Loose monetary policy increases the risk of financial crises

3 July 2014

Since the beginning of the financial crisis in 2007, the European Central Bank (ECB) has loosened its monetary policy to escape the recession. According to Moritz Schularick, Professor of Economics at the University of Bonn, more attention needs to be paid to the side effects of this loose monetary policy. In his recent study “Betting the House”, joint with Òscar Jordà and Alan M. Taylor from the University of California, Schularick analyzed a novel data set with data from 17 industrial countries ranging from 1870 to 2012. Looking at the historical evidence, the researchers found that loose monetary conditions regularly led to booms in real estate lending and house prices which in turn substantially increased the risk of banking crises. Schularick presented the study in a lecture at the Center for Financial Studies on 2 July.

The data show that overall mortgage lending and home ownership have strongly risen since the Second World War and mortgages have become the dominant share of bank lending, increasing from one third to two thirds. As a consequence, the possible adverse effects of loose monetary policy have become much more dramatic since the Second World War. Schularick also showed that the interest rate set by the ECB during the decade preceding the financial crisis was lower than would have been appropriate for Ireland and Spain while it should have been even lower for Germany. At the same time, mortgage lending and house prices rose sharply in Ireland and Spain whereas both values remained almost constant in Germany. After 2008, Ireland and Spain experienced a banking crisis, deep recessions and high unemployment. In contrast, Germany went through a more moderate recession soon followed by recovery and a return to growth. These developments support the finding that loose monetary policy can foster crises by an increase in mortgage lending and house prices.

Schularick stressed that an optimal interest rate policy is not sufficient to guarantee financial stability. Therefore central banks should make greater use of macroprudential policy tools to avoid crises. Today, in Germany the risk of a housing bubble is high, Schularick said, however, credit growth is moderate and mortgage credit has only increased by around two percent between March 2013 and 2014.