A cycle is a recurring period of time. Economic cycles are a sequence of stages or moments that occur over time, divided into periods of expansion and recession. The financing of the economic cycle corresponds to the credit cycle. A productive economy cannot be conceived without the financing that makes it possible through corporate investment and household consumption.
The crisis was the best proof that the economic cycle, sooner or later, materializes. The difficult past experience has led authorities to delve deeper into the study of economic cycles. Late last year, the European Central Bank published a paper analyzing the historical economic cycles of the main developed countries. The study showed that expansive phases spread between countries, something that does not happen with recessive phases. Cycles age until they restart, although their intensity and duration can depend on exogenous variables such as interest rates or commodity prices, but also on the approval of structural reforms that increase the potential growth of economies.
The priority of authorities over the last decade has been to strengthen financial stability, which is essential for economic recovery. Through the approval of extraordinary expansionary monetary measures, exceptionally loose financial conditions have been created to facilitate credit and also to carry out adjustments for past excesses. Given the severity of the crisis, the financial or credit cycle has been more decisive than usual in achieving economic recovery.
Banks are key in financing the economy. However, they are no longer the sole providers of financing. The non-bank financial sector has gained increasing prominence, induced by exceptional monetary policy, such as zero interest rates or the direct purchase of assets in financial markets by central banks. Regulatory changes have focused on banks, which has also created space for unequal competition from other entities that provide financial services without being subject to strict banking regulation and supervision. Wholesale markets and new technological competition from banks are increasingly important in the financial sector.
Current financial conditions are very accommodative, despite market behavior: their volatility in recent months, the rise in credit spreads, and the fall in medium and long-term interest rates in the United States while the Fed is raising its own interest rates. However, prolonging excessively loose financial conditions for too long also poses a threat, as it can lead to distortions in the price of financial assets and potential debt excesses. Central banks are calling for patience in the monetary normalization process, which can lead many to mistakenly confuse financial stability with rising markets.
It is dangerous to try to prolong the upward phase of the economic cycle by forcing expansionary financial conditions. It is also dangerous to prioritize monetary policy decisions based on the behavior of financial markets, which can become decoupled from economic evolution itself. In its latest minutes, the Fed acknowledged its bewilderment at the combination of economic strength and weak financial markets. Structural reforms in the economy and a clear medium-term economic policy strategy are fundamental to making the economic recovery more sustainable while preserving financial stability in the medium and long term.
