Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Kiss Me Deadly:From Finnish Great Depression to Great Recession

Adam Gulan Markus Haavio Juha KilponenBank of Finland1

April 10 2015

1The views expressed are those of the authors and do not necessarily reflectthe views of the Bank of Finland

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Introduction

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Finnish Great Depression: Two stories

Real:

Collapse of Finnish-Soviet trade in 1991:and ToT reversalreinforced by labor market frictions“From Russia with Love”, Gorodnichenko et al., AER 2012(see also Tarkka, 1994)

Financial:

Finnish Great Depression was preceded by financialliberalization, asset price boom, credit boomasset price collapsesevere banking crisis and credit crunche.g. Vihriala, 1997, Honkapohja and Koskela, 1999

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Finnish Great Depression: Two stories

Real:

Collapse of Finnish-Soviet trade in 1991and ToT reversalreinforced by labor market frictions“From Russia with Love”, Gorodnichenko et al., AER 2012 (see also Tarkka, 1994)

Financial:

Finnish Great Depression was preceded by financialliberalization, asset price boom, credit boomasset price collapsesevere banking crisis and credit crunche.g. Vihriala, 1997, Honkapohja and Koskela, 1999

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

%

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

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Finnish terms of trade, 1970-2010

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

0

100

200

300

400

500

600

1980 1985 1990 1995 2000 2005 2010

Finnish real exports 1980-2014 (1985=100)

-40

-30

-20

-10

0

10

20

30

1985 1990 1995 2000 2005 2010

%

Finnish investments and exports 1985-2014, % change from a year earlierInvestments Exports

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

New bank loans issued, 1981-2000 (€2000, million)

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Stock and house prices, 1985-1995 (1985=100)

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

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Methodology

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)

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)

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)

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)

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 ? – – +

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 ? – – +

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 ? – – +

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., 2010Helbling et al., 2011

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., 2010Helbling et al., 2011

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., 2010Helbling et al., 2011

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., 2010Helbling et al., 2011

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., 2010Helbling et al., 2011

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., 2010Helbling et al., 2011

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., 2010Helbling et al., 2011

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Partial identification

There are fewer identified domestic shocks (4) than domesticvariables (6)

Hence the model is partially identified: there are twounidentified 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

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 someidentification 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 .

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 someidentification 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 .

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 someidentification 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 .

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 someidentification 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 .

The procedure step by step

1 Reduced form residuals ut2 Cholesky-based structural shocks

et = B−1ut

where BB ′ = Σ and B is obtained by a the Choleskydecomposition

3 Draw an orthonormal rotation matrix Q, and produce analternative set of structural shocks

εt = Q ′et

The procedure step by step

1 Reduced form residuals ut2 Cholesky-based structural shocks

et = B−1ut

where BB′ = Σ and B is obtained by the Cholesky decomposition

3 Draw an orthonormal rotation matrix Q, and produce analternative set of structural shocks

εt = Q ′et

The procedure step by step

1 Reduced form residuals ut2 Cholesky-based structural shocks

et = B−1ut

where BB ′ = Σ and B is obtained by a the Choleskydecomposition

3 Draw an orthonormal rotation matrix Q, and produce analternative set of structural shocks

εt = Q ′et

The procedure step by step

1 Reduced form residuals ut2 Cholesky-based structural shocks et3 lternative set of structural shocks εt4 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 = AjW (period j)

5 If the impulse responses satisfy the sign restricitons, keep therotation matrix Q and the stuctural shocks εt . Otherwisediscard Q and the stuctural shocks εt .

The procedure step by step

1 Reduced form residuals ut2 Cholesky-based structural shocks et3 lternative set of structural shocks εt4 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 = AjW (period j)

5 If the impulse responses satisfy the sign restricitons, keep therotation matrix Q and the stuctural shocks εt . Otherwisediscard Q and the stuctural shocks εt .

The procedure step by step

1 Reduced form residuals ut2 Cholesky-based structural shocks et3 lternative set of structural shocks εt4 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 = AjW (period j)

5 If the impulse responses satisfy the sign restricitons, keep therotation matrix Q and the stuctural shocks εt . Otherwisediscard Q and the stuctural shocks εt .

The procedure step by step

1 Reduced form residuals ut2 Cholesky-based structural shocks et3 lternative set of structural shocks εt4 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 = AjW (period j)

5 If the impulse responses satisfy the sign restricitons, keep therotation matrix Q and the stuctural shocks εt . Otherwisediscard Q and the stuctural shocks εt .

The procedure step by step

1 Reduced form residuals ut2 Cholesky-based structural shocks et3 lternative set of structural shocks εt4 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 = AjW (period j)

5 If the impulse responses satisfy the sign restricitons, keep therotation matrix Q and the stuctural shocks εt . Otherwisediscard Q and the stuctural shocks εt .

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 Qmatrices) that satisfy all the sign restrictions (and theFry-Pagan filter)

In our case, K = 2700

Model selection

Which of the K structural models do we choose, when we tryto interprete Finnish business cycles, and economic crises?

We base model selection on the historical shock decomposition

Θt = ∑j

ΦjEt−j

where Et−j is matrix with εt−j on the diagonal (and zeroselsewhere)

The cumulative contribution of current and past structuralshocks to model variables

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, 2011Median historical decomposition:

x∗ = argminN

∑n=1

J

∑j=1

T

∑t=1+p

(θxn,j ,t − θn,j ,t)2

θxn,j ,t is normalized cummulative effect of shock j on variable nup to period t, obtained via vector MA representation,

θn,j ,t is the median over all model candidates.

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, 2011Median historical decomposition:

x∗ = argminN

∑n=1

J

∑j=1

T

∑t=1+p

(θxn,j ,t − θn,j ,t)2

θxn,j ,t is normalized cummulative effect of shock j on variable nup to period t, obtained via vector MA representation,

θn,j ,t is the median over all model candidates.

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, 2011Median historical decomposition:

x∗ = argminN

∑n=1

J

∑j=1

T

∑t=1+p

(θxn,j ,t − θn,j ,t)2

θxn,j ,t is normalized cummulative effect of shock j on variable nup to period t, obtained via vector MA representation,

θn,j ,t is the median over all model candidates.

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, 2011Median historical decomposition:

x∗ = argminN

∑n=1

J

∑j=1

T

∑t=1+p

(θxn,j ,t − θn,j ,t)2

θxn,j ,t is normalized cummulative effect of shock j on variable nup to period t, obtained via vector MA representation,

θn,j ,t is the median over all model candidates.

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 tosame impulse response patterns as the identified ones.Then, all unidentifed shocks remain orthogonal to identified ones. + − ?

+ + ?+ + ?

W 1 ≡

+ − ++ + ++ + +

and W 2 ≡

+ − ++ + −+ + +

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Results

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%

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Counterfactual - financial crisis was caused by the collapseof Soviet trade

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Historical decomposition of output growth

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

The role of external factors (World trade, ToT & Stress)

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

+ ...domestic real factors

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

+ ...domestic financial factors

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Counterfactual - domestic financial shocks andamplification

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Concluding remarks

“From Russia with Love” can explain at most half of FinnishGreat 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 loansupply and banking

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Impulse responses

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Positive asset price shock

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Positive loan supply shock

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Positive aggregate demand shock

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Positive aggregate supply shock

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Positive financial market stress shock

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Robustness

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Dropping the 2007-2008 financial crisis

Introduction Methodology Results Concluding remarks Impulse Responses Robustness

Dropping the Eurozone period