Vaughan / Economics 639 1. Research Questions What key stylized facts can be derived from long-run trends in money and credit aggregates? How have monetary.

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Vaughan / Economics 639

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Research Questions

• What key stylized facts can be derived from long-run trends in money and credit aggregates?

• How have monetary policy responses to financial crises changed over time?

• What role do credit and money play in financial crises?

Focus on long-run, cross-country evidence because financial crises are rare events.

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Research Strategy

• Use long-run, cross-country data set

• Time span: 1870 – 2008

• 14 developed countries (U.S., Canada, Australia, Denmark, France, Germany, Italy, Japan, the Netherlands, Norway, Spain, Sweden, Switzerland, and the United Kingdom)

• Core data series: credit series (annual data for bank loans and total balance sheet size of banking sector) and monetary aggregates (narrow money – M0, M1, broad money – M2, M3) – as well as nominal/real output, inflation, investment, and stock prices.

• Split sample at World War II.

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Key Data Series

Note:• Growth rates higher after WWII.• Bank loans/assets grow much faster than money after WWII.

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Money and Credit in Two Eras of Finance Capitalism

• First key stylized fact: two distinct eras (pre/post WWII)• Money/credit move together pre WWII, bank assets/loans grow faster post WWII.

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Implications

In sum…

• Ratio of credit to money remained broadly stable from 1870-1930. Since WWII, banks have grown loans relative to deposits, relying more on non-monetary liabilities.

This implies…

• Monetarism is problematic.

• Bank access to non-monetary funding more important to supply of credit.

• Central banks forced to intervene in funding markets during financial crises.

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Money, Credit, and Outputafter Financial Crisis

Note:• Higher overall growth of money and credit after WWII (“normal”). • Pre-WWII, money/credit dropped relative to trend significantly in

wake of financial crises; post WWII, dip barely discernible.

Years after crises

Based on 79 banking crises

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Money, Credit, and Outputafter Financial Crisis

Note:• Output/investment declines still significant after financial

crisis in post-WWII era.

Years after crises

Based on 79 banking crises

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Money, Credit, and Outputafter Financial Crisis

Based on 79 banking crises

Years after crises

Note:• Money growth/inflation higher overall after WWII (normal) • Money growth/inflation higher after WWII in wake of financial crises.

Overall Takeaway: More significant monetary policy response to financial crisis after WWII prevented significant deleveraging and potentially larger impact on real growth.

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Money vs. Credit as Predictorsof Financial Crises

• Dependent variable – probability of financial crisis.

• Real loans works well in terms of fit (pseudo R2) and predictive power (AUROC – area under receiver operating characteristic), both before and after WWII.

• Real broad money works reasonably well before WWII, but falls apart after WWII – much poorer fit and predictive power.

Takeaway:Real credit growth

is currently a much better predictor of

financial crises

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Robustness Tests

• Risk of financial crisis grows with higher credit-to-GDP ratio (i.e., larger, more complex financial systems may be inherently more at risk of financial crisis).

• Asset (stock) price booms/busts are more likely to cause financial crises in countries with a large sophisticated financial sector (proxied by credit-to-GDP ratio).

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Answers to Research Questions

• What key stylized facts can be derived from the long-run trends in money and credit aggregates?– Two financial eras – pre and post WWII

– Money and bank loans moved together prior to WWII; loans have grown faster than money since WWII.

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Answers to Research Questions

• How have the monetary policy responses to financial crises changed over time?– Since WWII, central banks have aggressively pumped up

the money supply following financial crises, which helped prevent deleveraging.Deflation (and debt deflation) were avoided.

– Real output declines following financial crises have not grown worse in post WWII era (might have been worse given more highly financialized economies, absent aggressive monetary policy response).

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Answers to Research Questions

• What role do credit and money play in financial crises?– Growth in real bank loans is a reliable predictor of

financial crises, even more so in the post WWII era.

TAKEAWAYS1. Results cast doubt on theory that “too easy” followed by “too

tight” monetary policy were responsible for financial crisis-cum-recession and anemic recovery.

2. U.S. financial crisis was predictable because of run-up in credit.