10 August 2016

New working paper on the financial cycle in Iceland

Working paper no. 72, “The long history of financial boom-bust cycles in Iceland - Part II: Financial cycles” by Bjarni G. Einarsson, Kristófer Gunnlaugsson, Thorvardur Tjörvi Ólafsson, and Thórarinn G. Pétursson has been published.

Claudio Borio recently quipped that “macroeconomics without the financial cycle is like Hamlet without the Prince” (Borio, 2014, p. 183). We rise to his call to arms and tackle the Prince’s existential question head-on. Our findings suggest that there exists a well-defined financial cycle in Iceland that has gradually become more prominent as the financial deepening and sophistication of the Icelandic economy has increased. Using a dataset spanning more than a century, including data on credit, house prices, and bank balance sheet size and composition, we find that the aggregate financial cycle is much longer than the typical business cycle, with a median duration of sixteen years. We find that there is a large difference in economic performance over different phases of the financial cycle, suggesting that it has played a prominent role in the country’s macroeconomic development. In fact, we find that almost all of the peaks in the financial cycle coincide with some type of a financial crisis and that cyclical expansions provide a robust early-warning signal for subsequent crises. We find strikingly strong ties between the Icelandic financial cycle and its global counterpart (proxied by the US financial cycle), with almost all of the cyclical peaks in the Icelandic financial cycle occurring close to peaks in the global cycle. Our findings suggest that understanding economic fluctuations in Iceland is hard without understanding the financial cycle and that we ignore the financial cycle at our peril. We conclude the paper with a first attempt at exploring some of the policy questions that our findings raise.

The paper is accessible at the Bank’s website: Working Papers.

Dataset used in the analysis in the paper.

Presentations on the financial cycle in Iceland at international and domestic conferences and seminars:

Presentation at the 10th Nordic Summer Symposium in Macroeconomics held in Ebeltoft 10-13 August 2016.

Presentation at the joint Central Bank of Iceland, IMF, and the Systemic Risk conference Capital Flows, Systemic Risk and Policy Responses held in Reykjavík 28-29 April 2016

Presentation at a seminar at Danmarks Nationalbank 12 April 2016

Presentation at the 5th NBRM Research Conference - Economic and financial cycle spillovers: Reconsidering domestic and cross-border channels and policy responses held in Macedonia 7 April 2016

Seminar at Íslandsbanki 9 March 2016

Seminar at the Central Bank of Iceland 23 February 2016