Financial Freedom Insider

Booms and crises are chronic features of the modern day global financial system. Such events can have serious impacts on the economy including a rise in unemployment and a downturn in output.

Below, I review several studies that examine the repercussions of booms and crises.

Study 1: Good Booms & Bad Booms

Is there such a thing as a “bad boom” in the financial world? According to Guillermo Ordoñez of the University of Pennsylvania and Gary Gorton of Yale, there is.

Ordoñez and Gorton define a “bad boom” as a boom that ends in a crisis; while a “good boom” is one that does not.

Following their model, all credit booms begin with an uptick in productivity that allows a company to use collateralized debt to finance projects. During this period, a lender can assess a collateral’s quality. He is unlikely to do so, however, as long as the project remains productive.

Productivity and investment quality eventually fall as more projects are financed. When lenders start to ask questions and examine collateral, those firms with inadequate collateral will no longer be able to secure financing – a crisis occurs.

However, if new technologies continue to improve, there is no need to cut credit and the boom will likely end without a crisis.

Ordoñez and Gorton’s empirical analysis shows that credit booms are common, last an average of 10 years, and are less likely to result in crisis if there is a larger productivity growth during the initial boom.

Study 2: Reallocation

Using data from several advanced economies between the years 1979 and 2009, four researchers from the Bank for International Settlements also examined the dynamics of credit booms in relation to productivity.

They found that credit booms typically result in a reallocation of labor, with workers moving towards construction and other sectors with low productivity growth.

When a crisis occurs, the negative impact of that misallocation on productivity is amplified. Study authors concluded that the slow recovery period resulting from a global crisis is a result of the misallocation of resources that happened before the crisis.

Study authors: Enisse Kharroubi, Claudio Borio, Fabrizio Zampolli, and Christian Upper.

Study 3: International Capital Flows

Luca Forno of the Universitat Pompeu Fabra, Nathan Converse of the Federal Reserve Board, and Gianluca Benigno of the London School of Economics examined capital inflows and economic performance.

These three researchers identified 155 periods of unnaturally large capital inflows in middle-income and high-income countries during the past 35 years. They found that larger inflows were associated with economic booms; these expansions were accompanied by a rise in TFP (total factor productivity) and an uptick in employment that ended when the inflows ceased.

This report also noticed a reallocation of resources, highlighting manufacturing as a sector that falls during such periods. It’s likely that a reallocation of employment will also occur if a government refuses to accumulate foreign assets during a period of large capital inflows and abundant international liquidity.

Capital inflows increase the chances of a sudden stop, with economic performance post-crisis negatively affected by capital inflows and reallocation of employment away from manufacturing that occurred before the crisis.

Study 4: Financial Integration & Productivity

Alessandra Bonfiglioli of the Universitat Pompeu Fabra took a look at 70 countries between the years 1975 and 1999. She found that TFP has a positive relationship with de jure measures of financial integration – despite the post-financial liberalization uptick in the likelihood of a banking crisis in developed countries that negatively affects productivity.

Bonfiglioli found that de facto liberalization enhanced productivity in developed countries only.

Study 5: Financial Integration & Productivity

Using data from 1966-2005, Eswar S. Prasad of Cornell, Ayhan Kose of the World Bank, and Marco E. Terrones of the IMF looked into the same issue. They focused on 67 industrial and developing countries.

This group found that de jure capital openness had a positive effect on TFP growth. However, in looking at the composition of flows and stocks, the researchers found that equity liabilities boost TFP growth and debt liabilities have the opposite effect.

Needless to say, the relationship between capital flows and economic activity is complex. While capital flows do contribute to booms and increase TFP, they may also result in a crisis that includes a sudden stop and failures in the banking sector.

Capital inflows may also distort allocation of resources and employment, which then affects post-crisis performance. Debt, which serves only to exacerbate a crisis, may also direct resources towards sectors with lower productivity.