With all eyes currently on the latest twists being played out in the Eurozone, the global financial crisis, now in its fifth year, appears alive and well. But there is still little agreement on the underlying macroeconomic causes of the build-up of financial imbalances that unwound so dramatically since the summer of the 2007.
Some blame central bankers for keeping policy rates ‘too low for too long’ in the early part of the last decade (eg Taylor 2007 and White 2009). According to this view, in the US, the Federal Reserve had cut rates sharply in response to the collapse of the stock market boom of the 1990s and then kept rates low into 2004, thereby sowing the seeds of the subsequent boom and bust. The European version of this argument is that low real short-term rates implied by the ECB’s one-size-fits-all monetary policy fuelled rapid credit extension and house-price bubbles in peripheral countries, such as Ireland and Spain, that would have benefitted from tighter monetary policy (eg Ahearne et al 2008).
Others (eg Bernanke 2010 and King 2010) point to rapidly increasing global financial flows in the early part of the decade, which resulted in part from growing current-account imbalances (‘global imbalances’). According to this explanation, a number of countries, including the US, Spain, Ireland, Portugal, and Greece ran unusually wide current-account deficits that were funded by the surplus countries (emerging Asia and Germany), thereby setting off strong cross-border capital flows (Suominen 2010). Proponents of this view argue that it was these flows that led to falling long-term yields in recipient countries, stimulating demand for credit in these countries even as policymakers started to tighten short-term rates.
Who is right? As a first pass, Figures 1–3 document:
- Policy rates that hovered below Taylor rates for much of the early part of the decade, on average for the OECD,
- The increasing dispersion of current-account imbalances, and
- The striking compression of the spread between long rates and short rates, across the OECD, especially since 2004.
Figure 1. Average OECD country monetary-policy stance (1999–2007)
Source: Ahrend et al (2008).
Note: This chart plots the average monetary-policy stance across OECD countries during 1999–2007. The monetary-policy stance is measured as the policy rate deviation from the Taylor rule benchmark.
Figure 2. Dispersion of current-account balances among OECD countries (1999–2007)
Source: Authors’ calculations using the IMF IFS statistics.
Note: This chart plots the cross-sectional dispersion of current accounts across OECD countries, as measured by its standard deviation.
Figure 3. Average long-term short-term spread, OECD countries (1999–2007)
Source: Authors’ calculations from the OECD SourceDatabase.
Note: This chart plots the average long-term short-term spread across OECD countries. The long-term rate is the ten-year government bond rate. The short-term rate is the three-month rate.
While these charts are suggestive that both explanations might have merit, more rigorous examination is needed to clarify the extent to which monetary policy on the one hand and growing global imbalances on the other might have played a role in fuelling the build-up of financial sector imbalances ahead of the crisis.
Our research (Merrouche and Nier 2011) does just that. Specifically, it examines whether differences in the time path of these variables across countries result in differences in the time path of various measures of financial imbalances in OECD countries over the 1999–2007 period.
The most comprehensive to date, our analysis employs a range of empirical measures to ensure the robustness of our findings.
Our main, and standard, measure of the monetary-policy stance is the deviation of the policy rate from the rate suggested by a contemporaneous Taylor rule. In addition, we look at the length of time that the policy rate has stayed below the Taylor rate, to capture the phenomenon of rates that were ‘too low for too long’, as well as simpler measures, such as the real short-term rate.
Our primary measure of the global imbalances hypothesis is a country’s current account as a share of GDP. This measure is used as a proxy for net capital flows, where a current-account deficit corresponds to net capital inflows. We also employ the spread between long rates and short rates as an alternative measure. Indeed we show empirically that (lagged) capital inflows are the main driver of this spread.
Since there is no universally accepted empirical measure of ‘financial imbalances’, we employ a range of measures. First, we use the ratio of banking-sector credit to core deposits. This captures well an increased reliance by intermediaries on volatile wholesale funding to expand their balance sheet ahead of the crisis, as documented in Figure 4. Moreover, recent independent research by Caprio et al documents that the ratio of credit to deposits is highly predictive of whether a country suffered a systemic crisis in 2008. In addition, we use a range of alternative indicators, including the ratio of credit to GDP, the ratio of household debt to GDP, and house-price appreciation.
Figure 4. Ratio of bank credit to bank deposits, average across OECD countries (1999–2007)
Source: Authors’ calculations from the World Bank Financial Development and Structure Database (2008).
Note: This chart plots the average ratio of bank credit to deposits across OECD countries.
Finally, since macroeconomic developments are likely to have interacted with weak supervision of the financial sector ahead of the crisis, we employ measures of the strength of supervision and regulation, sourced from a World Bank database. This allows for a powerful test, since we would expect a strong interaction between the strength of supervision and potential macroeconomic drivers only where the macroeconomic factor was causal for the build-up.
This empirical analysis yields the following key results:
- We find that cross-country differences in net capital inflows can account for differences between countries in the build-up of financial imbalances, as measured by the ratio of banking-sector credit to core deposits. By contrast we do not find that differences in the monetary-policy stance had an effect on the build-up of financial imbalances when capital flows are accounted for.
- We further document that the compression of the spread between long rates and short rates was an important mechanism through which rising global imbalances had an effect on the balance-sheet expansion sourced in wholesale funding markets. Where long rates declined more relative to short rates banks appear to have taken on extra leverage.
- The strength of the build-up was not driven by macroeconomic factors alone. It was less pronounced where supervisory and resolution powers were relatively strong. Indeed we find that strong supervisory powers have tended to dampen the effect of capital inflows and falling long-term rates on the expansion of bank balance sheets ahead of the crisis.
- Our main findings on the relative importance of external imbalances versus monetary policy carry through when we employ alternative measures of financial imbalances, including the ratio of credit to GDP, the ratio of household debt to GDP, and the increase in house prices over the period. In each case, the strength of net capital inflows, rather than the monetary-policy stance, re-emerges as the key determinant of differences in the growth of financial imbalances across OECD countries over the pre-crisis period.
Overall, our findings lend strong support to the conjecture that “[c]apital flows provided the fuel which the developed world’s inadequately designed and regulated financial system then ignited to produce the firestorm that engulfed us all” (King 2010).
Our findings also have important implications for policy. They underscore the importance of a concerted effort to encourage a rebalancing of the global economy, as is being discussed by the G20. They also point to the need for stronger prudential control of the financial system. In particular, inadequate prudential policies failed to address systemic vulnerabilities associated with excessive use of wholesale funding. Finally, we document that the period ahead the crisis coincided with low policy rates globally. However, we provide comprehensive evidence that sizable differences in the path of monetary policy across countries did not appear to affect the strength of the build-up of financial imbalances. This cautions against a major re-orientation of monetary-policy frameworks in response to the crisis.
Author's Note: The views expressed in this column are those of the authors and should not be attributed to the IMF, its Executive Board or its management.
Ahearne, Alan, Juan Delgado, and Jakob von Weizsaecker (2008), “How to prick local housing bubbles in a monetary union: Regulation and countercyclical taxes”, Vox EU.org, 27 June.
Bernanke, Ben S (2010), “Monetary Policy and the Housing Bubble”, Remarks at the Annual Meeting of the American Economic Association, 3 January, Atlanta, Georgia.
Caprio, Gerard, Jr, Vincenzo D’Apice, Giovanni Ferri and Giovanni Walter Puopolo (2011), “Macro Financial Determinants of the Great Financial Crisis: Implications for Financial Regulation”. Available at SSRN.
King, Mervyn (2010), Speech at the University of Exeter, 19 January.
Merrouche, Ouarda and Erlend Nier (2011), “What Caused the Global Financial Crisis?—Evidence on the Drivers of Financial Imbalances 1999–2007”, IMF Working Paper 10/ 265, December.
Suominen, Kati (2010), “Did global imbalances cause the crisis?”, VoxEU.org, 14 June.
Taylor, John B (2007), “Housing and Monetary Policy”, Federal Reserve Bank of Kansas City, 2007 Symposium.
White, William R (2009), “Should Monetary Policy “Lean or Clean?”, Globalization and Monetary Policy Institute Working Paper, Federal Reserve Bank of Dallas.