Non-technical summary of ESM Working Paper 64: Financial imbalances and macroeconomic tail risks: A structural regime-switching investigation

Financial crises tend to be preceded by excessive growth in real private credit and overvaluation of asset prices and are usually followed by more severe economic downturns that are significantly different from typical recessions, as is widely documented in the literature. Credit imbalances combined with overvalued house prices along with long-lasting financial cycles are key to explaining these events.

The paper aims to fill an existing gap in the literature that would explain the links between financial imbalances, the likelihood of financial turmoil and the resulting severity of economic downturns, and their policy implications. 

The authors study empirically the role of excessive credit growth and asset price overvaluation in increasing the likelihood and deepening the severity of financial crises in advanced economies. They then build a macroeconomic model of prolonged financial cycles that explains the key characteristic features of financial crises in these economies. The authors also 
investigate the implications for monetary and macroprudential policies, uncovering key policy trade-offs.

They then use the model to assess the potential policy complementarities between monetary and macroprudential policies, focusing on the episode surrounding the Global Financial Crisis (GFC) from the late 2003 to the late 2011, among many other policy exercises. The findings suggest that if capital requirements had been higher before the crisis, monetary policy would not have had to be as restrictive, as both the rise in inflation and output growth would have been less pronounced.

On the other hand, if one compares the implementation of higher capital requirements with conducting leaning against the wind-type monetary policy [where central banks tighten monetary conditions before financial imbalances become severe] before the GFC, we find that although the costs of implementing these two policies would have been comparable in terms of output loss before the crisis, the crisis would have been less severe, and the recovery would have been much faster in the case of using higher capital requirements.