Working Paper: CEPR ID: DP7507
Authors: Wouter Den Haan; Vincent Sterk
Abstract: Financial innovation is widely believed to be at least partly responsible for the recent financial crisis. At the same time, there are empirical and theoretical arguments that support the view that changes in financial markets played a role in the "great moderation". If both are true, then the price of reducing the likelihood of another crisis, e.g., through new regulation, could be giving up another episode of sustained growth and low volatility. However, this paper questions empirical evidence supporting the view that innovation in consumer credit and home mortgages reduced cyclical variations of key economic variables. We find that especially the behaviour of aggregate home mortgages changed less during the great moderation than is typically believed. For example, aggregate home mortgages declined during monetary tightenings, both before and during the great moderation. A remarkable change we do find is that monetary tightenings became episodes during which financial institutions other than banks increased their holdings in mortgages. Once can question the desirability of such strong substitutions of ownership during economic downturns.
Keywords: consumer credit; impulse response functions; mortgages
JEL Codes: E32; E44; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial innovation (G29) | Great Moderation (E65) |
| Financial innovation (G29) | Reduced frictions in lending (G21) |
| Great Moderation (E65) | Reduced impact of economic shocks (F69) |
| Monetary tightening (E52) | Expected reductions in home mortgages (G21) |
| Monetary tightening (E52) | Expected reductions in consumer credit (G51) |
| Shifts in ownership of mortgages (G21) | Economic stability concerns (E60) |
| Improved monetary policy (E52) | Great Moderation (E65) |
| Flexible labor markets (J46) | Great Moderation (E65) |