One of the more interesting research papers to come out recently has been "Credit Booms Gone Bust: Monetary Policy, Leverage Cycle, and Financial Crises 1870-2008" by Moritz Schularick and Alan Taylor. It can be found in the April 2012 American Economic Review. The paper tries to place the relationship between money and credit in context over the long-term.
This is a good extension of the book by Reinhart and Rogoff. This Time is Different. Reinhart and Rogoff talk about debt crises, but most of these crises are associated excessive credti expansion. If there is no credti expansion, there will not be a debt crisis later.
The main objective of the Schularick and Taylor paper is to try and determine the link between money, credit and output over the long-run across a broad number of countries. But looking at this link between credti expaniosn in the long-run is a problem of any infrequent events. There is just not that much information. This then plays out with financial crisese which are also rare events within a credit cycle. Hence, there has to be more work digging through the past to find the data necessary to make some generalizations.
This is a good extension of the book by Reinhart and Rogoff. This Time is Different. Reinhart and Rogoff talk about debt crises, but most of these crises are associated excessive credti expansion. If there is no credti expansion, there will not be a debt crisis later.
The main objective of the Schularick and Taylor paper is to try and determine the link between money, credit and output over the long-run across a broad number of countries. But looking at this link between credti expaniosn in the long-run is a problem of any infrequent events. There is just not that much information. This then plays out with financial crisese which are also rare events within a credit cycle. Hence, there has to be more work digging through the past to find the data necessary to make some generalizations.
Schularick and Taylor, through their analysis, are able to form a view that there have been "two eras of financial capitalism". The first era runs from 1870 until 1939. The second encompasses the post-WWII period. In the first era the relationship between money and credit was volatile but showed a stable relationship which also carried over to GDP. The would can be characterized by the "money view" which is consistent with the classic monetarist view of the link between money and output. This was the period studied by Friedman and Schawrtz in their classic A Monetary History of the United States. Monetarism is a function of the stable money relationship.
The second era or second period could be called "the ascension of credit". The link between money and credit broke down or more importantly, the amount of credit associated with any quantity of money increased. Credit was decoupled from money through the increased use of leverage and the development of financial intermediation outside of the banking system. This would also be the period when there was the development of the "credit view" toward banking whereby the impact of the credit transmission mechanism was independently important relative to the creation of money.
Between these two periods was the development of the "irrelevance view" toward banking where real economic decisions were independent of financial structure. This view, developed by Modigliani and Miller is consistent with ideas developed for corporate finance. This view was extreme with respect to money in that money would have nominal but nor real effects on an economy.
The view of the world that actually fits the facts is extremely important for policy makers and investors. The inflation target, monetarists, Taylor Rule, and Rational expectations would all to some degree come to the conclusion that credit transmission is not that important for central bankers. Of course, regulation of banks is necessary and tracking of credit is relevant, but it not something that should be explicitly controlled by central bankers. This would be the dominate school in the pre-2008 period. In reality, the transmission of credit is critical to economic growth. Under this view, central bankers have to spend time and effort on understanding the credit process.
More credit innovation lead to the growth of credit outside of money. More financial innovation further destroyed to close link between money and credit. The authors looked at financial crises in the two periods and found that the impact of credit crises had strong real effects during both periods. We have not been able to stop crises and their impact is real given the stronger role that credit plays in the economy. Lagging credit is a good predictor of financial crises. We live is a Minsky world. Regulators and central bankers have to accept this new world view and focus on credit expansion and not just money growth.
More credit innovation lead to the growth of credit outside of money. More financial innovation further destroyed to close link between money and credit. The authors looked at financial crises in the two periods and found that the impact of credit crises had strong real effects during both periods. We have not been able to stop crises and their impact is real given the stronger role that credit plays in the economy. Lagging credit is a good predictor of financial crises. We live is a Minsky world. Regulators and central bankers have to accept this new world view and focus on credit expansion and not just money growth.
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