The Great Moderation and Leverage

In response to my earlier post, The Great Moderation Never Ended,  the perceptive Kevin Drum noted that the moderation seems to have been asymmetric–the booms have moderated more than the busts. That’s correct but it’s more than lower economic growth–expansions also last longer. It’s as if the booms have been smoothed over a longer period of time but not the busts.

Søren Hove Ravn points me to a paper of his with co-authors, Leverage and Deepening: Business Cycle Skewness that documents this fact and also proposes a theory.

The authors argue that financial innovation made credit more easily accessible and easier credit led to more leverage. Leverage, however, has an asymmetric feature. When asset prices are up everything is golden, wealth is high and credit is easy because lenders are happy to lend to the rich. When asset prices decline, however, the economy takes a double hit, wealth is low and credit is tight. The net result is that booms are smoothed but busts become, if anything, even more violent.

The theory is promising because it explains both the negative skewness and the great moderation. It’s also important because higher leverage, longer expansions and greater negative skew are new features of business cycles that appear across many developed economies as shown by Jorda, Schularick and Taylor in Macrofinancial History and the New Business Cycle Facts. In this paper Jorda et al. create new data series using over 150 years of data from 17 economies and conclude:

…leverage is associated with dampened business cycle volatility, but more spectacular crashes.

and more generally:

We find that rates of growth, volatility, skewness, and
tail events all seem to depend on the ratio of private credit to income. Moreover, key
correlations and international cross-correlations appear to also depend quite importantly
on this leverage measure. Business cycle properties have changed with the financialization
of economies, especially in the postwar upswing of the financial hockey stick. The manner
in which macroeconomic aggregates correlate with each other has evolved as leverage
has risen. Credit plays a critical role in understanding aggregate economic dynamics.


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