How do we know when a boom is bad? 

We’ve all heard about good cholesterol and bad cholesterol. Too much of the good stuff probably won’t do you any harm. Too much of the bad stuff can lead to a heart attack.

The same idea applies to credit booms—periods when the amount of borrowing and lending in the economy rises very quickly. Slower economic growth or even a recession can follow a bad boom. Telling these two types apart in real time may help policymakers put the brakes on a bad boom before it’s too late.

Some investors assume that the good times will never end.

The Chart of the Week shows the impact of a bad boom on economic growth in the years that follow. But before we delve into the details, we should ask a basic question: what makes for a bad boom?

The answer: it is fueled by excessive optimism among investors. When the economy is doing well and everybody seems to be making money, some investors assume that the good times will never end. They take on more risk than they can reasonably expect to handle.

So how can we tell when risk-taking is getting out of hand? One way is to look at the riskiness of credit allocation, the subject of a recent blog based on the IMF’s April 2018 Global Financial Stability Report. Our research showed that when credit grows rapidly, the firms where debt expands faster become increasingly risky in relation to those with the slowest debt expansions, posing downside risks to growth down the road.

Another method is to look at the bond market to see how much of the money companies and governments are borrowing consists of high-yield debt, also known as junk bonds. (These are bonds that offer higher yields to make up for the greater risk of default by the borrower.) The larger the proportion of high-yield debt, the higher the level of risk in the financial system.

More junk

To help predict how bad booms might affect growth, we looked at data on debt issued by governments and non-financial companies in 25 advanced economies. We defined a boom as a period of faster-than-normal growth in credit relative to GDP. Then we looked at how much of the credit growth consisted of high-yield debt.

Our conclusion: credit booms marked by a rising share of junk bonds were followed by lower economic growth over the following three to four years. When the high yield share of debt rises by one standard deviation—a statistical measure of how much one number differs from the average in a set of numbers—GDP growth over the next three years is lower by 2 percentage points.

The result suggests that when credit is growing quickly, policymakers should pay attention to how much of that growth is allocated to riskier firms, such as those that issue high-yield debt. While we need more research on this topic, steps to fix the problem may include higher capital requirements and other measures to restrain credit growth and tighten lending standards more broadly.