Instability in Financial Markets: Sources and Remedies

The View from Economic History

Institute for New Economic Thinking Annual Conference 2012 Moritz Schularick Free University of Berlin

The View from History

Joint work with scar Jord and Alan Taylor
Systematic study of financial instablity in 14 advanced economies from 1870-2008 Details in Jord, Schularick, Taylor (2011a,b); Schularick/Taylor (2012) INET grant: more research forthcoming

New research in macroeconomic history

Reinhart and Rogoff have catalogued panel data on public debt and the link to economic performance Focus in our research is on private sector credit and its interaction with the macroeconomy
2

79 systemic financial crises

8 10

Frequency of Financial Crises, 1870-2010

frequency

0
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 year
Note: number of countries in crisis; sample of 14 countries

Three Points
1. Crises are typically credit booms gone bust 2. Changing policy responses (monetary and fiscal) to financial crises 3. Some tentative conclusions about remedies

Crises as Credit Booms Gone Bust

Acceleration of credit growth is the best early warning signal for crises
Schularick and Taylor (2012) Proximate vs. fundamental causes

Role of current account imbalances less clear cut

Jord, Schularick and Taylor (2011a)

Important information from credit trends that pure inflation targeting CB would miss

Credit and Crisis

UK: Bank loans (% of GDP) and financial crises
1.2 1 0.8 0.6 0.4 0.2 0

1880

1887

1894

1901

1908

1915

1922

1929

1936

1943

1950

1957

1964

1971

1978

1985

1992

1999

Source: Schularick and Taylor (2012)

2006

Baseline Model

Baseline Model ROC curve

Current Account

Source: Jorda, Schularick and Taylor (2011a)

Policy Responses
Dramatic differences in the policy responses to financial crises pre and post WWII
Clearly visible for both monetary and fiscal policy Lessons from the Great Depression learned

But policy parachute may have contributed to the dramatics build-up in leverage Real costs of financial crises have remained high despite more active policy

10

Reaction to financial crises

Source: Schularick/Taylor (2012)

Fiscal policy
Table 1: Cumulative Effects of Financial Crises Cumulative log level increase of public debt to GDP 5 years after crisis, vs. non crisis-trend Standard Coefficient error t-value All years 0.13*** 0.04 3.08 Pre-WWII 0.03 0.06 0.53 Post-WWII 0.31*** 0.07 4.15 Post-1975 0.32*** 0.07 4.61 Post-1975 and large financial sector 0.48*** 0.13 3.73 Note: Regression includes country fixed effects and a common time trend. *** Denotes significance at the 99% level.

12

The Great Leveraging

Source: Schularick/Taylor (2012)

13

Real Costs of Crises Remain High

Source: Jorda, Schularick and Taylor (2011b)

Remedies I
Some skepticism warranted. Historically, crises have occurred
when capital ratios were high as in the 19th and early 20th century. under gold standard and fiat money. with and without central banks. under fixed and floating exchange rates. with or without current account deficits.

Wholesale funding has brought new risks

Regulatory arbitrage was a driver, needs to be fixed
15

Remedies II
Policy frameworks such that rely on strong priors about the stability and rationality of financial markets are problematic. By neglecting finance inflation targeting has arguably contributed to the size of the recent credit bubble. Discretion and wariness instead of rules and benign neglect.

16