2/1/2015: Credit and Growth after Financial Crises

Generally, we think of private sector deleveraging as being associated with lower investment by households and enterprises, lower consumption and lower output growth, leading to reduced rates of economic growth. However, one recent study (amongst a number of others) disputes this link.

Takats, Elod and Upper, Christian, "Credit and Growth after Financial Crises" (BIS Working Paper No. 416: http://ssrn.com/abstract=2375674) finds that "declining bank credit to the private sector will not necessarily constrain the economic recovery after output has bottomed out following a financial crisis. To obtain this result, we examine data from 39 financial crises, which -- as the current one -- were preceded by credit booms. In these crises the change in bank credit, either in real terms or relative to GDP, consistently did not correlate with growth during the first two years of the recovery. In the third and fourth year, the correlation becomes statistically significant but remains small in economic terms. The lack of association between deleveraging and the speed of recovery does not seem to arise due to limited data. In fact, our data shows that increasing competitiveness, via exchange rate depreciations, is statistically and economically significantly associated with faster recoveries. Our results contradict the current consensus that private sector deleveraging is necessarily harmful for growth."

Which, of course, begs a question: how sound is banking sector 'return to normalcy at any cost' strategy for recovery? The question is non-trivial. Much of the ECB and EU-supported policies in the euro area periphery stressed the need for normalising credit operations in the economy. This thinking underpinned both the bailouts of the banks and the bailouts of their funders (bondholders and other lenders). It also underwrote the idea that although austerity triggered by banks bailouts was painful, restoration of credit flows is imperative to generating the recovery.