Instability in Financial Markets: Sources and Remedies

The View from Economic HistoryInstitute for New Economic Thinking

Annual Conference 2012

Moritz SchularickFree University of Berlin

The View from History• Joint work with Òscar Jordà and Alan Taylor

– Systematic study of financial instablity in 14 advanced economies from 1870-2008

– Details in Jordà, 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

3

02

46

81

0

freq

ue

ncy

1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010year

Note: number of countries in crisis; sample of 14 countries

Frequency of Financial Crises, 1870-2010

Three Points1. Crises are typically credit booms gone bust

2. Changing policy responses (monetary and fiscal) to financial crises

3. Some tentative conclusions about remedies

4

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 – Jordà, Schularick and Taylor (2011a)

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

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Credit and Crisis

0

0.2

0.4

0.6

0.8

1

1.21880

1887

1894

1901

1908

1915

1922

1929

1936

1943

1950

1957

1964

1971

1978

1985

1992

1999

2006

UK: Bank loans (% of GDP) and financial crises

Source: Schularick and Taylor (2012)

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

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Reaction to financial crises

Source: Schularick/Taylor (2012)

Fiscal policy

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Table 1: Cumulative Effects of Financial Crises Cumulative log level increase of public debt to GDP 5 years after crisis, vs. non

crisis-trend

Coefficient Standard

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.

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

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Remedies II

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• 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.