters have often identified leverage, that is excess credit, as the "Achilles heel of capitalism," as James Tobin described it in his review of Hyman Minsky's book Stabilizing an Unstable Economy (Tobin 1989). It was a historical mishap that just when the largest credit boom in history engulfed Western economies, consideration of the influence of financial factors on the real economy had dwindled to the point where it no longer played a central role in macroeconomic thinking. Standard models were therefore ill-equipped to identify the sources of growing financial fragility, so the warning signs of increased leverage in the run-up to the crisis of 2008 were largely ...

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