The second curve in the figure represents variations in the amount of credit or degree of indebtedness in the economy. There are slightly different terms for these cycles in academic literature – credit cycles, leverage cycles or financial cycles. 3 They can have slightly different meanings in different contents, but essentially refer to the same thing. For the sake of simplicity, I shall use the term credit cycles here. The credit cycle and the business cycle may occasionally coincide quite well, but can at times develop differently. In the figure, the two cycles are for illustrative purposes assumed to evolve rather differently. One occasion when the two cycles coincide, however, is when the credit cycle shows a rapid downturn, as at the end of the figure. Such a downturn is more likely when the preceding upturn has been unusually strong and characterised by exaggerated optimism and risk has been underestimated and under-priced. Credit boom that “goes wrong” – credit and business cycles coincide At some stage it becomes clear that the large amount of credit and the high level of indebtedness are based on overly optimistic calculations. Interest in selling the asset, usually housing, at the base of the credit expansion suddenly becomes greater than interest in buying it and a downward price spiral starts. The value of the collateral falls and the banks become cautious and reduce their lending. Households on the other hand see the value of their assets plummeting while the size of their loans remains unchanged.
In other words, the situation around six or seven years ago was such that we were more or less prepared to believe we had found the final solution as to how monetary policy should be conducted, and that financial crises no longer offered a severe threat. An illustration The international financial and debt crisis made it painfully clear that things were not that simple. There are several lessons that can be learned from the crisis. But if one were to choose the most important, for me there is no doubt that it is that a substantial increase in indebtedness in society can entail major problems, particularly if it is linked to price increases on an important asset market, in particular the housing market. This danger was definitely underestimated prior to the crisis. The underlying problems can be illustrated using a stylised figure (see Figure 1). The red line represents the usual cyclical fluctuations in the economy – the business cycle. Figure 1 Business and credit cycles  Business cycle Credit cycle  2  2  This so-called Jackson Hole Consensus is described by, for instance, Issing (2009). BIS central bankers’ speeches  Let us, for the sake of simplicity, assume that inflation follows the business cycle, so that the curve can also represent developments in inflation. Of course, the business cycle and inflation do not normally coincide so well in reality, but this has no significance for the points I will make here.