An anatomy of credit booms and busts

What is the relation between credit booms and bust and other macroeconomic variables such as housing prices, investment, output or consumption? In a recent paper, Mendoza and Terrones document this relation for 61 emerging and industrial countries over the 1960-2010 period. The crucial part of the paper (which is essentially descriptive) is identifying these events. This requires three steps. First, find the appropriate variable that captures the credit boom and bust. Second, decompose this variable into a trend component and deviations from this trend. Third, define some threshold level. When the deviation from trend exceeds this threshold you‘ve found your credit boom. In this way, Mendoza and Terrones identify 70 credit booms: 35 in industrialized countries and 35 in emerging markets. The graph below shows how these booms and busts are clustered around historic events.

Next, they look at the behaviour of output, domestic demand, non-tradables, current account, capital inflow, inflation, and prices. These quantities turn out to behave according to intuition. In the boom phase they rise above trend, while they drop below trend during the bust.  The graph below shows the typical relation for current account and capital inflow.

From a eurocrisis perspective, two of the paper’s findings are relevant. First, credit booms and busts seem more common in countries with managed exchange rates compared to those with  a flexible exchange rate. This suggests that countries in a currency union are more susceptible to such crises. As a result, these countries will have to be especially vigilant when it comes to preventing credit booms.

Second, for advanced economies government spending stays relatively flat over the boom-bust cycle. This suggests that for advanced economies credit booms are mainly driven by private credit and not government spending. Of course, counter examples exist. But for Spain and Ireland, these observations ring true. Consequently, we should not expect that constraining government spending or sovereign debt will prevent future credit booms.


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