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Title: The Myth of Financial Innovation and the Great Moderation

Author(s): Wouter Den Haan and Vincent Sterk

Publication Date: October 2009

Keyword(s): consumer credit, impulse response functions and mortgages

Programme Area(s): International Macroeconomics

Abstract: Financial innovation is widely believed to be at least partly responsible for the recent financial crisis. At the same time, there are empirical and theoretical arguments that support the view that changes in financial markets played a role in the "great moderation". If both are true, then the price of reducing the likelihood of another crisis, e.g., through new regulation, could be giving up another episode of sustained growth and low volatility. However, this paper questions empirical evidence supporting the view that innovation in consumer credit and home mortgages reduced cyclical variations of key economic variables. We find that especially the behaviour of aggregate home mortgages changed less during the great moderation than is typically believed. For example, aggregate home mortgages declined during monetary tightenings, both before and during the great moderation. A remarkable change we do find is that monetary tightenings became episodes during which financial institutions other than banks increased their holdings in mortgages. Once can question the desirability of such strong substitutions of ownership during economic downturns.

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Bibliographic Reference

Den Haan, W and Sterk, V. 2009. 'The Myth of Financial Innovation and the Great Moderation'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=7507