engleski

Money, Liquidity, and Financial Cycles

Since the end of the 1980s, inflation, measured by consumer prices, has fallen sharply in industrialized countries. At the same time, financial stability has become questionable due to substantial and lasting fluctuations registered by financial variables relative to their long-term equilibrium level. Traditionally, the business cycle and the financial cycle have been synchronized. However, in the recent history, this synchronization has changed somewhat. The downswings in the business cycle and the credit cycle are generally simultaneous, while upswings in the business cycle precede those in the credit cycle. Further, credit cycles play an increasingly prominent role in asset price cycles. The credit expansion affects the demand for financial and non-financial forms of assets, which in turn stimulates increases/decreases in asset prices. In the cause-effect relationship, the changes in the market value of assets used as collateral enable more or less borrowing by businesses and households. The behavior of banks is pro-cyclical. Banks and other financial intermediaries increase their leverage during asset price booms and reduce it during busts. Since that affects the asset prices, the financial cycle may be amplified due to the pro-cyclical leverage of financial intermediaries. In recent years, the level of liquidity has strongly affected asset prices, while economic instabilities have tended to shift from the goods and service market to those of the property market. The rise or fall in asset prices interwork with upward or downward trends in credit cycles and business cycles. In accordance with the balance sheet channel of monetary transmission, more expensive and overvalued share prices enable greater borrowing by businesses at seemingly lower risks. Similarly, more expensive and overvalued real estate makes the balance sheet position of the company, the creditworthiness of citizens and other owners of assets look better. Banks underestimate risks and increase the supply of credit guaranteed by nominally more valuable or even overvalued collateral. In this way, the exposure of the financial system to risks increased unnoticeably. Today’s financial crisis is closely connected with many aspects of asymmetric information and previous hazardous behaviors of many financial institutions. Since there was a positive relationship between risk appetite and leverage, the former surplus capacity of banks has forced upward pressure on the asset prices. In addition, a previous rise in the market value of securities has made the intermediaries’ balance sheets stronger and stimulated an artificially high expansion of the financial sector. However, when economic turbulence started in August 2007 and continued throughout 2008 and 2009, the fall in asset prices caused a series of unfavorable movements in the opposite direction. In the same way as mark-to market asset valuation makes the financial system more efficient in periods of boom, they become destructive in periods of bust. The fall in the value of asset prices weakens the capital position of the creditor (banks) and the balance sheet position of the borrowers (businesses). When liquidity falls, the banks’ financing becomes more expensive and difficult to access from practically all sources, thereby adding to pressures on these institutions to reduce the size of their balance sheets. As a consequence, liquidity becomes very scarce at longer maturities. It leads to the deleveraging process due to which lending is stopped. Consequently, a fall in household spending and reductions of firms’ cash flow, connected with a collapse in international trading and decrease in industrial production, deepens the recession. From the perspective of central banks, there are no alternatives to liquidity injections and selective measures by which central banks and governments provide liquidity support to particular sectors during the current crisis. The adverse consequences of this downswing would be more difficult for affected economies without the expansionary measures conducted recently. However, in spite of the monetary success by decreasing market interest rates, we must not expect that injecting liquidity into the banking system would increase banks’ willingness for credit expansion in the short term. If there are no signals for potential upswings in the business cycle, and when we account for the usual time lag between switches in business and credit cycles, a significant credit expansion could start at some point after the recession ended.

aggregate bank liquidity; asset prices; financial cycles; business cycles

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