Understanding the causes and consequences of the rise of finance is a first order concern for macroeconomists and policymakers. The increasing size and leverage of the financial sector has been interpreted as an indicator of excessive risk taking1 and has been linked to the increase in income inequality in advanced economies,2 as well as to the growing political influence of the financial industry (Johnson and Kwak 2010). Yet surprisingly little is known about the driving forces behind these trends.
In our recent research we turn to economic history. We build on our earlier work that first demonstrated the dramatic growth of the balance sheets of financial intermediaries in the second half of the 20th century and how periods of rapid credit growth were often followed by systemic financial crises and severe recessions (Schularick and Taylor 2012, Jordà et al. 2013).
We unveil a new long-run dataset covering disaggregated bank credit for 17 advanced economies from 1870 to today (Jordà et al. 2014). The new data allow us to delve much deeper than has been previously possible into the forces driving the growth of finance. For the first time we can construct the share of mortgage loans in total bank lending for most countries back to the 19th century. In addition, we can calculate the share of bank credit to business and households for most countries for the decades after WW2, and back to the 19th century for a handful of countries.
The global mortgage boom
The first important insight from our data collection effort is that the sharp increase of credit-to-GDP ratios in advanced economies in the 20th century has been first and foremost a result of the rapid growth of loans secured against real estate – i.e. mortgage and hypothecary lending. The share of mortgage loans in banks’ total lending portfolios has roughly doubled over the course of the past century –from about 30% in 1900 to about 60% today, as Figure 1 demonstrates.
Figure 1. Average ratio of two types of bank lending to GDP in 17 advanced economies
Notes: Mortgage (residential and commercial) and non-mortgage lending to the business and household sectors. Average across 17 countries.
In other words, banking today consists primarily of the intermediation of savings to the household sector for the purchase of real estate. The core business model of banks in advanced economies today resembles that of real estate funds: banks are borrowing (short) from the public and capital markets to invest (long) in assets linked to real estate.
By contrast, non-mortgage bank lending to companies for investment purposes and nonsecured lending to households have remained stable over the 20th century in relation to GDP. Nearly all of the increase in the size of the financial sectors in Western economies since 1913 stems from a boom in mortgage lending to households and has little to do with the financing of the business sector.
Figure 2. Shares of bank lending by type in 17 advanced economies at key dates
Notes: Share of mortgage lending to total lending in 1928, 1970, and 2007 for each of the countries in the sample.
These findings have important implications for the debate about the role of finance. The intermediation of household savings for productive investment in the business sector – the textbook description of the financial sector – constitutes only a minor share of the business of banking today, even though it was a central part of that business in the 19th and early 20th centuries. Figure 2 well illustrates this structural shift in financial intermediation for all the countries in our sample at three benchmark years: 1928, 1970, and 2007.
A natural follow-up question is whether the surge in household borrowing reflects rising asset values without substantial shifts in household leverage ratios (the ratio of household mortgage debt to the value of residential real estate); or whether households increased debt levels relative to asset values. The latter would raise greater concerns about the macroeconomic stability risks stemming from more highly leveraged household portfolios.
We also gathered historical data for the total value of the residential housing stock (structures and land) for a number of benchmark years in order to relate household mortgage debt to asset values. We combine information from Goldsmith’s (1985) seminal study of national balance sheets with the more recent and more precise estimates of historical wealth to income ratios by Piketty and Zucman (2014).
We find that, as a byproduct of the boom in mortgage lending, household leverage ratios (mortgage debt divided by the value of the housing stock) have increased substantially in many economies over the 20th century, as seen in Figure 3. Put differently, household mortgage debt has typically risen faster than asset values, resulting in record-high leverage ratios that potentially increase the fragility of household balance sheets and the financial system itself.
Real estate credit and macro-prudence
Another important finding of our study is that mortgage credit has played an increasingly important role in the generation of financial fragility in advanced economies. We present evidence that the changing nature of financial intermediation has shifted the locus of crisis risk towards mortgage activity. Mortgage lending booms were only loosely associated with financial crisis risks before WW2, but since then real estate credit has become a significant predictor of impeding financial fragility in the postwar era.
Figure 3. Trends in aggregate loan-to-value ratios
Sources: Piketty and Zucman (2014), Goldsmith (1985) and our data. Individual data points are rough approximations relying on reconstructed historical balance sheet data for benchmark years.
Complementing the influential recent work of Mian and Sufi (2014) for the US, our work takes a longer and wider view to show that the blowing up and bursting of private credit booms – centered on aggressive mortgage expansion – reflects deep processes at work across all of the advanced countries. This is a phenomenon that has built up persistently across the mid to late 20th century.
The crucial role of mortgage credit in financial fragility is significant for the design of new macro-prudential policies today. The results underline the need for better, more nuanced monitoring of the buildup of financial instability: it is not just a matter of how loose credit is in the aggregate, but also how it is being used.
Housing finance and the business cycle
In the last part of the paper, we turn to the aftermath of lending booms and study their consequences for the real economy. The objective is to see if the important shifts in the structure of financial intermediation have had implications for the role of credit over the business cycle: is there historical evidence that recessions are more severe if they are preceded by real estate lending booms?
Our analysis is based on the near-universe of business cycles in advanced economies since 1870, and we use local projections with a broad set of macroeconomic controls. We employ inverse probability weighting to re-randomise the allocation of observations into normal business cycles and those associated with a financial crisis so as to address endogeneity concerns.
By using our new disaggregated credit data we can demonstrate that contemporary business cycles seem to be increasingly shaped by the dynamics of mortgage credit, with nonmortgage lending playing only a minor role. Since WW2, it is only the aftermaths of mortgage booms that are marked by deeper recessions and slower recoveries. Both in normal recessions and in financial crisis recessions, the slump is deeper and the recovery slower if mortgage growth was rapid in the preceding boom, as Figure 4 shows.
Figure 4. Conditional cumulated deviations (in %) for real GDP per capita from the start of the recession by type of recession and mortgage/non-mortgage credit perturbations
Notes: Samples are 1870-1939 (excluding WWI), and 1948-2010. Each path shows IPWRA estimates of the cumulative change relative to peak for years 1-5 of the recession/recovery period under different experiments. The blue solid line with the shaded region refers to the average path in normal recessions. The shaded region is a 95% confidence interval. The red solid line without a shaded region refers to financial crisis recessions. The dotted lines refer to the path in a normal/financial crisis recession when nonmortgage credit during the expansion grew at the mean plus one standard deviation. The dashed lines refer to the path in a normal/financial crisis recession when mortgage credit during the expansion grew at the mean plus one standard deviation. The IPWRA estimates are conditional on the full set of macroeconomic aggregates and their lags, with paths evaluated at the means.
Our new research combines modern methods of statistical analysis with the painstaking construction of a new large-scale historical dataset. We expect that the value of this dataset will transcend the present paper and that it will become an important resource for macroeconomic research going forward.
Our findings call for a more differentiated view on credit growth and on the implications that this differentiation has for financial stability, macroeconomic policies, and financial regulation. Important insights into the sources of financial fragility and the role of credit in the business cycle would be overlooked without a disaggregated perspective on the various types of credit and their development over the course of modern macroeconomic history.
In the second half of the 20th century, banks and households have been heavily leveraging up through mortgages. Mortgage credit on the balance sheets of banks has been the driving force behind the increasing financialisation of advanced economies. Our research shows that this great mortgaging has been a major influence on financial fragility in advanced economies, and has also increasingly left its mark on business cycle dynamics.
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1 Admati and Hellwig (2013), Aikman, Haldane, and Nelson (2014).
2 Piketty (2013), Godechot (2012), Philippon and Reshef (2013).