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 –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

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 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 5

Credit and Crisis 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 10

Reaction to financial crises Source: Schularick/Taylor (2012)

Fiscal policy 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 19 th and early 20 th 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 16 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.