Managing Credit Bubbles

We study a dynamic economy where credit is limited by insu¢ cient collateral and, as a result, investment and output are too low. In this environment, changes in investor sentiment or market expectations can give rise to credit bubbles, that is, expansions in credit that are backed not by expectations of future pro…ts (i.e. fundamental collateral), but instead by expectations of future credit (i.e. bubbly collateral). During a credit bubble, there is more credit available for entrepreneurs: this is the crowding-in e¤ect. But entrepreneurs must also use some of this credit to cancel past credit: this is the crowding-out e¤ect. There is an “optimal”bubble size that trades o¤ these two e¤ects and maximizes long-run output and consumption. The “equilibrium”bubble size depends on investor sentiment, however, and it typically does not coincide with the “optimal”bubble size. This provides a new rationale for macroprudential policy. A lender of last resort can replicate the “optimal”bubble by taxing credit when the “equilibrium” bubble is too high, and subsidizing credit when the “equilibrium”bubble is too low. This leaningagainst-the-wind policy maximizes output and consumption. Moreover, the same conditions that make this policy desirable guarantee that a lender of last resort has the resources to implement it. JEL classi…cation: E32, E44, O40 Keywords: bubbles, credit, business cycles, economic growth, …nancial frictions, pyramid schemes Martin: CREI , Universitat Pompeu Fabra and Barcelona GSE, [email protected]. Ventura: CREI, Universitat Pompeu Fabra and Barcelona GSE, [email protected]. CREI, Universitat Pompeu Fabra, Ramon Trias Fargas 25-27, 08005-Barcelona, Spain. A previous version of this paper was circulated under the title “Bubbly Collateral and Economic Activity”. We thank seminar participants at various institutions and Zeno Enders, Raquel Fernandez, Bernardo Guimaraes, Zhiguo He, Joachim Jungherr, Fabrizio Perri, and Oren Sussmann for very helpful discussions. We acknowledge support from the Spanish Ministry of Economics and Competitiveness (grant ECO2011-23192) and the Generalitat de Catalunya-DIUE (grant 2009SGR1157). In addition, Ventura acknowledges support from the ERC (Advanced Grant FP7-249588), and Martin from the Spanish Ministry of Science and Innovation (grant Ramon y Cajal RYC-2009-04624) and the IMF Research Fellowship. Credit markets play an increasingly central role in modern economies. Within the OECD, for instance, domestic credit has risen from 100% of GDP in 1970 to approximately 160% of GDP in 2012 (Figure 1). This growth masks large variations across countries and over time (Figure 2). And yet, there is a common feature to all these di¤erent country experiences that stands out: credit has often alternated periods of rapid growth or “booms”, with periods of stagnation or signi…cant decline or “busts”. Moreover, there is some evidence that these credit booms and busts have become more common in recent years.1 Consider the case of the United States, where credit has grown more or less continuously throughout the sample period. Even there, it grew by approximately 40 percent of GDP between 1990 and 2010, only to contract sharply afterwards. In Greece, Ireland, Spain and Portugal, the dynamics of credit look similar during the last decades: stagnant or declining credit between the mid 1980s and the mid 1990s, a spectacular surge in credit between the mid-1990s and 2010, and stagnation or a sharp decline since then. Looking ahead, these drops in credit need not be shortlived as the Japanese and Swedish experiences show. In Japan, for instance, credit grew rapidly in the late 1990s and has fallen steadily since its 1999 peak. In Sweden, credit collapsed during the …nancial crisis of the early 1990s and it took over a decade to return to its previous peak. These credit booms and busts tend to be accompanied by changes in key economic variables. It has been well documented that credit booms are associated with high asset prices and high growth rates of real GDP, consumption and investment. According to some estimates the growth rate of investment doubles during booms.2 In spite of this, credit booms are still viewed with concern by policymakers and academics. The reason is that they eventually end, and their aftermaths are often characterized by …nancial crises and low economic growth.3 This has prompted calls for policies that restrain credit during booms, in the hope that smaller booms will lead to smaller crises. See Mendoza and Terrones (2012) and Dell’Ariccia et al. (2012) for a brief discussion on the formal de…nition and empirical identi…cation of credit booms. Mendoza and Terrones (2012) analyze the evolution of private credit to the private sector in 61 countries between 1960 and 2010 and identify 70 credit booms: each of the countries plotted in Figure 2 contains at least one of these. Dell’Ariccia et al. (2012) analyze data on bank credit to the domestic private sector in 170 countries between 1960 and 2010. They identify 175 credit booms, which translates into a 14% probability of a country experiencing a credit boom in any given year. They also document that credit booms appear to have become more common over time, in the sense that the fraction of countries experiencing a credit boom in any given year has been increasing since the 1980s. Claessens et al. (2011) use a di¤erent approach and study “credit cycles”, but they also …nd them to be common: in a sample of 21 advanced economies between 1960 and 2007, they are able to identify 114 such cycles. See Mendoza and Terrones (2012) and Dell’Ariccia et al. (2012). Dell’Ariccia et al. (2012) …nd that one third of credit booms end up in …nancial crises. Mendoza and Terrones (2012) …nd slightly lower numbers. The recent …nancial crisis in the United States also provides evidence in this regard: it was those regions that experienced the largest credit booms in the run up to the crisis that su¤ered the greater increase in credit delinquency during the crisis (Dell’Ariccia et al. 2008, Mian and Su… 2009).