Leaning against the Wind and Crisis Risk

These questions have sparked considerable disagreement among economists. Proponents of policies that ‘lean into the wind’ argue that tight monetary policy can rein in roaring financial markets, lowering the risk and severity of financial crashes. Critics of such policies counter by arguing that monetary policy is ineffective in lowering crisis risk and that the side-effects are potentially severe.  

The issue looms large for current thinking about monetary policy. It has become exceedingly clear how large the economic costs of financial crises are. Crisis prevention may outweigh the costs of tighter monetary policy. Yet empirically we do not know much about the effects of monetary policy changes on financial stability during financial booms. Our new research aims to close this gap. We systematically study the available evidence for the effects of discretionary monetary policy on financial stability based on the ‘near-universe’ of advanced economy financial cycles and crises since the 19th century.  

Our findings substantiate concerns that have been voiced by the opponents of leaning against the wind: a discretionary monetary policy tightening appears more likely to trigger financial crises rather than prevent them. Despite this crisis trigger effect, discretionary policy could still be beneficial if, by causing a small crisis now, it prevents a much bigger crisis later on. In other words, by hindering financial booms from proceeding unchecked, discretionary leaning against the wind policy might limit the fallout from the subsequent bust. Our findings suggest that this is not the case, underscoring that a contractionary monetary policy is not the right tool for the job when it comes to defusing risks to financial stability.