The Myth of Financial Innovation and the Great Moderation

Abstract

Financial innovation is widely believed to be at least partly responsible for the recent financial crisis. There are also 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 for 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 behavior of aggregate home mortgages changed less during the great moderation than is typically believed. Although aggregate home mortgages declined during monetary tightenings, both before and during the great moderation, we find strong substitutions in the ownership of home mortgages during such episodes. That is, monetary tightenings became episodes during which financial institutions other than banks increased their holdings in mortgages. One can question the desirability of such strong substitutions of ownerships during economic downturns.

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