The crisis of 2008-09 has focused attention on money and credit fluctuations, financial crises, and policy responses. In this paper we study the behavior of money, credit, and macroeconomic indicators over the long run based on a newly constructed historical dataset for 12 developed countries over the years 1870-2008, utilizing the data to study rare events associated with financial crisis episodes. We present new evidence that leverage in the financial sector has increased strongly in the second half of the twentieth century as shown by a decoupling of money and credit aggregates, and we also find a decline in safe assets on banks' balance sheets. We also show for the first time how monetary policy responses to financial crises have been more aggressive post-1945, but how despite these policies the output costs of crises have remained large. Importantly, we can also show that credit growth is a powerful predictor of financial crises, suggesting that such crises are

Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008

Recent tests for the convergence hypothesis derive from regressing average growth rates on initial levels: a negative initial coefficient is interpreted as convergence. These tests turn out to be plagued by Galton's classical fallacy of regression towards the mean. Using a dynamic version of Galton's fallacy, I establish that coefficients of arbitrary signs in such regressions are consistent with an unchanging cross-section distribution of incomes. Alternative, more direct empirics used here show a tendency for divergence, rather than convergence, of cross-country incomes.

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Galton's fallacy and tests of the convergence hypothesis

Econometric policy evaluation: A critique

In this paper, we document a structural break in the volatility of U.S. GDP growth in the first quarter of 1984 and provide evidence that this break emanates from a reduction in the volatility of durable goods production. Further, the reduction in durables volatility corresponds to a decline in the share of durable goods accounted for by inventories. We find no evidence of increased stability in the nondurables, services or structures sectors of the economy. Our evidence is compatible with a scenario in which changes in inventory management techniques in the durable goods sector have reduced the variability of aggregate output.

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Output Fluctuations in the United States: What Has Changed since the Early 1980's?

This paper argues that financial imbalances can build up in a low inflation environment and that in some circumstances it is appropriate for policy to respond to contain these imbalances. While identifying financial imbalances ex ante can be difficult, this paper presents empirical evidence that it is not impossible. In particular, sustained rapid credit growth combined with large increases in asset prices appears to increase the probability of an episode of financial instability. The paper also argues that while low and stable inflation promotes financial stability, it also increases the likelihood that excess demand pressures show up first in credit aggregates and asset prices, rather than in goods and services prices. Accordingly, in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability.

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Asset prices, financial and monetary stability: exploring the nexus

In recent decades, developments in the financial sector have played a major role in shaping macroeconomic outcomes in a wide range of countries. Financial developments have reinforced the momentum of underlying economic cycles, and in some cases have led to extreme swings in economic activity and a complete breakdown in the normal linkages between savers and investors. These experiences have led to concerns that the financial system is excessively procyclical, unnecessarily amplifying swings in the real economy. In turn, these concerns have prompted calls for changes in prudential regulation, accounting standards, risk measurement practices and the conduct of monetary policy in an attempt to enhance both financial system and macroeconomic stability.

Procyclicality of the financial system and financial stability: Issues and policy options

Procyclicality of the financial system and financial stability: issues and policy options

Over the last two decades, banking crises have become more frequent and severe in both emerging market and industrial countries.2 Their cost in terms of output lost has been high, typically double digit percentages of GDP. For this reason, considerable efforts have been made recently to develop “early warning indicators” of crises that could allow policymakers to take remedial action in a more timely fashion. This special feature proposes a set of forward-looking indicators of banking distress. As in Borio and Lowe (2002) we argue that it may be possible recognise the build-up of one set of vulnerabilities that foreshadows banking distress with a reasonable degree of confidence, although the exact timing of the crises remains unpredictable. The corresponding indicators draw exclusively on ex ante information, are based on the interaction among a small set of variables, focus on the cumulative processes giving rise to distress and allow for variable horizons. Here we extend our previous work, which had mainly considered credit aggregate and asset prices, by examining the information contained in real exchange rate appreciations and the relative performance of indicators in industrial and emerging market countries. In the first section of this article we briefly discuss the origins of banking crises. In the second we motivate the choice of indicators and assess their performance. In the concluding section we note some caveats to the analysis and suggest areas for future work.

Assessing the risk of banking crises

In this paper we develop a theoretical framework that helps to analyse the role of monetary policy in responding to asset-price bubbles. A large and rapid fall in the nominal price of assets that form the basis of collateral for loans from financial intermediaries can have adverse effects on financial system stability. This asymmetric effect of asset price changes, by reducing the extent of intermediated finance, can reduce output below potential and keep inflation below the central bank’s target for extended periods. We demonstrate that there may be circumstances where monetary policy should be tightened in response to an emerging asset-price bubble, in order to burst the bubble before it becomes too large, even though this means that expected inflation is below target in the short run. Such a policy is optimal because it can help to avoid extreme longer-term effects of a larger asset-price bubble and its eventual collapse. In principle, the adverse effects of asset-price bubbles on financial system stability can be moderated through appropriate financial system regulation and supervision. Nevertheless, provided that the effects of asset-price bubbles on the economy are not entirely eliminated, a role for monetary policy may remain.

Philip Lowe

Papers

Asset prices, financial and monetary stability: exploring the nexus

Procyclicality of the financial system and financial stability: Issues and policy options

Procyclicality of the financial system and financial stability: issues and policy options

Assessing the risk of banking crises

Asset-price bubbles and monetary policy