The experience of the 1990s, especially though not exclusively in the United States, renewed economists‘ interest in the role of credit in macroeconomic fluctuations. Among the insights of this view is that not just money but also credit matters for macroeconomic and financial conditions. Not just banks but also nonbank financial intermediaries and securities markets play an important role in the provision of credit to households and firms. Not just macroeconomic policy but also the structure, regulation and response of the financial system shape the development of financial conditions and thereby macroeconomic dynamics. The policy implication drawn by some is that central banks should not simply set monetary policy with an eye toward inflation; they should also attend to conditions in credit markets and contemplate preemptive action to prevent the development of excesses that threaten economic stability even if there is no sign of inflationary pressure. Economists at the Bank for International Settlements (BIS) have been forceful proponents of this position, which for want of a better label is referred to as the BIS view.
A capsule account of the role of credit in macroeconomic cycles, as informed by the experience of the 1990s, would go something like this. There is first an upswing in economic activity. As the economy expands, banks and financial markets provide an expanding volume of credit to finance the growth of both consumption and investment, particularly where regulation is lax and competition among bank and non bank financial intermediaries is intense. Whether because the exchange rate is pegged or for other reasons such as a positive supply shock, upward pressure on wholesale and retail prices is subdued. Hence, the central bank has no obvious reason to tighten and stem the growth of money and credit, leading to a further expansion of output and further increase in credit.
Higher property and securities prices encourage investment activity, especially in interest-sensitive activities like construction. But, as lending expands, increasingly risky investments are underwritten. The demand for risky investments rises with the supply, since, in the prevailing environment of stable prices, nominal interest rates and therefore yields on safe assets are low. In search of yield, investors dabble increasingly in risky investments. Their appetite for risk is stronger still to the extent that these trends coincide with the development of new technologies, in particular network technologies of promising but uncertain commercial potential.
Eventually, all this construction and investment activity, together with the wealth effect on consumption, produces signs of inflationary pressure, causing the central bank to tighten. The financial bubble is pricked and, as asset prices decline, the economy is left with an overhang of ill-designed, non-viable investment projects, distressed banks, and heavily indebted households and firms, aggravating the subsequent downturn.
No single policy implication necessarily flows from this story, but some readers will conclude that the monetary authorities should respond preemptively to the rise in asset prices. Central banks should not be misled, in this view, by the disconnect between asset price inflation and consumer price inflation. They should respond to the inflation of asset prices by reining in credit and preventing the expansion from taking a form that ultimately renders subsequent difficulties more severe.
This tale from the 1990s has obvious appeal for historians of the 1920s. The 1920s was a decade of expansion, reflecting recovery from World War I, new information and communications technologies like radio, and new processes like motor vehicle production using assembly-line methods. Accounts of the ”twenties in the United States (such as Kindleberger 1973) emphasize the ready availability of credit, reflecting the ample gold reserves accumulated by the country during World War I, the stance of Federal Reserve policies, and financial innovations ranging from the development of the modern investment trust to consumer credit tied to purchases of durable goods like automobiles. Credit fueled a real estate boom in 1925, a Wall Street boom in 1928-9, and a consumer durables spending spree spanning the second half of the 1920s. That these booms developed under the fixed exchange rates of the gold standard meant that they generated little inflationary pressure at home and that their effects were transmitted to the rest of the world. Absent overt signs of inflation, the Fed had no reason to raise the official short-term rate.
Eventually, however, the Fed and other central banks grew increasingly restive over what they perceived as speculative excesses in financial markets and with a growing incidence of malfeasance and graft, evident in the activities of Charles Ponzi in Florida, Clarence Hatry in London, and Ivar Kreuger in Stockholm. This concern with the effects of asset-price inflation on the economy led them finally to tighten. Banks passed along the higher cost of additional reserves to their borrowers, and, in the U.S. case, they further felt direct pressure to limit their lending to securities market participants. By this time, positions -- stock market positions in particular -- were highly leveraged; as a result, borrowers experienced severe financial strain when credit tightened, leading them to compress their spending, and consumption and investment turned down. Ultimately, the resulting deflation became sufficiently severe to threaten the stability of the financial system and the economy more generally.
