How Does Credit Supply Expansion Affect the Real Economy? The Productive Capacity and Household Demand Channels

• Published date: 01 April 2020
• Author: AMIR SUFI,EMIL VERNER,ATIF MIAN
• Date: 01 April 2020
• DOI: http://doi.org/10.1111/jofi.12869

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 2 •APRIL 2020

How Does Credit Supply Expansion Affect the

Real Economy? The Productive Capacity and

Household Demand Channels

ATIF MIAN, AMIR SUFI, and EMIL VERNER∗

ABSTRACT

Credit supply expansion can affect an economy by increasing productive capacity

or by boosting household demand. In this study, we develop a test to determine if

the household demand channel is present, and we implement the test using both a

natural experiment in the United States in the 1980s and an international panel

of 56 countries over the last several decades. Consistent with the importance of the

household demand channel, we find that credit supply expansion boosts nontradable

sector employment and the price of nontradable goods, with limited effects on tradable

sector employment. Such credit expansions amplify the business cycle and lead to

more severe recessions.

THERE IS INCREASING RECOGNITION THAT credit supply expansions and business

cycles are closely connected.1However, less is known about the exact channel

through which credit supply expansion affects the business cycle. This study

outlines two potential channels. First, a credit expansion may allow constrained

firms to borrow and grow,thereby increasing the economy’s productive capacity.

Second, a credit expansion may allow households to borrow and consume more,

∗Atif Mian is with Princeton University and NBER. Amir Sufi is with the University of Chicago

Booth School of Business and NBER. Emil Verneris with MIT Sloan. This research was supported

by funding from the Washington Center for Equitable Growth, the Julis Rabinowitz Center for

Public Policy and Finance at Princeton, and the Initiative on Global Markets at Chicago Booth. Se-

bastian Hanson, Bianca He, Hongbum Lee, Oliver Giesecke, and Seongjin Park provided excellent

research assistance. We thank Alan Blinder, Jesus Fernandez-Villaverde, Itay Goldstein, Guido

Lorenzoni, Philip Strahan, the Editor, an Associate Editor,two anonymous referees, and seminar

participants at Georgetown University,Columbia University, University College London, Imperial

College, Princeton University,the University of Chicago, Danmarks Nationalbank, the University

of Maryland, and the NBER Summer Institute for helpful comments. A previous version of this

study was called: “How do Credit Supply Shocks Affect the Real Economy? Evidence from the

United States in the 1980s.” We have read The Journal of Finance’s disclosure policy and have no

conflicts of interest to disclose.

1See, for example, Reinhart and Rogoff (2009), Jord`

a, Schularick, and Taylor (2013), Krishna-

murthy and Muir (2017), Mian, Sufi, and Verner(2017), Baron and Xiong (2017), and L ´

opez-Salido,

Stein, and Zakrajˇ

sek (2017). A credit supply expansion refers to a greater willingness to lend, all

else equal. It may be driven by factors such as deregulation, liberalization, a global savings glut,

or behavioral factors (as examples, see Gennaioli, Shleifer, and Vishny (2012), Justiniano, Prim-

iceri, and Tambalotti (2015), Greenwood, Hanson, and Jin (2016), Landvoigt (2016), Favilukis,

Ludvigson, and Van Nieuwerburgh (2017), and Bordalo, Gennaioli, and Shleifer (2018)).

DOI: 10.1111/jofi.12869

C2019 the American Finance Association

949

950 The Journal of Finance R

increasing overall household demand. The distinction between the two chan-

nels is important because the macroeconomic implications of a credit expansion

may differ depending on whether the expansion increases household demand

or productive capacity. For example, researchers have highlighted that a rise

in household debt is associated with a heightened risk of financial crisis and

a slowdown in economic growth (Jord`

a, Schularick, and Taylor (2016), Mian,

Sufi, and Verner (2017)).

This paper develops and empirically implements a test of whether the house-

hold demand channel is operative during a credit supply expansion. The basic

insight comes from Bahadir and Gumus (2016), who show that a credit expan-

sion operating through the household demand channel is inflationary in nature

and expands employment in the nontradable sector relative to the tradable sec-

tor. In contrast, a credit expansion operating through the productive capacity

channel has a negligible effect on the ratio of employment in the nontradable to

tradable sectors, and a more ambiguous effect on the relative price of nontrad-

able goods. As a result, empirical evaluation of employment and nominal price

patterns across the nontradable and tradable sectors can be used to highlight

the importance of the household demand channel. This study implements the

test using both a natural experiment in the United States in the 1980s and a

broader international panel of 56 countries with data going back to the 1960s.

To test for the presence of the household demand channel, an ideal natural

experiment would entail an exogenous shock to credit supply that could, in the-

ory, boost either household demand or productive capacity. The United States

in the 1980s provides such a setting. First, there was an aggregate expansion

in credit supply. The top panel in Figure 1shows that credit to GDP expanded

by 21.8 percentage points between 1982 and 1988, the largest growth in credit

during an expansionary cycle prior to the 2000s. The bottom panel of Figure 1

further shows that measures of the credit risk premium fell as the quantity of

credit increased; for example, the spread between corporate bonds rated BAA

and AAA fell by over 100 basis points. In addition, the share of high-yield corpo-

rate debt issuance increased from 14.6% to 56.1%. Taken together, a fall in the

credit spread and a rise in the high-yield share during an era of rapid overall

credit growth is a telltale sign of credit supply expansion (see, e.g., Greenwood

and Hanson (2013), Krishnamurthy and Muir (2017), and L´

opez-Salido, Stein,

and Zakrajˇ

sek (2017)).

Second, the effect of the aggregate credit supply expansion varied across

states based on the extent of deregulation in the state’s geographic restric-

tions on banking activity. Figure 2shows that growth in total bank credit

between 1982 and 1988 was on average 42 percentage points stronger in the

states that started deregulating their banking sector in 1983 or earlier com-

pared to the states that did not deregulate until after 1983. Credit growth in

early-deregulation states was broad-based, with large relative increases in the

household debt to income ratio, consumer credit, and mortgage applications.

Exploiting this variation across states, we show that the household demand

channel was an important channel through which the banking deregulation-

driven credit supply expansion affected the real economy during the 1980s.

How Does Credit Supply Expansion Affect the Real Economy? 951

Figure 1. Aggregate credit supply: Private credit to GDP, Baa-Aaa spread, and high-

yield share of corporate debt issuance. The top panel shows a time-series plot of the private

credit to GDP ratio. The bottom panel shows a time-series plot of the Baa-Aaa spread (left axis)

and the high-yield share (HYS) of corporate debt issuance from Greenwood and Hanson (2013)

(right axis). Shaded bars represent NBER recession dates. (Color figure can be viewed at wileyon-

linelibrary.com)