Financial Cycles: What? How? When?

WP/11/76

Financial Cycles: What? How? When?

Stijn Claessens, M. Ayhan Kose and Marco E. Terrones

? 2011 International Monetary Fund

WP/11/76

IMF Working Paper Research Department

Financial Cycles: What? How? When? Prepared by Stijn Claessens, M. Ayhan Kose and Marco E. Terrones1

April 2011

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Abstract

This paper provides a comprehensive analysis of financial cycles using a large database covering 21 advanced countries over the period 1960:1-2007:4. Specifically, we analyze cycles in credit, house prices, and equity prices. We report three main results. First, financial cycles tend to be long and severe, especially those in housing and equity markets. Second, they are highly synchronized within countries, particularly credit and house price cycles. The extent of synchronization of financial cycles across countries is high as well, mainly for credit and equity cycles, and has been increasing over time. Third financial cycles accentuate each other and become magnified, especially during coincident downturns in credit and housing markets. Moreover, globally synchronized downturns tend to be associated with more prolonged and costly episodes, especially for credit and equity cycles. We discuss how these findings can guide future research on various aspects of financial market developments.

JEL Classification Numbers: E32; F42; G12; G15

Keywords: Credit booms; credit cycles; asset busts; crunches; house prices; equity prices.

Author's E-Mail Address:sclaessens@, akose@, mterrones@

1 We are grateful for helpful comments from Frank Diebold, Sandra Eickmeier, Charles Engel, Marty Feldstein, Michael Klein, Lucrezia Reichlin, Ken West, Frank Warnock, and especially our discussants, Jeff Frankel, Steve Cecchetti, and Carmen Reinhart. We wish to thank participants of the 2010 NBER ISOM Conference, 2011 AEA Meetings, the Turkish Economic Association International Conference on "The Global Economy after the Crisis: Challenges and Opportunities," and other workshops where earlier related work was presented. We thank David Fritz and Ezgi Ozturk for providing outstanding research assistance.

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Contents

Page

Executive Summary ...................................................................................................................3 Figure A. Financial Cycles: Duration and Coincidence ............................................................4

I. Introduction ............................................................................................................................5

II. Database and Methodology ...................................................................................................7

III. What are the Main Features of Financial Cycles? .............................................................10 A. Frequency, Duration, Amplitude and Slope............................................................10 B. Synchronization of Financial Cycles.......................................................................12

IV. When do Financial Cycles Become More Intense? ...........................................................13 A. Intense Financial Cycles: Financial Disruptions and Booms..................................13 B. Implications of the Coincidence of Financial Cycles..............................................14

V. Duration and Amplitude of Financial Cycles: A Formal Analysis .....................................17 A. Duration of Downturns ...........................................................................................17 B. Amplitude of Downturns and Upturns ....................................................................18

VI. Conclusion .........................................................................................................................19

Tables

1A. Financial Cycles: Basic Features ......................................................................................24 1B. Financial Cycles: Basic Features.......................................................................................25 2. Synchronization of Cycles within Countries .......................................................................26 3. Synchronization of Cycles across Countries........................................................................27 4. Financial Downturns and Upturns .......................................................................................28 5. Likelihood of Financial Cycles ............................................................................................29 6. Credit Cycles Associated with Financial Disruptions and Booms ......................................30 7. House Price Cycles Associated with Financial Disruptions and Booms .............................31 8. Equity Price Cycles Associated with Financial Disruptions and Booms ............................32 9. Synchronized Financial Downturns .....................................................................................33 10. Determinants of the Duration of Financial Downturns: Bivariate Regressions ................34 11. Determinants of the Amplitude of Financial Downturns: Bivariate Regressions..............35

Figures

1. Financial Cycles: Downturns/Upturns and Disruptions ......................................................22 2. Evolution of Financial Disruptions and Booms...................................................................23

References ................................................................................................................................36

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EXECUTIVE SUMMARY

Gyrations in financial markets have greatly influenced real activity around the world over the past two decades. Following the largest housing bubble in its modern history, Japan experienced a massive asset market crash in the early 1990s, which marked the start of its "Lost Decade." After prolonged credit booms, many emerging economies in Asia faced deep financial crises in the second half of the 1990s. The equity market booms of the late 1990s in many advanced economies ended with simultaneous busts and recessions. The 2008-2009 crisis is the latest in a long list of economic events shaped by cycles in financial markets.

The severity of the latest crisis has made the study of financial cycles a central topic of research. Although there have been many studies covering various aspects of fluctuations in financial markets, research has yet to provide a comprehensive analysis of these cycles using objective methods, such as those widely used for the study of business cycle. The objective of this paper is to fill this gap using a rich dataset of 21 "advanced" OECD countries for the period 1960:12007:4. We exclude from our analysis the years following the recent crisis because a number of financial cycle episodes associated with the crisis are still ongoing. Our paper answers three specific questions.

What are the main features of financial cycles? First, financial disruptions tend to be long whereas booms are relatively short (see Figure A). Second, equity and house prices cycles are typically longer and more pronounced than credit cycles. Third, the features of financial cycles have changed over time; in particular, equity price cycles have become shorter.

How synchronized are financial cycles within and across countries? Cycles in credit and house prices appear to be the most highly synchronized within countries. The degree of synchronization across countries is the highest for credit and equity cycles, and has been increasing over time.

When does the coincidence of financial cycles lead to intense outcomes? There are strong feedback effects between house price and credit cycles as disruptions in one market intensify the other, probably because of collateral constraints and other complementarities between credit and housing finance. Globally synchronized financial downturns result in longer and deeper episodes, especially for credit and equity cycles.

We employ various regression models to analyze how a wide range of factors help explain the duration and amplitude of financial cycles. We find positive duration dependence for the downturn phase of financial cycles, implying that the longer a downturn has gone on, the more likely it is to end. The regression results also confirm the presence of feedback effects between cycles in different financial markets, even after controlling for other potential factors.

Our analysis is relevant to current policy debates, in particular regarding the role of financial markets in the real economy and the design of macro-prudential approaches. We conclude with a brief discussion of these issues and directions for future research.

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Figure A. Financial Cycles: Duration and Coincidence

Financial disruptions tend to be long

(duration, number of quarters, average) 20

Downturns

16

Disruptions

...whereas booms are relatively short

(duration, number of quarters, average) 30

Upturns

25

Booms

20 12

15

8 10

4 5

0

Credit

House Price Equity Price

0

Credit

House Price Equity Price

Credit cycles accompanied with cycles in housing typically last longer

(duration, number of quarters, average) 10

without busts / booms with busts / booms 8

6

...and are also more pronounced

(amplitude, percent, median)

8 without busts / booms

6

with busts / booms

4

2

4

0

-2 2

-4

0 House Price Bust House Price Boom

-6 House Price Bust House Price Boom

Notes: Duration for downturns is defined as the number of quarters between peak and trough. Duration for upturns is defined as the time it takes to attain the level at the previous peak after the trough. Disruptions (booms) correspond to the bottom (top) 25 percent of downturns (upturns) in terms of amplitude. Downturns (upturns) refer to episodes other than disruptions (booms). A credit downturn (or upturn) is accompanied with a housing bust (boom), if it starts at the same time or after the beginning of an ongoing housing episode.

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