Austrian business cycle theory refuses to die

There is a new paper from Princeton by Matthew Baron and Wei Xiong (pdf), preliminary draft but the results are striking:

This paper examines financial instability associated with bank credit expansion in a set of 23 developed countries over the years 1920-2012. We find that credit expansion, measured by the three-year change in bank credit to GDP ratio, predicts a significantly increased crash risk in the returns of the bank equity index and equity market index in the subsequent one to eight quarters. Despite the increased crash risk, credit expansion predicts both lower mean and median returns of these indices in the subsequent quarters, even after controlling for a host of variables known to predict the equity premium. Furthermore, conditional on credit expansion of a country exceeding a modest threshold of 1.5 standard deviations, the predicted excess return for the bank equity index in the subsequent four quarters is significantly negative, with a magnitude of nearly -20%, while the positive predicted excess return subsequent to a credit contraction of the same size is substantially more modest. These findings present a challenge to the views that credit expansions are simply caused by either banks acting against the will of shareholders or by elevated risk appetite of shareholders, and instead suggest a role for optimism of bankers and stock investors.

The pointer is from Hyun Song Shin.  I would continue to stress, however, that Austrian approaches still need more Hyman Minsky and should cease putting all of the “blame” — causal, moral, or otherwise — on the monetary expansion of the central bank.  Don’t forget my banana point:

Let’s say that the government subsidized the price of bananas, you bought so many bananas, put them on your roof, and then the roof collapsed.  Is that government failure or market failure?  The price was distorted, but I still say this is mostly market failure.  No one made you put so many bananas on your roof.


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