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Financial cycles sovereigns bankers and stress tests


Financial Cycles


Also by Dimitris N. Chorafas
Public Debt Dynamics in Europe and the US (2014)
The Changing Role of Central Banks (2013)
Breaking Up the Euro: The End of a Common Currency (2013)
Household Finance: Adrift in a Sea of Red Ink (2013)
Quality Control Applications (2013)
Basel III, the Devil, and Global Banking (2012)
Sovereign Debt Crisis: The New Normal and the New Poor (2011)
Business, Marketing, and Management Principles for IT and Engineering (2011)
Energy, Environment, Natural Resources and Business Competitiveness (2011)
Education and Employment in the European Union: The Social Cost of
Business (2011)
Cloud Computing Strategies (2011)
The Business of Europe Is Politics (2010)
Risk Pricing (2010)
Capitalism without Capital (2009)
Financial Boom and Gloom: The Credit and Banking Crisis of 2007–2009

and Beyond (2009)
Globalization’s Limits: Conflicting National Interests in Trade and Finance (2009)
IT Auditing and Sarbanes-Oxley Compliance (2009)
An Introduction to Derivative Financial Instruments (2008)
Risk Accounting and Risk Management, for Professional Accountants (2008)
Risk Management Technology in Financial Services (2007)
Stress Testing for Risk Control Under Basel II (2007)
Strategic Business Planning for Accountants: Methods, Tools, and Case Studies (2007)
International Financial Reporting Standards (IFRS): Fair Value and Corporate
Governance (2006)
Wealth Management: Private Banking, Investment Decisions and Structured
Financial Products (2006)
The Management of Bond Investments and Trading of Debt (2005)


Financial Cycles
Sovereigns, Bankers, and
Stress Tests
Dimitris N. Chorafas


FINANCIAL CYCLES

Copyright © Dimitris N. Chorafas, 2015.
Softcover reprint of the hardcover 1st edition 2015 978-1-137-49797-0

All rights reserved.
First published in 2015 by
PALGRAVE MACMILLAN®
in the United States—a division of St. Martin’s Press LLC,
175 Fifth Avenue, New York, NY 10010.
Where this book is distributed in the UK, Europe and the rest of the world,
this is by Palgrave Macmillan, a division of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills,
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Palgrave Macmillan is the global academic imprint of the above companies
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ISBN 978-1-349-69816-5
ISBN 978-1-137-49798-7 (eBook)
DOI 10.1057/9781137497987
Library of Congress Cataloging-in-Publication Data
Chorafas, Dimitris N.
Financial cycles : sovereigns, bankers and stress tests /
Dimitris N. Chorafas.
pages cm
Includes bibliographical references and index.
1. Business cycles. 2. Financial crises. 3. Finance. 4. Monetary
policy. I. Title.
HB3722.C463 2014
338.542—dc23

2014037907

A catalogue record of the book is available from the British Library.
Design by Newgen Knowledge Works (P) Ltd., Chennai, India.
First edition: March 2015
10 9 8 7 6 5 4 3 2 1


Contents

List of Illustrations

ix

Preface

xi

1

1

2

Financial Cycles
1. The Difference between a Financial Cycle and a
Business Cycle
2. Financial Cycles in a Sophisticated Economy
3. Sizing Up the Financial Cycle
4. A Currency Union Is Incompatible with Sovereignty
5. A Lesson Learned from Fermentation
6. Economic Vibrions
7. Can the Financial Cycle Be Managed?

1
4
9
12
15
17
20

Financial Stability
1. Financial Stability Defined
2. The Financial Stability Board
3. Nineteenth-Century Economic Theories Are Unfit
for Today’s Problems
4. Financial Stability and the Sovereign’s Budget
5. Are Western Economies on Their Way to Financial Stability?

25
25
29
31
34
38

3

Dismantling Globalization by Changing the Rules
1. Reserve Currencies
2. Monopoly Money and the Unfunded Liabilities
3. The March of De-globalization
4. The Transatlantic Trade and Investment Partnership
5. IMF and the New Development Bank of BRICS
6. Uneven Policies in Deleveraging
7. The Risk of Disinflation

43
43
47
50
53
56
60
65

4

Twists of Monetary Policy and of Supervision
1. The Shadow Banking System
2. Macro-Prudential Supervision

69
69
72


vi

5

6

7

CONTENTS

3. Resolution Regimes
4. Can Eurobonds Fly?
5. Risks with Securitizations

77
80
83

Debt and Democracy
1. Property-Owning Democracy versus Debt-Laden
Democracy
2. An Unaffordable Level of Public Debt
3. Budget Deficits Are a Wrong-Way Policy
4. A Democracy in Deep Debt Is in Terminal Decline
5. “Just Buying Time” Is an Invitation to Disaster

89

Debt Sustainability
1. Overindebted Countries Abandon Their Sovereignty
2. The Sense of Debt Sustainability
3. Public Debt Affordability Cannot be Taken for Granted
4. Vulnerabilities of Borrowers and Lenders:
The Case of Venezuela
5. Private Debt Is Another Nightmare
6. A Lesson Learned from the Fall of Feudalism

89
92
95
99
103
109
109
113
116
121
124
127

What Is Special about Banks?
1. A Snapshot of the Banking Industry
2. Tangible Book Value and Other Metrics
3. Universal Banking
4. The Challenge of Past-Due Loans
5. What’s the Sense of Huge Penalties for
Alleged “Misconduct”?
6. The Banking Industry Is Still Not Out of the Tunnel

131
131
134
136
140

8

A Structure of Analysis through Stress Testing
1. Structure of Analysis by Means of Stress Testing
2. Dry Holes in the Finances of Euroland’s Credit Institutions
3. A Methodology for Stress Testing
4. Policies with Stress Tests in the US and Europe
5. Risk Analysis and Asset Quality Review
6. Exposure at Default and Unexpected Losses

153
153
156
160
163
167
170

9

The Hydra of Financial Exposure
1. Loans to Governments
2. Risk-Weighted Assets and Helicopter Fines
3. Espirito Santo: The Bank That Drove Itself Nuts
4. Interbank Contagion
5. International Accounting Standards: The New Rules on
Banks’ Credit Losses

175
175
178
182
186

144
149

190


CONTENTS

10

The European Banking Union: An Exercise in Abstraction
1. Banking Union and the Financial Cycle
2. Reservations about the Banking Union and Its Impact
3. Banking Union Weaknesses Because of Profligate
Member States
4. Political Risks with the Banking Union
5. The Crisis of Confidence Is an Expected Risk
6. The Cost Is Half a Billion. The Benefit Is Uncertain

Appendix

Bitcoins: A Solution or a Hoax?

vii

195
195
199
202
206
210
214
219

Notes

225

Index

233


This page intentionally left blank


Illustrations

Figures
1.1
8.1
10.1

Financial cycle and business cycles
Stress tests help to project real-life worst cases and
associated unexpected losses
Banking union and supervisory assessment of exposure of
Euroland’s banking industry

11
171
196

Table
1.1

The five cycles of the Western economy, post–World War II

6


Preface

A

s financial positions expanded, economies became more vulnerable to adverse and unexpected developments, many of which took
place outside the usually six to seven years of a business cycle. Nikolai
Kondratieff, a Russian economist, developed the theory of long waves of
up to 50 years, incorporating in it an extended cycle of innovation and
upward thrust, despite the setback of recessions, followed by a longer era
of decline that business cycles classically admit.
In the background of the financial cycle lies the fact that, in this longer run the trend of growth would eventually exhaust itself while recovery requires a consolidating period which, compared to the good years,
represents depression and retrenchment. This pause is necessary before
the economy can regain self-confidence; hence, vigor and growth. This
is the concept underpinning the Kondratieff cycle. Other economists,
like Arthur Burns, the former chairman of the Federal Reserve, identified the long swings of up to 25 years, when economic growth and capital
formation:
M
M

First reaches a peak, and
Then retreats to an era of slower expansion, and eventually
deleveraging.

Neither should the role played by human capital be underestimated.
According to Paul Volcker, the former chairman of the Federal Reserve,
as the long financial cycle is unfolding, its duration is crucially influenced
by what is inside people’s minds: the psychology of investors, consumers,
businessmen, and government executives. Peoples’ reactions vary:
M

M

They could be disappointed and try to preserve the status quo by
aggravating the crisis,
Or, they may adjust to the inevitable and accept the more modest
prospects imposed by the new economic conditions characterizing
the lower part of the cycle.


xii

PREFACE

It should not escape attention that in the 50-year cycle are included
two successive generations of economists and market players, with plenty
of psychological effects coming into the picture. The third generation that
follows the 50 years of a financial cycle has practically forgotten the lessons of the past and is more likely to repeat the same wrong-way moves
and mistakes. This is also happening, though at lower intensity, with the
25-year cycle.
If economists, market players, politicians, and bureaucrats fail to
honor the limits to growth, then the economy is destined to suffer turmoil
and a greater crisis. Essentially, the statements of Volcker, Burns, and
Kondratieff have been articulating a classic perspective of central bankers
that dictates the choice of order and financial stability, hence moderation
of aspirations aimed at rebuilding the economic infrastructure.
Written for an academic readership and addressing itself to the new
generation of economists, this book concentrates on three areas that have
not yet entered the mainstream of economic thinking, but are not far
from doing so. The one is the impact of the longer-term financial cycle;
the second is the beginning of de-globalization as the world enters an era
of iron-clad economic blocks; the third is the new structure of analysis
that, to a significant measure, involves stress testing the financial staying
power of credit institutions.
As far as de-globalization is concerned, after nearly seven decades
of an effort directed toward globalization, the trend has changed as the
financial and political world started to split into economic blocs. This
emerging policy of de-globalization is not a faraway future. It is a reality
imposed by political authorities that are changing the rules.
It is too early to say how far it will go, or whether it will reverse itself.
At the beginning of World War I the German kaiser queried what a quarter of a million–strong Swiss Army would do if faced with an invasion
by half a million Germans. A Swiss militiaman replied, “Shoot twice.”1
De-globalization is that second shooting. We shall see the results.
The study of an increasingly complex economic and financial environment also requires a new structure of analysis. This is still in the making.
It is provided by asset quality reviews of the banking industry made by
central banks and supervisory authorities, and most particularly by way
of stress tests. The need for a rigorous financial analysis is most widespread because, like the mountains of debt, uncontrollable risks have
become a most corroding malady of our generation.
*

*

*

Chapter 1 explains the concept underpinning financial cycles, bringing
to attention the fact that many of the notions behind it are subject to an


PREFACE

xiii

ongoing evolution. The interest in financial cycles comes from the fact
that, by being longer term, they incorporate economic forces at work that
are poorly accounted for in classical business cycles. The text outlines the
reasons why financial cycles are vital particularly in connection with the
study of a sophisticated economy, and it provides a snapshot of the most
important methods and tools for their analysis.
One of the basic reasons for the examination of the background and
foreground forces affecting a financial cycle is to promote financial stability. This is the theme of chapter 2, which outlines current efforts to ensure
financial stability, like the institution of a Financial Stability Board, and
demonstrates that nineteenth-century economic theories applied by
socialist regimes are unfit for today’s problems and are counterproductive. One of the focal points brought to the reader’s attention is the connection between financial stability and sovereign budgets.
The seven decades that have elapsed since the end of World War II have
been characterized by economic globalization. This process is now being
reversed as de-globalization forces gain the upper ground. Practically all
major industrial economies try to change the rules of the game to their
advantage. Chapter 3 starts with a historical review of reserve currencies, which have provided globalization’s common ground; brings attention to socioeconomic problems characterized by unfunded liabilities;
explains why globalization is undermined by parochial agreements like
the TTIP; and discusses the likely future of the New Development Bank
of BRICS—a competitor to the IMF.
Antiglobalization is boosted by the rapid rise of novel economic and
financial forces like shadow banking, the uncertain trumpet of crossborder macro-prudential supervision, and the development of regional
resolution regimes. Chapter 4 examines the impact of such ongoing
developments, in parallel with unorthodox policies by central banks that
fill their vaults with the toxic waste of profligate government bonds. It
also brings in perspective the renewed risk from questionable securitizations that, a short seven years ago, pushed the Western economies to the
precipice.
Chapter 5 concentrates on the economic aftereffects of the rising
mountains of public debt. It discusses why this practice is undemocratic
and unwarranted. Eventually all citizens, and most particularly a country’s economically weakest members, are going to pay for it. “We must
tax the poor, they are the most numerous,” said André Tardieu, a former
French socialist prime minister.
Returning to the theme of financial stability, discussed in chapter 2,
chapter 5 demonstrates that a policy of steady budget deficits is wrong. Its
existence is a clear sign of a democracy in terminal decline. The infective
virus of exploding public debt has infiltrated all Western sovereigns. Italy


xiv

PREFACE

and France are basket cases, Greece went bankrupt, and the United States
is confronted by a guesstimated $300 trillion of unfunded liabilities (How
and why are explained in the chapter).
Goldman Sachs said that Italy’s slam amplifies its public debt woes.
The installation and steady expansion of modern welfare systems have
failed to account for their longer-term affordability. A way of life built
around endowments has required high and expanding levels of income,
as well as a significant degree of confidence about the future. But this
is exactly what is collapsing, taking along with it the personal freedoms
that, after World War II, characterized Western society.
While engaged in accumulating debt, sovereigns have failed to consider whether or not they are able to serve it, and which ways and means
they have available to confront their obligations. The theme of chapter 6
is debt sustainability, starting with the fact that, whether they know it or
not, overindebted countries are abandoning their economic sovereignty.
Public debt affordability is a complex notion that combines “easy solutions” with the absence of prudence in managing the country’s wealth.
Venezuela is taken as a case study of the new financial cycle, with emphasis on both borrowers’ and lenders’ vulnerabilities.
The close connection characterizing many of the activities of sovereigns and of big banks mandates the need for a close look at the status
of the banking industry. Chapter 7 explains what is special with banks,
the problems they encounter with past-due loans, the different questionable policies that make a mockery of banking as social service, and the
new income sovereigns derive by prosecuting the banks—a practice that
started in America and has now spread to Europe.
The fact that the banking industry is not out of the long, dark tunnel it entered in 2008, mandates a close look at its financial health. Risk
analysis can be promoted by stress testing, provided that such tests are
both pragmatic and honest. As chapter 8 brings to the reader’s attention,
this is not always the case. There are prerequisites to stress testing that
are not necessarily observed. The results of testing for exposure to default
are often bent to hide a bad situation. Belatedly, both the Federal Reserve
and the European Central Bank warn of tougher stress tests. We shall see
the outcome.
Chapter 9 is a continuation of chapter 8 and provides the reader with
case studies. One of the case studies concentrates on what happens, and
what could happen, with loans to governments. Another revolves around
the interpretation and manipulation of risk-weighted assets. A third looks
into the reasons for the recent virtual bankruptcy of Banco Espirito Santo,
Portugal’s biggest bank by assets. A fourth examines the likelihood of
interbank contagion. The common ground of these case studies is the


PREFACE

xv

search for rigorous accounting standards that can contribute to transparency and an effective risk control.
Banks can fail and the bankruptcy of a big and complex financial
group may create havoc in the economy. It could even unravel the common currency shared by a number of sovereign states and their banks.
In recognition of this fact and in order to avoid its aftereffects, Euroland
has worked on systems and procedures of a banking union, the subject
of chapter 10. This European endeavor is far from being perfect, as the
harder-working sovereigns seek to protect themselves from undue exploitation by the profligates. There is as well the question of whether or not
a single supervisory mechanism is the solution for repairing damaged
balance sheets and for implementing structural reforms.
The message to retain from this book is that to overcome the more
narrow limits of the business cycle, we need to go beyond its traditional
six to seven years focus and address the longer term. This includes the
analysis of economic risks characterizing the financial cycle, as well as the
appreciation of forces underwriting both the cycle’s growth and its decay.
An ever- increasing public debt and the behavior of the banking industry
are two principal reasons why the structure of analysis that served the
previous financial cycle is no more adequate for present-day realities. A
new methodology is starting to take shape, even if it still has to acquire
political legitimacy.
*

*

*

I am indebted to a long list of knowledgeable people and organizations for
their contribution to the research that made this book feasible. I am also
grateful to several experts for constructive criticism during the preparation of the manuscript. Dr. Heinrich Steinmann and Eva Maria Binder
have, as always, made significant contributions.
Let me take this opportunity to thank Leila Campoli for suggesting
this project, Erin Ivy for seeing it all the way to publication, and Bhavana
Nair for the editing work.
September 2014

Dimitris N. Chorafas

Valmer and Entlebuch


1

Financial Cycles

1. The Difference between a Financial Cycle and a Business Cycle
Ancient Egyptian mythology spoke of seven fat cows followed by seven
lean ones. Unlike other accounts based on hearsay and traditions, this one
had an evidence. The fat cows represented the good years when the assets
of the king and the citizens increased; the lean cows reflected the misery
associated with bad harvest, floods, and the destruction of wealth.
The Bible, too, speaks of cycles of decay and renewal, without making
it explicit that they are integral parts of economic life. They have been so
since the beginning of civilization, predating commerce, banking, and
the early financial transactions. The invention of money and the structure of institutions specializing in creating and holding virtual assets,
gave a new meaning to these cycles of decay and renewal.
Over the centuries economic life acquired its own momentum and
the creation of excess reserves saw to it that those possessing significant
wealth could not remain indifferent to the demand for loans. Economic
historians developed the theory that this was for the better, because the
existence of a capital base could act as lifesaver in lean times. Without it,
something in the normal regenerative process would have been missing.
The absence of a force promoting recovery from the business cycle’s bottom would have deprived the economy of an upside.
The theory of the business cycle established itself on these premises
that reflected the switches in the tempo and mood of business activity
over a period of six to seven years. Typically, though not always, those
swings between rich and lean years were influenced by a variety of more
or less objective events that repeated themselves, but there have been as
well less-tangible psychological factors.
Also, typically, the high time in the business cycle’s pattern has been a
period of prosperity that bred confidence and led to revised standards of
what is prudent and what is risky. Good years led to risk-on policies, while


2

FINANCIAL CYCLES

risk-off policies characterized the lean years. In the case of both renewal
and decay, the underlying process was self-reinforcing but also contained
some seeds of its own demise as:
M
M
M

Natural limits to the trend supporting prosperity were reached,
Excesses and extremes multiplied, battering the economy, and
The prevailing risk-taking could not be sustained for much longer.

As financial positions expanded, economies became more vulnerable
to adverse and unexpected developments, many of which went beyond
the usual six to seven years boundary of a business cycle. In the early
1920s, Nikolai Kondratieff, a Russian economist, developed the theory of
long waves of 50 years or so, incorporating in it an extended cycle of innovation and upward thrust, despite the setback of recessions, and followed
by a longer era of decline than business cycles classically admit.
Economic historians suggest that in his theory Kondratieff was influenced by the record-breaking global boom from about 1850 to the early
1870s, followed by a couple of decades of lean years and of economic
uncertainties. Though neither he nor other economists could give a satisfactory explanation of this long wave, he did point out that social and
economic forces were propping it up.1
Proposed for equities, Elliot’s Grand Super Cycle theory is close to
Kondratieff’s long leg cyclical analysis. Elliot used statistics from financial assets prices. Some economic history books suggest that in an effort
parallel to that of Elliot, the Russian economist had also looked into
crucial fluctuations in commodities in terms of patterns characterizing
financial instruments and their behavior.
In the background of these studies, and of theories based on them, lies
the fact that the longer cycle of growth eventually exhausts itself followed
by a chute. Recovery requires a period of consolidation, which, compared
to the good years, represents depression and retrenchment before the
economy can regain self-confidence; hence, vigor and growth. The long
wave is the concept underpinning the “Kondratieff cycle.” Other economists, like Arthur Burns, the former chairman of the Federal Reserve,
too identified long swings of up to 25 years, when economic growth and
capital formation:
M
M

First reaches a peak, and
Then retreats to an era of slower expansion, or deleveraging.

Neither should the role played by human capital be underestimated.
Kondratieff’s 50-year cycle represents two successive generations of


FINANCIAL CYCLES

3

economists and market players with plenty of psychological effects coming into the picture. The third generation that follows the 50 years of a
financial cycle has practically forgotten the decay earlier on in that period
and therefore is more likely to repeat the same wrong-way moves and
mistakes. This also happens, though at a lower intensity, with the 25-year
cycle.
According to Paul Volcker, the former chairman of the Federal Reserve,
as the long financial cycle is unfolding, its duration is crucially influenced
by what is inside people’s minds: the psychology of investors, consumers,
businessmen, and government executives. Peoples’ reactions vary:
M

M

They could be disappointed and try to preserve the status quo by
aggravating the crisis,
Or, they may adjust to the inevitable and accept the more modest
prospects imposed by the new economic conditions characterizing
the lower part of the cycle.2

If economists, market players, politicians, and bureaucrats fail to
honor the limits to growth, then the economy is destined to suffer turmoil
and a greater crisis. Essentially, the statements of Volcker, Burns, and
Kondratieff have been articulating the classic perspective of central bankers that dictates the choice of order and financial stability, hence moderation of aspirations aimed at rebuilding the economic infrastructure.
Volcker, Burns, and Kondratieff have seen the reasons why attention
should be paid to the long wave. So did other economists, but the majority
kept on working on the shorter-term, hence more limited, business cycle.
This is attested by statistics.
It needs no explaining that to overcome the more narrow limits of the
business cycle, we have to go beyond its traditional six to seven years focus
and address the longer term, including the building-up and running-off
of economic risks characterizing the long wave of the financial cycle. The
impact exercised by the longer term underlying economic forces is much
greater than it might seem at first sight, because it means shifting away
from debt as the main engine of growth and targeting policies such as:
M
M

Repairing balance sheets, and
Implementing structural reforms.

Indeed, economies that escaped the worst effects of the most recent
economic and financial crisis have more or less followed assets-based
policies, with an eye on dampening the extremes by way of prudential
monetary and fiscal frameworks. Ducking away from reform, the way


4

FINANCIAL CYCLES

France and Italy have been doing, ensures that the worst continues to
worsen as room for policy changes runs out.
In the shorter run accommodative monetary conditions theoretically
help in keeping volatility low. But they penalize the financially weaker citizen, while signaling a strong appetite for risk on the part of the betteroff investors. Eventually, economies become vulnerable to shifting global
conditions as no market is completely insulated from bouts of turbulence.
As long as the economy is in doldrums, companies, sovereigns, and
banks face severe balance sheet weaknesses largely stemming from overexposure to risky holding and (in the case of banks) to highly indebted
borrowers. Debt drags the recovery at all levels. Following the aftereffect
of the Great Recession, from 2007 till today, households and industrial
firms have tried to reduce their debt but sovereigns and many banks continued accumulating red ink and toxic “assets”—therefore adding to the
problem they intended to solve.
A visible part of this discrepancy has been the diminished monetary
policy effectiveness all the way to the central banks’ puzzle on how to
address unexpected disinflation (chapter 3). Central banks also discovered that unorthodox measures, like quantitative easing (QE), present
unexpected consequences. One of the more puzzling is how to siphon an
excessive liquidity injected into the financial system out of it,
M
M

Without rattling the market, and
Prior to it creating significant damage.

According to a mounting wave of opinions, several present-day difficulties can be traced in part to a kind of overconfidence generated by a long
period of prosperity that did away with a more conservative and cautious
approach in the hope that the “New Economy” represents sustained growth
to infinity.3 Instead the economic players, including financial markets and
political leaders, should have appreciated the importance of caution as the
better way to avoid a long cycle of retreat, failure, and disappointment.
2. Financial Cycles in a Sophisticated Economy
The message conveyed by section 1 is that the more complex and more
global the economic and financial environment becomes, the less adequate is the classical business cycle timeframe. A six to seven years
perspective is simply not enough for understanding and analyzing the
prevailing economic conditions and to elaborate ways and means for
influencing their future behavior.


FINANCIAL CYCLES

5

Past theories did not fully account for the interaction between debt,
input, output, and asset prices as well as the prevailing impedances. Yet,
these help in explaining why many advanced economies are now characterized by poor health. To do so, we must explore the roles played by
debt, leverage, and risk-taking in driving economic and financial developments, as well as assess where different economies stand in terms of the
financial cycle.
The length of time of rise and fall in economic output is not the only
factor that distinguishes a financial cycle from a business cycle. In contrast to classical business cycles, financial cycles also include existing
interactions between perceptions of value, profits, risks, and constraints
that translate into booms and busts. Their aftereffects are measured by a
combination of:
M
M

Credit aggregates, and
Property (assets) prices.

Such combinations may be self-reinforcing or self-defeating. Critical
variables can move in different directions for a relatively long period of
time, turning booms into busts and vice versa. Quite often the downturn
coincides with banking crises and deeper recessions than those that characterize the typical business cycle.
High debt levels undermine sustainable economic growth by making vulnerable the sovereigns, households, and financial institutions at
large. Alert minds can see this coming but their advice is not heeded
by politicians and by populist economists. In an article he published in
the Financial Times Raghuram Rajan, governor of the Reserve Bank of
India and former chief economist at the International Monetary Fund,
warned: “Some of our macroeconomists are not recognizing the overall build-up of risks. We are taking a greater chance of having another
crash at a time when the world is less capable of bearing the cost.”4
In the same issue of the Financial Times William Rhodes, former senior
executive of Citibank and elder statesman of the banking industry, stated:
“Financial groups are dialing up risk in their search for yield because of
the extraordinary amounts of liquidity created by central banks and the
prolonged low-rate environment. This is often not being done prudently.
The key causes of past financial crises are being forgotten at many financial institutions.”5
Both quotes essentially point out why the present financial cycle is
characterized by financial distress and economic strains. Countries hardest hit by the crisis, a reference that now applies to the majority of Western
nations, find themselves in a debt and risk trap: An attempt to relaunch


6

FINANCIAL CYCLES

Table 1.1

The five cycles of the Western economy, post–World War II
Long Wave

1945–1960
1960–1973
1973–1990
1990–2007

Age of Growth
Age of Intervention
Age of Inflation and Instability
Age of Excess

Growth and Intervention

2007–present

Age of Deep Indebtedness

Economic and Banking Crisesa

Note:

a

Inflation, Instability, and
Excesses

This is still in the beginning stages.

the economy by way of very low interest rates through a protracted time
period encourages the assumption of:
M
M

Even more debt, and
An even greater amount of risk.

A financial cycle, or a major part of it, may as well be characterized by a
more general trend that is not directly connected to finance and economics but underpins and influences its evolution. Table 1.1 presents, as an
example, five different cycles that divide among themselves the 70 years
that have elapsed since the end of World War II. The first and second
could collapse into an Age of Growth and Intervention, and the third and
fourth into an Age of Inflation, Instability, and Excesses. Notice that each
age lasts about three decades.
To obtain an analytical insight to these macroeconomic challenges,
it is necessary to account for joint fluctuations among critical variables
involving a wider range of factors. These are not moving in unison but
they correlate. Such a broader picture should include supplies, quantities,
prices, and debt as a proxy for leverage, as well as credit spreads, risk premia, risk appetite, and default rates.
Of particular importance are peaks and lows in the financial cycle that
tend to coincide with banking crises and/or periods of financial stress.
Also booms during which surging asset prices and rapid credit growth
reinforce each other, particularly when they are driven by a prolonged and
accommodative monetary policy. Loose financing conditions feeding into
the real economic structure lead to excessive leverage and bubbles in one
or more areas.
Financial cycles are often, but not always, synchronized across an
economy, while liquidity conditions tend to correlate across markets.
External capital often plays a critical role in unsustainable credit booms,


FINANCIAL CYCLES

7

including overshooting rates when national currency is used outside
its jurisdiction. On the other hand, monetary conditions, including
exchange rate appreciation or depreciation, can spread indirectly.
Rather than damaging themselves with higher levels of liabilities,
countries with large public debts and with steady deficits should give
priority to balance sheet repair and structural reforms. It serves nothing
to blame austerity for their woes. Special attention must be paid to new
sources of risks that impact upon the financial cycle affecting a sovereign’s ability to come up from under.
Even if the ratios of private sector debt to GDP have slid from their
peaks in the recent crisis, these reductions alone cannot turn around the
economy. They hardly compensate for the huge increase in household
and corporate debt during the crisis, and they fall short of what is needed
to give confidence to the market.
As for the record low interest rates, while they have allowed the more
serious borrowers to service their debt, they have provided no lasting basis
to wipe that debt out. In Euroland, for example, in 2013 and 2014, the economic situation somewhat stabilized but did not significantly improve.
The end result has been that the debt overhang continues particularly
among profligate member states.
There have been attempts to justify this failure to be in charge of the
economic situation by distorting the facts. A good example is provided by
an article in the Financial Times by Philip Stephens that reads as a paid
advertisement of the policies of Matteo Renzi, the Italian premier who
tried to jump the gun of ultra-heavy public debt through a variety of gimmicks. The Italian socialist is simply forgetting the old adage that lies and
gimmicks have short legs.
According to Stephens’s article, the argument between Italy’s Matteo
Renzi and Germany’s Angela Merkel revolves around whether or not an
arrangement that falls short of a textbook monetary union, can be both
economically robust and politically sustainable.
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Germany and other northern EU states focus on robustness.
Italy and other indebted southern economies want a “politically
sustainable” solution, whatever that is supposed to mean.

Quite incorrectly, indeed against all logic, Stephens says that the
two opposing concepts should be seen as self-reinforcing, particularly
in the sense of credibility.6 But credibility is precisely what Renzi’s
socialist party (in essence, social-communist party masquerading as
“democratic”) utterly lacks. Reduced business confidence and dubious
credibility are characteristic of the financial cycle we are in.


8

FINANCIAL CYCLES

The Financial Times article goes on further to maintain that Merkel’s
and Renzi’s “common ground” extends to the urgency of structural
reforms. That’s a hyperbole because structural reforms are an alien concept in Italy, France, and other profligates. The Italian prospectus begins
and ends with a call for “more economic integration in the EU”—including
the suggestion that governments should also throw their weight behind
opening Europe’s markets through a transatlantic trade and investment
partnership. This is another red herring (see chapter 3 on TTIP).
What this and similar articles or pronouncements fail to notice is that a
sophisticated economy cannot be managed, much less redressed, through
words, empty promises, and questionable comparisons. Even a prosperous economy will not be able to afford words, words, and words for a long
time. The day of reckoning is always around, as risks accumulate. If they
are not put under lock and key, exposures that seem to be affordable tend
to become bogeymen.
Take Switzerland as an example. It is, today, one of the few prosperous European economies. Successive popular referendums have demonstrated the political maturity of the Swiss public that understood that it
cannot afford to say “yes” to initiatives that are diametrically opposed to
the notion of Switzerland as an attractive business location able to generate jobs and wealth. This, in spite of the fact that, promoted by the socalled young socialists
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The amount of regulatory and administrative red tape is on the rise,
and
Demands for the redistribution of wealth are stifling entrepreneurship and the pioneering spirit.

Steady vigilance is the answer to economic problems and this is true
all the way to the exchange rate of the currency (the Swiss franc) fixed
by the central bank at the rate of 1.20 francs to the euro. To uphold that
rate, in the first year of the fixing, from autumn 2011 to summer 2012,
the Swiss National Bank (SNB) had to buy the counterbalance of about
440 billion Swiss francs in foreign currency to defend its lower limit.
That policy inflated the SNB’s balance sheet significantly, but the lower
limit held.
The downside is that the SNB cannot abandon its lower limit for the
time being. At the moment, sales of its enormous euro, US dollar, and
other foreign currency reserves appear near impossible, as such they
would push up the franc’s exchange rate. If the SNB were to explicitly
abandon its lower limit, the way to bet is that there will be an escalation
of the speculators’ effort for franc-euro parity or worse.


FINANCIAL CYCLES

9

Exchange rate parity is one of the economic problems transcending
the classical business cycle. It is also a part of the financial cycle’s underlying forces—an important issue relating to imports and exports that
dearly affects an economy depending on exports for roughly 50 percent of
its GDP. In addition to foreign exchange policy, sovereigns with a strong
currency must watch their fiscal policies influenced by long cycles. This
implies constraints. The Swiss National Bank cannot raise its key rates
before the European Central Bank (ECB) does so, or the exchange rate
policy will be undone.
3. Sizing Up the Financial Cycle
In developing economies the financial cycle is measured by aggregating
movements of real credit, credit-to-gross domestic product, and real house
prices. Through these metrics economists estimate peaks and troughs, then
compare which might have coincided, and under what conditions, with
widespread banking crises and other notable events like inflection points.
For instance, when was a going trend uninterrupted and for how long.
Two methods are favorably looked at in studying business cycles as
well as, by extension, financial cycles. One of them, known as the turning point, rests on original work accomplished in the 1940s. It identifies
cyclical highs and lows by examining growth rates of a broad range of
variables over a span of time, including output, employment, production,
consumption, and more. The focal points are changes from positive to
negative and vice versa.
Research at the Bank for International Settlements (BIS) has shown
that real credit growth, credit-to-GDP ratios and the evolution of real
property prices represent the smallest set of selected variables needed.
They are used to depict in an adequate way the mutually reinforcing
interaction between:
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Positive and negative forces,
Financing constraints,
Perceptions of value, and
Assumed risks that can cause serious economic dislocations.

This small group of key variables can be expanded by including other
factors such as credit spreads, equity prices, risk premia, and default rates.
Their analysis helps in measuring risk and in providing a perception of
exposure, making the turning point method adaptable to the analysis of
not only business cycles but also financial cycles.


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FINANCIAL CYCLES

The alternative approach is based on statistical filters that extract
from a specific time series cyclical fluctuations within a particular cycle
such as output. This method, too, concentrates on developments in real
credit growth, the credit-to-GDP ratio, and the evolution of real property
prices. Bandpass filters are used with cycles lasting between eight and
thirty years. Obtained results are combined into a single series by way of
a simple average.7
Nevertheless, contrary to business cycle estimates, which have been
supported by many decades of research, observation and the measurement of financial cycles is still in its formative years. Neither is the modeling approach preferred by economists and analysts fixed forever. Given
the novelty of financial cycle studies, the examination of many variables
is not based on generally accepted blueprints. As a result, those in charge
have to draw conclusions as they go along using their imagination and
initiative. What is required of them is to assume:
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How a given crisis should be mapped,
Whether or not a panic might be contained, and
What sort of tangible evidence exists that the situation under their
watch stops from deteriorating, or, alternatively, there is an uptick.

Up to a point, but only up to a point, the behavior of a process subject
to economic decay can be equated to what goes on in fermentation in
chemical engineering. This can best be done by employing the pioneering
principles originally developed in the nineteenth century by the genius
of Louis Pasteur.8 I know of no work undertaken in this direction, but it
holds a promising novel way of analysis, briefly described in section 4.
A basic principle of science and technology is that, no matter which
specific analytical methodology is chosen, at the end of the day it must
be able to map the conditions prevailing in real life—in this case, the
financial cycle. While the choice of the right approach is important, the
keyword is personal accountability in applying an experimental solution.
Cookie-cutter approaches often found in connection to a variety of problems are totally unacceptable, because:
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The prevailing economic conditions are fluid, and
The idea that from start to finish a current crisis is a carbon copy of
preceding events is patently false.

Figure 1.1 presents the general schema of business cycles and of a
financial cycle. Among the better-known turning points have been the


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