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 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. 2

Research Strategy Use long-run, cross-country data set Time span: 1870 – 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. 3

Key Data Series Note: Growth rates higher after WWII. Bank loans/assets grow much faster than money after WWII. 4

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. 5

Implications In sum… Ratio of credit to money remained broadly stable from 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. 6

Money, Credit, and Output after 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 7

Money, Credit, and Output after Financial Crisis Note: Output/investment declines still significant after financial crisis in post-WWII era. Years after crises Based on 79 banking crises 8

Money, Credit, and Output after 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. 9

Money vs. Credit as Predictors of Financial Crises Dependent variable – probability of financial crisis. Real loans works well in terms of fit (pseudo R 2 ) 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. 10 Takeaway: Real credit growth is currently a much better predictor of financial crises

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). 11

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. 12

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). 13

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. 14 TAKEAWAYS 1.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.