MONETARY REGIMES: New evidence of the impact on financial stability since 1920

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Date:
29 Mar 2017

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New research by German Forero-Laverde, to be presented at the Economic History Society’s 2017 annual conference, examines a key factor in the frequency and intensity of booms and busts in stock and credit markets: the ‘rules of the game’ – the idea that different monetary regimes endow the financial system with varying levels of elasticity, allowing for imbalances to accumulate in the form of booms and unwind in the form of crises at different rates and intensity. He concludes that: 

  • First, there is a role for the monetary regime in the evolution of asset prices and credit. 
  • Second, some sort of currency peg, with commitments to exchange rate stability and capital controls, favours financial stability both in the short and long run. Stricter pegs are favourable for controlling stock market booms but increase both short- and medium-run volatility of credit growth. 
  • Finally, a nominal anchor of the currency, through the gold exchange standard or the European Monetary Union, appears to be insufficient in generating financial stability as they coincide with booms and heightened volatility in stock and credit markets. 

More… 

The author explains the findings in more detail: 

Financial crises come in many shapes and forms. They can occur in stock markets, private or public debt markets, housing markets or any asset class you can think of (yes, even tulips). Attempts to predict the timing and asset class where the next crisis will raise its ugly head have been unsuccessful in part due to the amount and diversity of forces at play. The veil of uncertainty that surrounds them and the negative effect they have on long-run economic growth makes the study of crises both pertinent and challenging. 

My research, to be presented at the 2017 EHS annual conference, studies one possible factor that may be related to the frequency and intensity of booms and busts in stock and credit markets: the ‘rules of the game’. 

I study the possibility that the monetary regime, competing decisions on monetary policy, exchange rates and capital flows, is related to the evolution of financial aggregates to different time horizons. The underlying idea, following the work of the Bank for International Settlements, is that different regimes endow the financial system with varying levels of elasticity, allowing for imbalances to accumulate in the form of booms and unwind in the form of crises at different rates and intensity. 

This is a stepping stone on the road to answering a question that has troubled policy-makers for over a century: should authorities and regulators intervene in the market trying to anticipate crises; or is the best course of action to react once crises ensue? If regimes do play a role, and the channels of accumulation of imbalances are contingent on the institutions at play, it is possible that authorities may have a wider array of tools at their disposal to avoid the accumulation of financial stability. 

I develop three new measures for the evolution of the stock market and credit aggregates since 1922 for France, Germany, Italy, the Netherlands, Sweden and the UK. The new measures – Boom Bust Indicators (BBIs) – result from a variation on my earlier work, and allow me to characterise booms and busts depending on their effects to different horizons: explosive ones affect the short-run (up to one year); expansive ones have an effect up to the third year; and pervasive ones show effects after five years. 

BBIs complement what has been traditionally done in the financial crisis literature. They depart from decomposition techniques such as spectral analysis in that they use all the information in the original series instead of extracting part of the data. They depart from turning point analysis and other crises dating techniques since the outcome is a triplet of continuous series instead of a summary sequence of dates for booms and crashes. They complement measures like the severity index, which pays unduly little attention to explosive booms and busts to the benefit of lengthier events. Finally, the measures allow for comparisons across countries and time. 

I study the evolution of BBIs for credit and stock markets under five different regimes: the gold exchange standard (GES), the fixed peg rate of Bretton Woods (PEG), the managed float of the Exchange Rate Mechanism (MF), the periods of free floatation (FF) and the European Monetary Union (EMU). 

To characterise the differences in behaviour under each regime, I pool all countries together and measure the statistically significant differences in means and volatility for BBIs under each regime. 

Although the mechanisms through which the regime impinges on the boom-bust cycle of credit and stocks still remains unclear, I can highlight several findings: 

  • First, there is a role for the monetary regime in the evolution of asset prices and credit. 
  • Second, some sort of currency peg, with commitments to exchange rate stability and capital controls, favours financial stability both in the short and long run. Stricter pegs are favourable for controlling stock market booms but increase both short- and medium-run volatility of credit growth. 
  • Finally, a nominal anchor of the currency, through the gold exchange standard or the European Monetary Union, appears to be insufficient in generating financial stability as they coincide with booms and heightened volatility in stock and credit markets. 

ENDS 

Do the rules of the game matter? Monetary regimes and financial stability since 1920
German Forero-Laverde
Universidad Externado de Colombia/Universitat de Barcelona
german.forero@gmail.com

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