Credit shocks boost economies, but beware the fall

Brian Wallheimer | Aug 11, 2017

Sections Economics

US President Donald Trump and a Republican majority in Congress are moving to roll back some of the banking regulations put in place after the Great Recession. Proponents maintain that deregulation would boost the economy by freeing banks to offer credit to more people and businesses.

It might work, at least for a while, but there is some recent history that lawmakers might take into account. One of the last major efforts to deregulate banking proved quite successful for some states in the short run, but these same states were later hurt by the effects of the regulatory easing.

Princeton’s Atif Mian, Princeton PhD candidate Emil Verner, and Chicago Booth’s Amir Sufi studied the rollback of banking regulations in the 1980s, when states had the latitude to control the speed of deregulation. Those that moved quickly experienced the greatest benefits as wages and employment rose, GDP expanded, and house prices climbed. But they also later saw the steepest declines in those same metrics when the United States fell into recession in 1990–91.

States that rapidly deregulated banking sharply expanded credit availability. More money available to borrow led to increased demand for goods and services, particularly from individuals who bought nontradable goods such as real estate and services. Wages and employment grew in areas such as construction, the service industries, and public services.

But the regulatory easing magnified the effects of the 1990–91 recession in early-deregulation states, the researchers find. With household debt high, consumers had to cut back, and they did so in the nontradable sectors that had seen growth. “Credit supply shocks that operate primarily on the demand side of the economy may lead to an amplified business cycle, boosting demand during the expansion but leading to a more severe subsequent contraction,” write the researchers, who also find a link between the rise in a state’s household debt prior to the recession and the severity of the recession in that state.