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The 2008 financial crisis was a seismic event that laid bare how financial institutions' instabilities can have devastating effects on societies and economies. COVID-19 brought similar financial devastation at the beginning of 2020 and once more massive interventions by central banks were needed to heed off the collapse of the financial system. All of which begs the question: why is our financial system so fragile and vulnerable that it needs government support so often? For a generation of economists who have risen to prominence since 2008, these events have defined not only how they view financial instability, but financial markets more broadly. 'Leveraged' brings together these voices to take stock of what we have learned about the costs and causes of financial fragility and to offer a new canonical framework for understanding it.
BUSINESS & ECONOMICS / Economic Conditions. --- BUSINESS & ECONOMICS / Economics / Macroeconomics. --- Capital market. --- Debt. --- Finance. --- Financial crises. --- Risk. --- Finance --- Capital market --- Debt --- Risk --- Financial crises --- Money market. Capital market --- Private finance --- E-books
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The crisis of 2008–09 has focused attention on money and credit fluctuations, financial crises, and policy responses. In this paper we study the behavior of money, credit, and macroeconomic indicators over the long run based on a newly constructed historical dataset for 12 developed countries over the years 1870– 2008, utilizing the data to study rare events associated with financial crisis episodes. We present new evidence that leverage in the financial sector has increased strongly in the second half of the twentieth century as shown by a decoupling of money and credit aggregates, and we also find a decline in safe assets on banks' balance sheets. We also show for the first time how monetary policy responses to financial crises have been more aggressive post-1945, but how despite these policies the output costs of crises have remained large. Importantly, we can also show that credit growth is a powerful predictor of financial crises, suggesting that such crises are “credit booms gone wrong” and that policymakers ignore credit at their peril. It is only with the long-run comparative data assembled for this paper that these patterns can be seen clearly.
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Do external imbalances increase the risk of financial crises? In this paper, we study the experience of 14 developed countries over 140 years (1870-2008). We exploit our long-run dataset in a number of different ways. First, we apply new statistical tools to describe the temporal and spatial patterns of crises and identify five episodes of global financial instability in the past 140 years. Second, we study the macroeconomic dynamics before crises and show that credit growth tends to be elevated and natural interest rates depressed in the run-up to global financial crises. Third, we show that recessions associated with crises lead to deeper recessions and stronger turnarounds in imbalances than during normal recessions. Finally, we ask if external imbalances help predict financial crises. Our overall result is that credit growth emerges as the single best predictor of financial instability, but the correlation between lending booms and current account imbalances has grown much tighter in recent decades.
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This paper studies the role of leverage in the business cycle. Based on a study of nearly 200 recession episodes in 14 advanced countries between 1870 and 2008, we document a new stylized fact of the modern business cycle: more credit-intensive booms tend to be followed by deeper recessions and slower recoveries. We find a close relationship between the rate of credit growth relative to GDP in the expansion phase and the severity of the subsequent recession. We use local projection methods to study how leverage impacts the behavior of key macroeconomic variables such as investment, lending, interest rates, and inflation. The effects of leverage are particularly pronounced in recessions that coincide with financial crises, but are also distinctly present in normal cycles. The stylized facts we uncover lend support to the idea that financial factors play an important role in the modern business cycle.
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