1. UNSW Research Fair 2018: An Historical Analysis of Financial Crises and Low Interest Rates
Tristan Truuvert – UNSW School of Economics Honours Program
Lessons from Tailoring a Taylor Rule
Do low interest rates increase the risk of a financial crisis?
What qualifies as a ‘low’ interest rate?
Created a Taylor Rule (1999) as a benchmark policy rate and compared whether short term interest rates were below this baseline in absolute and relative terms.
𝑅 𝑡 = 𝑟 𝑡 + 𝜋 𝑡 + 𝛼 𝜋 𝜋 𝑡 − 𝜋 𝑡 + 𝛼 𝑦 𝑦 𝑡 − 𝑦 𝑡
What qualifies as a ‘financial crisis’?
Focused primarily on banking crises which occur as capital in the aggregate domestic banking system is almost completely eroded. These are traditionally linked with credit growth and interest rates.
Data & Methods
Data drawn from the Jorda-Schularick-Taylor Macrohistory Database (2018). Particular attention was paid to the following economies;
i) Small, open colonial economies: Australia & Canada
ii) Small, open Nordic economies: Sweden, Norway & Denmark
iii) Large, open economies: France, the UK & the US
Identified 30 economic crises occurring in each and added an additional 12 from the historical record.
Utilised a country-fixed effects logit model to determine the risk of a crisis occurring in an economy at a given point in time given five-year lags of credit growth and ‘low’ rates;
𝑃𝑟 𝐶𝑟𝑖𝑠𝑖 𝑠 𝑖𝑡 =1 = 𝛽 0𝑖 + 𝛽 1 𝐿 𝛥 𝑙𝑛 𝐶𝑟𝑒𝑑𝑖 𝑡 𝑖𝑡 + 𝛽 2 𝐿 𝐿𝑜𝑤 𝑅𝑎𝑡𝑒 𝑖𝑡 + 𝜇 𝑖 + ℰ 𝑖𝑡 a
Econometric Analysis
Regression of the baseline model indicates that excessive credit growth one and two years prior increases the risk of a financial crisis. A ‘low’ interest rate four years prior to a crisis increases the risk of a crisis by a similar margin, but a ‘low’ rate one year prior actually decreases the risk of a crisis.
Results are robust to a number of variations such a;
Altering the Taylor Rule to include empirical values for the inflation target & responsiveness coefficients.
Using a variation of the Taylor Rule for small, open economies that includes real exchange rates.
Redefining ‘low’ interest rates as those at least one or two standard deviations below the Taylor Rule.
Inclusion of covariates such as trade balances, government deficits and international credit flow.
Separation into each of the three sub-samples.
Country
Gold Standard,
Interwar Float,
Bretton Woods,
Monetary Targeting,
Inflation Targeting,
Australia
1893, 1930* -
1989
Canada
1873*, 1907, 1913*, 1923*
1983*
Sweden
1878*, 1907, 1922
1931
1991, 1992*
2008
Norway
1899, 1922
1988, 1992*
Denmark
1877, 1885, 1908, 1921
1984*, 1987 UK
1890, 1914*
1931*
1974, 1982, 1991
2007
France
1882, 1889, 1930 US
1873, 1884*, 1893, 1907, 1929
1984
Variable
Logit Fixed Effects, Scaled
Credit Growth (T-1)
1.797*** (0.516)
Credit Growth (T-2)
1.118*** (0.435)
Credit Growth (T-3)
0.229 (0.540)
Credit Growth (T-4)
(0.541)
Credit Growth (T-5)
2.032 (1.386)
‘Low’ Rate (T-1)
-1.764*** (0.596)
‘Low’ Rate (T-2)
(0.495)
‘Low’ Rate (T-3)
0.278 (0.483)
‘Low’ Rate (T-4)
1.595*** (0.622)
‘Low’ Rate (T-5)
(0.461)
LR Credit Growth
4.595*** (1.414)
LR ‘Low’ Rates
(0.100)
Discussion & Conclusions
Central results are relatively surprising;
Theories of credit proposed by Minsky and Fisher appear empirically valid as excessive credit growth is fuelled by the banking system rather than interest rates.
There are only marginal long run relationships between short term interest rates and the Taylor residual in most of the economies explored.
Systemic financial risk of deviating from a Taylor Rule appear minimal, monetary policy discretion appears to have an advantage.
Concerns relating to ‘low’ rates remains a contextual concern and policy management should primarily focus on managing credit growth.
Only instances where theses results do not hold are when one assumes central bankers are completely backward-looking and do not anticipate future changes.
Motivation & Contribution
Examines the role of the cash rate as an economic tool. Particularly relevant given economic policy over the past decade.
Is modern reliance on interest rates as the dominant policy instrument problematic?
What are the implications of low interest rate environments?
Are policy prescriptions themselves harmful?
Explores a gap in the literature and conducts analysis across eight countries over a time period that is generally observed episodically.
References
Bordo, M.,Eichengreen B., Klingebiel D. & Martinez–Peria M. 2001, ‘Is the crisis problem growing more severe?’ Economic Policy: A European Forum, vol. 32, pp ; Bordo, M. & Schwartz, A. 1997, ‘Monetary policy regimes and economic performance: the historical record’, NBER Working Paper no 6201; Muller, U. & Watson, M. 2017, ‘Long-run covariability’, NBER working paper, Princeton University; Schularick, M. & Taylor A.M. 2012, ‘Credit booms gone bust: monetary policy, leverage cycles, and financial crises, ’, American Economic Review, vol. 102, no. 2, pp ; Taylor, J. 1993, ‘Discretion versus policy rules in practice’, Carnegie-Rochester Conference Series on Public Policy, vol. 39, pp