VoxEU Column Financial Markets

The myth of financial innovation and the Great Moderation

Financial institutions played a leading role in the global crisis, and policymakers are under pressure to do something about them. This column argues that before any draconian measures are passed, we need to be reminded of the benefits of the financial sector and the innovation it provides.

Many changes have taken place in the financial sector over the last couple of decades. Deregulation was followed by a burst of innovation, a step-up in leverage, an increase in cross-border capital flows, and larger financial institutions. The recent financial crisis is believed to have been caused by some of these changes in the financial sector, and lawmakers are under pressure to come up with new legislation that will do a better job in restraining the financial sector and result in a more stable economy.

But it is not that long ago that growth of the financial sector and financial innovation were thought to be central for sustainable growth and also to be partly responsible for the Great Moderation (the period with mild business cycle volatility characterising several developed economies from the mid-1980s to the onset of the crisis). In particular, Levine (2005) presents an overview of the literature on the role of financial market on growth and argues that financial development has been important for countries’ economic progress. And numerous articles argue that the changes that reshaped financial markets are at least partly responsible for the Great Moderation.1 The view that financial innovation was beneficial was shared by policymakers.2

It is difficult to deny that the behaviour of financial institutions played a key role in the recent crisis. But this does not mean that the earlier views on the importance of the financial sector have no validity. A well-developed market for private equity and venture capital is likely to be good for young, innovating businesses, as is documented by Popov and Roosenboom (2009). And securities that make it possible for risk to be spread across more market participants are likely to be beneficial as well.

The risks brought to the surface by the recent crisis have spurred an active debate on new and better legislation. It is important to reconsider the question of in which aspects the financial sector has been beneficial, so that new legislation not only makes the financial sector safer, but also allows the sector to continue in those roles that are truly beneficial.

In Den Haan and Sterk (2011), we investigate the question of whether the changes that reshaped the financial sector really did contribute to the Great Moderation. There are both empirical and theoretical reasons to believe that better access to finance dampened business cycles. Theories that support this view build on the premise that financial frictions may prevent promising investment projects from obtaining financing. Similarly, consumers may postpone consumer purchases when funds to bridge unemployment spells are not available. Firms that do not invest and consumers that do not buy can reinforce each other and deepen an economic downturn. But if financial sectors are better able to provide financing to individual firms and consumers, then it could very well be the case that unnecessary deepening of recessions could be avoided. On the empirical side, there are two striking changes in the observed behaviour of real activity and loans that are consistent with this view. This is documented in Figure 1 which plots detrended aggregate mortgages (top panel) and (detrended) aggregate consumer credit (bottom panel) together with detrended output (GDP). In the beginning of the sample, both loan series displayed sharp reductions (increases) whenever GDP decreased (increased). In the later part of the sample, the fluctuations in GDP became more subdued and the co-movement between the loan series and GDP displayed a sharp drop.3

Figure 1. Cyclical components consumer loans.

In our paper, we investigate the reasons behind the reduced cyclicality of loans to households, by estimating a structural VAR which allows us to condition on various structural shocks. It turns out that the bulk of the drop in the correlation between household loans and GDP can be explained by changes in the responses to only two types of shocks: “monetary shocks” and “real activity shocks”. However, after carefully studying the particular changes in the responses to these shocks, we find very little evidence for the idea that financial innovation contributed to greater macroeconomic stability.

Figure 2 plots the impulse response functions (IRFs) for an adverse real activity shock, both for the 1954-78 sample and for the 1984-2008 sample.4 The responses are remarkably similar across the two samples, except that the size of the shocks has become smaller. It is true that the response of mortgages turns positive somewhat earlier (possibly quickening a recovery), but the response of consumer credit turns positive later. These changes mechanically push down the correlation between real activity and loan variables, but at the same time these are minor shifts that do not suggest an important change in how the financial sector affects the economy.

Figure 2. IRFs following a real activity shock

Figure 3. IRFs following a monetary tightening.

There have been changes in how variables behave following a monetary tightening, as documented in Figure 3. In fact, these changes are the main reason why the co-movement between real activity and loan variables has dropped so much. Monetary tightenings no longer seem to have a strong negative impact on consumer credit and real activity (except residential investment) and only a small negative effect on mortgages.5 To see what type of financial institution is responsible for these changes, we divide consumer loans between those held by banks and those held by other financial institutions. We include both those held directly and those held indirectly, for example, as asset backed securities. We find that the largest changes are observed for non-bank institutions. As documented in Figure 4, consumer loans held by non-banks declined during monetary downturns in the earlier part of the sample, but increased significantly during the latter part of the sample.

Figure 4. IRFs following a monetary tightening; non-bank loans.

The changes in how the economy responds to a monetary tightening seem, at first sight, consistent with the view that better intermediation made it possible for the financial sector to keep on lending, therefore limiting the severity of downturns. However, we have several reasons to believe that the observed changes in the IRFs are not due to financial markets being better able to absorb macroeconomic fluctuations.

First, while it is true that the percentage drop in home mortgages is smaller in the later sample, this is not really the right measure given that home mortgages have increased sharply relative to both GDP and residential investment. In fact, following a monetary tightening, the maximum drop in home mortgages relative to GDP is actually somewhat higher in the later sample and substantially higher relative to residential investment, even though the monetary policy shock has become smaller.

Second, counterfactual experiments, as documented in our paper, provide no evidence that either mortgages or consumer credit are important for swings in economic activity.

Third, when we calculate what the responses of mortgages and consumer credit would have been if both the responses of the federal funds rate and GDP had been the same as in the first subsample, then we find that both mortgages and consumer credit would have dropped by much more, which does not provide evidence for the view that financial innovation has improved the ability of the financial sector to provide financing during economic downturns.

Finally, if this ability has increased, then financial institutions other than banks play a key role. We cannot help but wonder whether it is beneficial for an economy that institutions that know the least about the quality of the borrowers choose to hold more mortgages and other consumer loans during economic downturns.

The observed sharp reduction in the co-movement between real activity and loan variables is consistent with the view that changes in financial markets were influential in dampening macroeconomic shocks. However, by considering the reasons behind the change in the co-movement and by investigating more aspects of the data, we find no evidence for this hypothesis. Of course, we should be careful drawing conclusions based on aggregate data series alone. But it is remarkable that the loan and output responses following key shocks have remained fairly similar despite important regulatory and other changes in financial markets. This could indicate that – as long as market participants are not concerned about the health of the financial sector, a condition satisfied during our sample – changes in regulation, like higher capital adequacy ratios, will not affect the ability of the financial sector to intermediate efficiently during economic downturns.


Den Haan, WJ, and V Sterk (2011), “The Myth of Financial Innovation and the Great Moderation”, Economic Journal, 121(335):707.

Levine, Ross (2005), “Finance and growth: theory and evidence”, in Philippe Aghion and Steven Durlauf (ed.), Handbook of Economic Growth, 1st Edition, 1(12):865‐934, Elsevier.

Popov, Alexander, and Peter Rosenboom (2009), “Does private equity investment spur innovation”, ECB working paper series No 1063.

1 See references in Den Haan and Sterk (2011).

2 See online appendix of Den Haan and Sterk (2011) available at www.wouterdenhaan.com.

3 The correlation between HP‐filtered output and mortgages was equal to 0.76 in the sample from 54Q3 to 78Q4 and only 0.32 in the period from 84Q1 to 08Q1. For consumer credit these corresponding numbers are 0.74 and 0.19.

4 Our split is consistent with the convention in the literature according to which the great moderation starts in the beginning of the 80s.

5 In the benchmark specification, GDP even increases following a monetary tightening, but this is not a robust result. We find that the responses for output are either just below or just above zero.


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