Adam Gulan, Markus Haavio, Juha Kilponen. Kiss Me Deadly: From Finnish Great Depression to Great Recession

1. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Kiss Me Deadly: From Finnish Great Depression to Great Recession Adam Gulan Markus Haavio Juha Kilponen Bank of Finland1 April 10 2015 1The views expressed are those of the authors and do not necessarily reﬂect the views of the Bank of Finland

2. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Introduction

3. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Finnish Great Depression: Two stories Real: Collapse of Finnish-Soviet trade in 1991: and ToT reversal reinforced by labor market frictions “From Russia with Love”, Gorodnichenko et al., AER 2012 (see also Tarkka, 1994) Financial: Finnish Great Depression was preceded by financial liberalization, asset price boom, credit boom asset price collapse severe banking crisis and credit crunch e.g. Vihriälä, 1997, Honkapohja and Koskela, 1999

4. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Finnish Great Depression: Two stories Real: Collapse of Finnish-Soviet trade in 1991 and ToT reversal reinforced by labor market frictions “From Russia with Love”, Gorodnichenko et al., AER 2012 (see also Tarkka, 1994) Financial: Finnish Great Depression was preceded by financial liberalization, asset price boom, credit boom asset price collapse severe banking crisis and credit crunch e.g. Vihriälä, 1997, Honkapohja and Koskela, 1999

5. ECB-RESTRICTED Exports to Russia / Finnish GDP 3.4.2014 Adam Gulan 1 0 1 2 3 4 5 6 7 1985 1990 1995 2000 2005 2010 %

6. ECB-RESTRICTED Finnish GDP and exports to Russia, change from a year earlier, million €2000 3.4.2014 Adam Gulan 2 -5000 -4000 -3000 -2000 -1000 0 1000 2000 3000 1985 1990 1995 2000 2005 2010 Exports to Russia GDP

7. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Finnish terms of trade, 1970-2010

8. Finnish real investments and real exports 1985-1996 (1985=100) 0 20 40 60 80 100 120 140 160 180 200 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Investments Exports

9. 0 100 200 300 400 500 600 1980 1985 1990 1995 2000 2005 2010 Finnish real exports 1980-2014 (1985=100)

10. -40 -30 -20 -10 0 10 20 30 1985 1990 1995 2000 2005 2010 % Finnish investments and exports 1985-2014, % change from a year earlier Investments Exports

11. Introduction Methodology Results Concluding remarks Impulse Responses Robustness New bank loans issued, 1981-2000 (€2000, million)

12. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Stock and house prices, 1985-1995 (1985=100)

13. 1985 1990 1995 2000 2005 2010 2015 -100 0 100% New bank loans, change from a year earlier 1985 1990 1995 2000 2005 2010 2015 -50 0 50 % Real house prices, change from a year earlier 1985 1990 1995 2000 2005 2010 2015 -100 0 100 % Real stock prices, change from a year earlier

14. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Methodology

15. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Model specification Estimate a partially identified SVAR(1) model of 9 variables External block: - World trade (real total global imports) - Finnish ToT (price of exports over price of imports) - financial market stress indicator CISS (Hollo et al. 2012) New Keynesian block: - real GDP - inflation (GDP deflator) - interest rate spread (lending rate - 3m MM rate) Financial block: - asset prices (first PCA of stock and house prices) - new loan volumes (to nonfinancial private sector) - loan losses (total real losses of banks)

19. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Sign Restrictions - demand and supply Shock type Real Financial Variable Demand Supply Asset price Loan supply GDP + + + + Inﬂation + – + ? Stock prices + + + + New loans + ? + + Interest rate spread + ? – – House prices + ? + + Loan losses ? – – +

20. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Sign Restrictions - asset price shocks Shock type Real Financial Variable Demand Supply Asset price Loan supply GDP + + + + Inﬂation + – + ? Stock prices + + + + New loans + ? + + Interest rate spread + ? – – House prices + ? + + Loan losses ? – – +

21. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Sign Restrictions - domestic loan supply shocks Shock type Real Financial Variable Demand Supply Asset price Loan supply GDP + + + + Inﬂation + – + ? Stock prices + + + + New loans + ? + + Interest rate spread + ? – – House prices + ? + + Loan losses ? – – +

22. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Financial shocks Asset price shock: exuberance and bubbles (Bernanke and Gertler, 1999) net worth shock (Bernanke and Gertler, 1989 risk shock (Christiano et al. 2014) news about future TFP? (Christiano et al., 2010 vs Gilchrist and Leahy, 2002) Loan supply shock: changes in lending standards and regulatory environment monitoring costs (De Fiore et al. 2011, Fuentes-Albero, 2014) Which ﬁnancial shocks matter? Bassett et al., 2010 Helbling et al., 2011

29. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Partial identification There are fewer identified domestic shocks (4) than domestic variables (6) Hence the model is partially identified: there are two unidentified shocks Some shocks cannot be identified, given the set of variables, and the time range (e.g. monetary policy shocks) More generally: the limitations of economic modelling

30. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Methodology - sign restrictions Reduced-from VAR(1) model yt = Ayt−1 + ut, ut ∼ N(0, Σ) Structural shocks: linked to residuals through some identiﬁcation matrix W ut = W εt, Σ = WW Start with Cholesky decomposition on Σ Σ = BB where B is a lower triangular matrix Draw some orthonormal matrix Q (such that QQ = I) Σ = BB = BQQ B so that W = BQ and ut = BQεt.

34. The procedure step by step 1 Reduced form residuals ut 2 Cholesky-based structural shocks et = B 1 ut where BB0 = Σ and B is obtained by a the Cholesky decomposition 3 Draw an orthonormal rotation matrix Q, and produce an alternative set of structural shocks εt = Q0 et

35. The procedure step by step 1 Reduced form residuals ut 2 Cholesky-based structural shocks et = B 1 ut where BB0 = Σ and B is obtained by the Cholesky decomposition 3 Draw an orthonormal rotation matrix Q, and produce an alternative set of structural shocks εt = Q0 et

36. The procedure step by step 1 Reduced form residuals ut 2 Cholesky-based structural shocks et = B 1 ut where BB0 = Σ and B is obtained by a the Cholesky decomposition 3 Draw an orthonormal rotation matrix Q, and produce an alternative set of structural shocks εt = Q0 et

37. The procedure step by step 1 Reduced form residuals ut 2 Cholesky-based structural shocks et 3 lternative set of structural shocks εt 4 Let W = BQ The impulse responses to the structural shocks εt are given by Φ0 = W (on impact, or period 0) Φ1 = AW (period 1) ... Φj = Aj W (period j) 5 If the impulse responses satisfy the sign restricitons, keep the rotation matrix Q and the stuctural shocks εt . Otherwise discard Q and the stuctural shocks εt .

42. The procedure step by step We repeat the procedure N times In our case, N = 8 1010 (or 80 billion) ... and we get a certain number K of structural models (or Q matrices) that satisfy all the sign restrictions (and the Fry-Pagan …lter) In our case, K = 2700

43. Model selection Which of the K structural models do we choose, when we try to interprete Finnish business cycles, and economic crises? We base model selection on the historical shock decomposition Θt = ∑ j Φj Et j where Et j is matrix with εt j on the diagonal (and zeros elsewhere) The cumulative contribution of current and past structural shocks to model variables

44. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Methodology - choosing the model Each draw of Q gives rise to a different model and IRFs. Keep only those draws of Q which satisfy sign restrictions. Choosing the final model from all admissible candiates. Modification of Fry and Pagan, JEL, 2011 Median historical decomposition: x∗ = argmin N ∑ n=1 J ∑ j=1 T ∑ t=1+p (θx n,j,t − ¯θn,j,t )2 θx n,j,t is normalized cummulative effect of shock j on variable n up to period t, obtained via vector MA representation, ¯θn,j,t is the median over all model candidates.

48. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Methodology - multiple shocks problem To avoid contaminating identified shocks with unidentified ones, disregard all draws of Q for which unidentified shocks give rise to same impulse response patterns as the identified ones. Then, all unidentifed shocks remain orthogonal to identified ones.   + − ? + + ? + + ?   W 1 ≡   + − + + + + + + +   and W 2 ≡   + − + + + − + + +  

49. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Results

50. Introduction Methodology Results Concluding remarks Impulse Responses Robustness USSR vs ﬁnancial crisis USSR Finance Peak (4Q 1989) - Trough (1Q 1993) 52.7% 41.7% Peak (4Q 1989) - Recovery (4Q 1996) 44.6% 40.6%

51. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Counterfactual - ﬁnancial crisis was caused by the collapse of Soviet trade

52. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Historical decomposition of output growth

53. Introduction Methodology Results Concluding remarks Impulse Responses Robustness The role of external factors (World trade, ToT & Stress)

54. Introduction Methodology Results Concluding remarks Impulse Responses Robustness + ...domestic real factors

55. Introduction Methodology Results Concluding remarks Impulse Responses Robustness + ...domestic ﬁnancial factors

56. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Counterfactual - domestic ﬁnancial shocks and ampliﬁcation

57. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Concluding remarks “From Russia with Love” can explain at most half of Finnish Great Depression. Financial crisis started the depression and prolonged it Great recession was very different. Imported recession. No financial crisis in Finland. Initial financial conditions much more robust. Large overall role of financial shocks, esp. related to loan supply and banking

58. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Impulse responses

59. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Positive asset price shock

60. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Positive loan supply shock

61. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Positive aggregate demand shock

62. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Positive aggregate supply shock

63. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Positive ﬁnancial market stress shock

64. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Robustness

65. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Dropping the 2007-2008 ﬁnancial crisis

66. Introduction Methodology Results Concluding remarks Impulse Responses Robustness Dropping the Eurozone period

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