Ebook Do Credit Shocks Matter? A Global Perspective
The global financial crisis of 2007-09 that originated in U.S. credit markets rapidly spread across borders and led to recessions or severe downturns in almost all advanced economies and many emerging economies at the same time. The global reach and depth of the crisis, which are without precedent in the post-World War II period, have renewed interest in the linkages between the real economy and credit markets and have triggered an intensive debate about the importance of shocks originating in financial markets for business cycles. Our objective in this paper is to attempt to answer one of the central questions of this debate: Do credit shocks matter in the global economy?
We study this question by analyzing the importance of a fairly comprehensive set of shocks in the context of G-7 countries. We estimate common components of various macroeconomic and financial variables, and examine the roles played by credit shocks in explaining global business cycles employing a set of VAR models. In addition, we study the transmission of credit shocks in the U.S. to the global economy using a factor-augmented VAR (FAVAR). Our results suggest that credit shocks play an important role in the global recessions.
Our study contributes to a large body of research focusing on the interactions between financial markets and the real economy. A short review of this literature reveals the central nature of the question we are studying. Depending on the class of models under consideration, the role of credit markets in driving business cycles varies substantially. While some models consider that the credit markets are only peripherally important for the dynamics of business cycles, some others assign a significant importance to the shocks originating in credit markets.
Basic economic theory suggests that, in a frictionless world under complete markets, macroeconomic and financial variables can interact closely through wealth and substitution effects. Developments in credit markets, which are simply reflected by movements in asset prices, can influence consumption through their impact on household wealth, and can affect investment by altering a firm’s net worth and the market value of the capital stock relative to its replacement value (see Campbell, 2003; Cochrane, 2006). However, in models with complete markets, the financial sector is a “veil” in the sense that there is no role for financial intermediaries or credit market disturbances, since these models do not consider financial imperfections/frictions. These models, hence, imply that shocks originating in credit markets play only a minor role, if any, in explaining business cycles.
In theory, interactions between financial variables and the real economy can be amplified when financial imperfections are present. This amplification largely occurs through the financial accelerator and related mechanisms operating through firms, households and countries’ balance sheets. According to these mechanisms, an increase (decrease) in asset prices improves an entity’s net worth, enhancing (reducing) its capacities to borrow, invest and spend. This process, in turn, can lead to further increases (decreases) in asset prices and have general equilibrium effects (e.g., Bernanke and Gertler, 1989; Bernanke, Gertler, and Gilchrist, 1999; Kiyotaki and Moore, 1997; and numerous other studies on the role of financial imperfections). In other words, disturbances in credit markets can translate into much larger cyclical fluctuations in the real sector in these models.
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