Henrik Jensen, Søren Hove Ravn, and Emiliano Santoro publish in European Economic Review: "Changing credit limits, changing business cycles"

Over the last half-century, capital markets across the industrialized world have undergone massive deregulation. One dimension of this phenomenon has consisted in a large increase in the loan-to-value (LTV) ratios of both households and firms.

In their paper, Jensen, Hove Ravn, Santoro study how this structural transformation of the economy changes the shape of the business cycle, with a focus on the U.S. economy.

The authors explain: we construct a dynamic general equilibrium model with multiple credit-constrained agents. In contrast to most of the existing business cycle literature, we explore the implications of credit constraints not binding at all points in time. To ensure that the model matches key features of the U.S. economy, we estimate it on U.S. data for the period 1980-2016 using the Simulated Method of Moments.

Our main findings are that macroeconomic volatility and co-movement between debt and real variables display a hump-shaped pattern in response to changes in the LTV ratio. A progressive increase in credit limits initially leads to both higher volatility and stronger comovement between debt and economic activity. This pattern reverses at LTV ratios not far from those currently observed in many advanced economies, due to credit constraints becoming non-binding more often.

The non-monotonic relationship between credit market conditions and macroeconomic fluctuations carries important lessons for regulatory and macroprudential policymakers, as it questions the adequacy of measures aimed at imposing caps on the LTV ratio. In fact, reducing the average LTV ratio may unintentionally increase macroeconomic volatility. In contrast, the authors demonstrate that imposing a countercyclical LTV ratio is successful in dampening business cycle fluctuations and, most importantly, avoiding dramatic output drops.