Credit booms can seriously damage an economy’s health. They may damage the economy even as they occur by reducing productivity growth, regardless of whether a crisis follows according to a recent BIS working paper – “Labour reallocation and productivity dynamics: financial causes, real consequences” which investigates the link between credit booms, productivity growth, labour reallocations and financial crises in a sample of over twenty advanced economies and over forty years.
They find first, credit booms tend to undermine productivity growth by inducing labour reallocations towards lower productivity growth sectors. A temporarily bloated construction sector stands out as an example. Second, the impact of reallocations that occur during a boom, and during economic expansions more generally, is much larger if a crisis follows. In other words, when economic conditions become more hostile, misallocations beget misallocations.
These findings have broader implications: they shed light on the recent secular stagnation debate; they provide an alternative interpretation of hysteresis effects; they highlight the need to incorporate credit developments in the measurement of potential output; and they provide a new perspective on the medium- to long-run impact of monetary policy as well as its ability to fight post-crisis recessions.
In this paper we investigate the empirical link between credit booms, financial crises and productivity growth more closely. We focus on labour reallocations across sectors, although within-sector effects may also be important. Specifically, we ask two questions. First, during credit booms, does labour shift to lower productivity growth sectors? And second, does a financial crisis amplify the effect of labour reallocations that took place during the previous economic expansion? The answer to both of these questions is a clear “yes”. At least, this is the conclusion based on a sample of 21 advanced economies over the period 1969 to the present.
Graph 1 summarises our key findings. To help fix ideas, it shows the impact on productivity of a synthetic credit boom-cum-financial crisis episode – specifically, the impact of an assumed 5-year credit boom that is followed by a financial crisis, and considering a 5-year post-crisis window.
Three points stand out. First, credit booms tend to undermine productivity growth as they occur. For a typical credit boom, a loss of just over a quarter of a percentage point per year is a kind of lower bound. Second, a large part of this, slightly less than two thirds, reflects the shift of labour to lower productivity growth sectors – this is the only statistically significant component. Think, for instance, of shifts into a temporarily bloated construction sector. The remainder is the impact on productivity that is common across sectors, such as the shared component of aggregate capital accumulation and of total factor productivity (TFP). Third, the subsequent impact of labour reallocations that occur during a boom is much larger if a crisis follows. The average loss per year in the five years after a crisis is more than twice that during a boom, around half a percentage point per year. Put differently, the reallocations cast a long shadow. Taking the 10-year episode as a whole, the cumulative impact amounts to a loss of some 4 percentage points. Regardless of the specific figure, the impact is clearly sizeable. The findings are robust to alternative definitions of credit booms, to the inclusion of control variables and to techniques to identify the direction of causality.
While our results are quite general, it is easy to identify obvious recent examples of these mechanisms at work. The credit booms in Spain and Ireland in the decade to 2007 coincided with the rapid growth of employment in construction and real estate services at the expense of the more productive manufacturing sector. Once the boom turned to bust and the financial crisis struck, the economies went through a painful rebalancing phase, as resources had to shift back under adverse conditions – not least a broken financial system that did not facilitate, indeed may well have hindered, the process. In this sense, the reallocations of resources during the boom were clearly misallocations.
Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.
Yes, and the paper made the specific point that over-stimulated construction and finance sectors sucked resources (funds and people) from more productive growth sectors. Again, RBA please note.
This implies that the RBA should be acting to prevent credit booms, given its mandate to “the economic prosperity and welfare of the Australian people”.
It also undermines the Greenspan view that central banks should just stabilise the economy after a crash and not pre-judge the preceding boom.
Thanks for posting this.