When financial crises are predictable…
Greenwood and al. estimate the probability of financial crises as a function of past credit and asset price growth. In particular, they use the historical chronology of financial crises developed by Baron, Verner, and Xiong (BVX 2020) to construct an indicator variable called the Red zone (R-zone) that identifies periods of potential credit-market overheating. They find:
- The probability of a crisis at a 1-year horizon is 13% if a country is in the business R-Zone, a substantial increase over the unconditional probability of 4%. The comparable 1-year probability is 14% if a country is in the household R-zone—i.e., if household credit growth and home price growth are jointly elevated.
- The degree of predictability increases dramatically with horizon: the probability of experiencing a financial crisis within the next three years is 45% for countries that are in the business R-zone, and 37% for countries in the household R-zone.
- Most importantly, even after entering the R-zone, crises are slow to develop, suggesting that policymakers have time to act based on early warning signs.
Predictable Financial Crises
Authors: Robin Greenwood, Samuel G. Hanson, Andrei Shleifer, Jakob Ahm Sørensen
From: Harvard University, Copenhagen Business School
…”lean against the wind” policies should be favored
What should policymakers do to mitigate a Minsky cycle? To answer this question, Fahri and Werning build a stylized three-period model of a Minsky cycle with two classes of agents: borrowers and savers. Borrowers borrow from savers to finance the purchase of a risky asset. Their model shows that:
- With rational expectations or extrapolative expectations during the boom, if macroprudential policy is available, it is optimal to deal with financial stability using macroprudential policy and to let monetary policy deal with macroeconomic stability. It is only when macroprudential policy is not available that monetary policy must be willing to trade off macroeconomic and financial stability.
- With extrapolative expectations during the bust, this assignment of targets to instruments breaks down. Even when macroprudential policy is available, monetary policy must be conducted with an eye towards financial stability instead of focusing exclusively on macroeconomic stability. In this setting, financial stability becomes a multidimensional target influenced by leverage and beliefs/asset prices.
Taming a Minsky Cycle
Authors: Emmanuel Farhi, Ivan Werning
From: Harvard University, MIT
*The picture of this newsletter is by Robert Hanson and first appeared on the Economist.
