NOVEMBER 30, 2011
Readers may be interested in a fascinating paper by the Federal Reserve Bank of San Francisco titled, "When Credit Bites Back: Leverage, Business Cycles, and Crises." It's a must-read.
Some key findings:
We document a new and, in our view, important stylized fact about the modern business cycle: the credit-intensity of the expansion phase is closely associated with the severity of the recession phase. In other words, we show that a stronger increase in financial leverage, measured by the rate of growth of bank credit over GDP in the boom, tends to lead to a deeper subsequent downturn. Or, as the title of the paper suggests|credit bites back.
...Higher leverage raises the vulnerability of economies to shocks. With more nominal debts outstanding, a procyclical behavior of prices can lead to greater debt-deflation pressures. Higher leverage can also lead to more pronounced confidence shocks and expectational swings, as conjectured by Minsky. Financial accelerator effects described by Bernanke and Gertler (1990) are also likely to be stronger when balance sheets are larger and thus more vulnerable to weakening. Moreover, many of these effects are likely to be more pronounced when leverage explodes" in a systemic financial crisis.
It certainly is worth considering how this dynamic will play out for Canada over the next few years as the prospects of a global recession mount while Canadian debt burdens continue to push into unchartered territories: