Sudden contractions in credit supply have the power to significantly impact and exacerbate recessions, as evident from the 2008 global financial crisis. Quantifying these effects poses a challenge, but our innovative approach using Granular Instrumental Variables (GIV) in the UK mortgage market sheds new light on this issue. By leveraging market concentration to isolate exogenous fluctuations in credit supply, we uncover the profound effects of contractionary mortgage supply shocks on the macroeconomy.
Why Use an Instrumental Variable?
- Understanding the Impact: Attempting to assess the impact of credit supply shocks solely through macroeconomic aggregates is flawed due to simultaneous causality. Identifying variations in credit supply unaffected by the business cycle requires an instrumental variable.
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The Solution: Enter our GIV approach, which capitalizes on the high market concentration and volatile idiosyncratic shocks in credit markets. By utilizing these features, we can create a robust instrumental variable for analyzing credit supply shocks.
Why Focus on the Mortgage Market?
- Relevance of Mortgages: Mortgages are a significant liability for UK households, making changes in mortgage supply impactful on real disposable income. A contraction in mortgage lending can ripple through the economy by affecting consumption, investment, and housing prices, highlighting its policy relevance.
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Market Concentration: The UK mortgage market’s high concentration, dominated by the Big-6 lenders, makes it an ideal candidate for GIV analysis. Coupled with the volatility of idiosyncratic lender shocks, this market is ripe for studying credit supply effects.
Constructing Our GIV
- Data Analysis: We utilize lender-level data on mortgage issuance to isolate idiosyncratic mortgage supply shocks. By combining parametric and non-parametric techniques, we extract and aggregate these shocks to form our GIV.
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Principal Component Analysis: To ensure the authenticity of our shocks, we employ a PCA to cleanse the data from any residual macroeconomic correlations. This step enhances the accuracy of our GIV by isolating purely idiosyncratic movements in mortgage supply.
Key Results
- Granularity Confirmed: Our GIV proves to be a robust instrument for aggregate mortgage volumes, confirming the granularity of the UK mortgage market. This finding supports the efficacy of our approach in capturing credit supply shocks accurately.
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Real Economic Impacts: Contractionary mortgage supply shocks have substantial and persistent effects on the macroeconomy. Decreases in output, consumption, and investment, coupled with a rise in unemployment, underscore the significance of credit supply shocks in driving economic cycles.
Key Takeaways
- GIV Applicability: Our method of constructing GIV demonstrates its relevance in assessing credit market dynamics, especially in granular and concentrated markets like UK mortgages. This approach addresses challenges in finding valid macroeconomic instruments.
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Economic Impact: The tangible effects of mortgage supply shocks on the macroeconomy emphasize the importance of monitoring and addressing credit supply fluctuations. Understanding and mitigating these shocks is crucial for policymakers to maintain economic stability and growth.
In conclusion, our study highlights the critical role of credit supply shocks in shaping economic outcomes. By employing innovative methodologies like GIV, we enhance our understanding of these dynamics and emphasize the necessity for proactive policy responses to mitigate their effects on the economy.
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