Financial Crises: Explanations, Types, and Implications; by Stijn Claessens and M. Ayhan Kose; imf working Paper 13/28; January 1, 2013

 

C.   Impact of Asset Price and Credit Busts 

Sharp movements in asset and credit markets during financial crises are quite different from 

those normally observed. Asset prices and credit booms and busts differ from the movements 

observed over the course of a normal business cycle. Booms in credit and asset markets are 

shorter, stronger, and faster than other upturns. For example, these episodes often take place 

over relatively shorter time periods than other episodes and are associated with much faster 

increases in the financial variables (Figure 2A). The slope of a typical boom is two to three 

times larger than that of regular episodes. And crunches and busts are longer, deeper and 

more violent than other downturns. Credit crunches and asset price busts have much larger 

declines than other declines (Figure 2B). Specifically, credit crunches and house price busts 

lead to respectively roughly 10 and 15 times larger drops than other downturns, while equity 

busts more than 2.5 times as large. These episodes also last longer, some two times, than 

other downturns, with house price busts the longest of all, about 18 quarters, whereas a credit 

crunch and equity busts last about 10-12 quarters. Moreover, disruptions are more violent, as 

evidenced by higher slope coefficients, with busts in equity prices three times more violent 

than those in credit and house prices (Claessens, Kose and Terrones, 2010a).  

 

There are typically adverse real effects of asset price busts and credit crunches on the real 

economy.

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 Asset price busts can affect bank lending and other financial institutions’ 

                                                 

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 Some used to be sanguine on the costs of busts in credit and asset markets. Until the most recent 

crisis, for example, some appeared to be sanguine on the economic cost of bubbles. For example, 

Roger W. Ferguson, then Vice Chairman of the Federal Reserve Board, argued in January 2005 that 

“recessions that follow swings in asset prices are not necessarily longer, deeper, and associated with 

a greater fall in output and investment than other recessions…” There are also theories in which even 

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investment decisions and in turn the real economy through two channels. First, when 

borrowing/lending is collateralized and the market price of collateral falls, the ability of firms 

to rely on assets as collateral for new loans and financial institutions’ ability to extend new 

credit become impaired, which in turn adversely affect investment. Second, the prospect of 

large price dislocations arising from fire sales and related financial turmoil distorts decisions 

of financial institutions to lend or invest, prompting them inter alia to hoard cash. Through 

these channels, fire sales can trigger a credit crunch and cause a severe contraction in real 

activity. 

 

Those asset price booms supported through leveraged financing and involving financial 

intermediaries appear to entail larger risks for the economy. Evidence from past episodes 

suggests that whether excessive movements in asset prices lead to severe misallocations of 

resources depends in large part on the nature of boom and how it is financed. Booms largely 

involving equity market activities appear to have lower risks of adverse consequences. The 

burst of the internet bubble of the late 1990s, which largely involved only equity markets, has 

not been very costly for the real economy. When banks are involved in financing asset price 

booms, however, as in real estate mortgage and corporate sector financing, risks of adverse 

consequences of a following asset bust are typically much higher. The main reason is that 

these booms involve leverage and banks, implying that the flow of credit to the economy gets 

interrupted when a bust occurs.  

 

The burst of the latest bubble, as it was financed by banks (and the shadow banking system) 

and involving housing, has been very costly. For the most recent episode, Dell’Ariccia et al 

(2011) report that, in a 40-country sample, almost all the countries with “twin booms” in real 

estate and credit markets (21 out of 23) ended up suffering from either a crisis or a severe 

drop in GDP growth rate relative to the country’s performance in the 2003–07 period (Figure 

3). Eleven of these countries actually suffered both financial sector damage and a sharp drop 

in economic activity. In contrast, of the seven countries that experienced a real estate boom, 

but not a credit boom, only two went through a systemic crisis and, on average, had relatively 

mild recessions. We present a broader discussion of the real and financial implications of 

financial crises and disruptions in Section V.