Too Good is Bad? Exuberance Indicators and the Business Cycle

Authors: Mikhail Mamonov and Anna Pestova

Abstract: Following the recent revival of the endogenous business cycle theories which highlight the predictability of changes of the business cycle phases, we provide a first comprehensive test of the associated ``too good is bad" hypothesis. The literature so far has convincingly shown that a rapid growth of credit predicts financial instability and is followed by a deeper recession. We employ the concept of ``exuberance indicators" and extend the list of these indicators beyond the credit by considering several other domestic overheating and external imbalance indicators. In a panel of 25 countries, we show that our exuberance indicators --- besides credit market exuberance --- convey important information about the probability of future recession, controlling for the classical recession predictors (term spread, stock market return, short-term interest rates) and sentiment indicators. In a causal analysis, we show that domestic credit supply and global financial shocks push exuberance indicators to hazardous values associated with a higher recession risk. Our counterfactual analysis indicates that, if we shut down global financial shocks during 2002--2006, the probability of the 2007--2009 recession would decline on average by 11 percentage points.