Central bank responses to financial crises
Was easy monetary policy in the United States the cause of the crisis?
For monetary policy – and Philip Turner mentioned this in his introduction (in this volume) – the obvious observation is that easy monetary policy cannot depress real interest rates for seven years. There is no model that tells you that a continuously expansionary monetary policy for seven years does anything else but cause inflation. Real interests rates were low leading up to the crisis, but the cause cannot have been monetary policy.
The second observation is that easy monetary policy does not have an imaginary evil twin called liquidity. We hear a lot that the crisis was caused by excess liquidity sloshing around the system for seven years. But nobody has a very good idea of what that is or where it came from. It kind of reminds me of ether. Scientists decided that light was a wave that had to travel through something. But there was a vacuum out there and we would all freeze in the dark if there was not something to get the light from the sun to us. So scientists invented ether. Economists did not know what was going on before the crisis, so they invented liquidity.
The final thing, which is just so obvious to somebody in the financial markets, is that leverage is profitable at any level of interest rates. Low interest rates do not cause people to reach for a higher leverage. Leverage simply multiplies profits from spreads. Excessive leverage did make the system vulnerable, but the link between leverage and the level of interest rates is weak at best.
At the G20 meeting that just concluded, the US position was that international imbalances were a big part of what led up to the crisis. Large net flows of credit from emerging markets – China, in particular – to the United States and other industrial countries can account for a low interest rate and expectations of future low real interest rates for a considerable time period. That is a perfectly sensible idea.
The associated sensible idea which gets a lot less attention is that equilibrium asset values will be high. If you have a lower real discount rate, and people expect it to continue for a very long time, asset prices are going to rise. It is in the denominator of every asset price that you can think of.
But the crisis that was predicted for that system was a stop in capital flows from emerging markets to the United States and to other industrial country markets. That predicted stop in net capital inflows was supposed to generate a spike in US real interest rates, a collapse in asset prices, a collapse in the dollar, and a crisis; but that did not happen. What I find quite astonishing is that even though the crisis that was predicted did not happen, the cure is still being touted as a proper policy response. This is not sensible.
Breaking down supervision and regulation and the need for improving supervision