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 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
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79 systemic financial crises
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4
2
0
frequency
8
10
Frequency of Financial Crises, 1870-2010
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
3
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
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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
5
Credit and Crisis
UK: Bank loans (% of GDP) and financial crises
1.2
1
0.8
0.6
0.4
0.2
Source: Schularick and Taylor (2012)
2006
1999
1992
1985
1978
1971
1964
1957
1950
1943
1936
1929
1922
1915
1908
1901
1894
1887
1880
0
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
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.
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The Great Leveraging
Source: Schularick/Taylor (2012)
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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
• 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.
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