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The Myth of Financial Innovation and the Great Moderation

  • Den Haan, Wouter
  • Sterk, Vincent

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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7507.

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Date of creation: Oct 2009
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Handle: RePEc:cpr:ceprdp:7507
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  1. Matteo Iacoviello & Marina Pavan, 2011. "Housing and Debt over the Life Cycle and over the Business Cycle," Working Papers 2011/04, Economics Department, Universitat Jaume I, Castellón (Spain).
  2. Urban Jermann & Vincenzo Quadrini, 2006. "Financial innovations and macroeconomic volatility," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
  3. Jonathan McCarthy & Richard W. Peach, 2002. "Monetary policy transmission to residential investment," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 139-158.
  4. Stephen G. Cecchetti & Alfonso Flores-Lagunes & Stefan Krause, 2006. "Assessing the Sources of Changes in the Volatility of Real Growth," NBER Working Papers 11946, National Bureau of Economic Research, Inc.
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