April 2020

Sowing the Seeds of Financial Imbalances: The Role of Macroeconomic Performance

Elena Afanasyeva, Sam Jerow, Seung Jung Lee, and Michele Modugno

Abstract:

The seeds of financial imbalances are sown in times of buoyant economic growth. We study the link between macroeconomic performance and financial imbalances, focusing on the experience of the United States since the 1960s. We first follow a narrative approach to review historical episodes of significant financial imbalances and find that the onset of financial disturbances typically occurs when the economy is running hot. We then look for evidence of a statistical link between measures of macroeconomic conditions and financial imbalances. In our in-sample analysis, we find that strong economic growth is followed by a build-up of financial imbalances across all dimensions of the National Financial Conditions Index. In our out-of-sample analysis, we find that the link between strong economic performance and increases in nonfinancial leverage is particularly strong and robust. Using a structural VAR identified with narrative sign restrictions, we also demonstrate that business cycle shocks are important drivers of non financial leverage.

Keywords: Economic Performance; Non financial Leverage; Financial Imbalances; Financial Stability; Forecasting; VARs; Sign Restrictions; Narrative.

DOI: https://doi.org/10.17016/FEDS.2020.028

PDF: Full Paper

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Last Update: April 07, 2020