There is a widespread view that monetary policy has been fundamentally changed by the 2008 financial crisis. The IMF’s Chief Economist Olivier Blanchard says that ‘Monetary policy will never be the same’.
Policy certainly explored new areas in response to unusual circumstances, but when the dust settles, how different will it be? For some, the economy has fundamentally changed, and monetary policy has to adapt to the new world. For others, monetary policy itself has shown its deficiencies and needs to be made effective.
Answering the first group is straight-forward. Some economists have become so pessimistic about the intrinsic dynamism of mature economies that they foresee secular stagnation, with this pessimism sometimes extending to emerging economies as well. They argue that monetary policy should become accustomed to providing constant stimulus in the form of negative real (ie. inflation-adjusted) interest rates, to encourage investment and discourage saving.
While ageing demographics will produce low growth, it isn’t sensible to undertake investments which have such a low value to society that they can’t support a positive real interest rate. Any economy in this state has deeper problems. It may well be sensible for monetary policy to temporarily administer negative real interest rates during a recession, but this can’t be a sensible long-run policy setting.
What did the 2008 crisis reveal about the effectiveness of monetary policy?
First, should monetary policy be blamed for the crisis itself? It certainly played a role, but it was a policy mistake rather than an intrinsic deficiency — American monetary policy remained accommodative for too long after the bursting of the internet bubble in 2001. But this was a minor issue compared with the comprehensive failure of prudential supervision in America and Europe. Banks leveraged hugely, lent to borrowers who could not repay, and indulged in a welter of derivative-based transactions which made their balance sheets so complex that their own management lost track of what was happening.
Second, should inflation targeting (the near-universal approach to monetary policy) be blamed? Inflation was well contained in the two decades before the 2008 crisis, and the argument goes that this made central banks complacent, lulled by the belief that if inflation was low, all was well. But this ignores the division of labour between monetary policy and prudential supervision. Even where both these functions were in the remit of the central bank, it was supervision which failed.
But surely monetary policy should have stopped the irrational exuberance in asset prices (houses and equities)? Asset bubbles had, in fact, long been part of the monetary policy debate. Some central banks were adamant that they couldn’t identify asset bubbles beforehand (a view most closely associated with former Fed Chairman Alan Greenspan), while others were prepared to ‘lean against the wind’ with marginally tighter policy settings. But all agreed that an interest rate high enough to constrain an asset bubble would be grossly excessive for the rest of the economy.
What about the innovation of ‘unconventional policies’, notably America’s quantitative easing (QE)?
Back in the 1930s Keynes had explored the possibility that even when the policy interest rate was reduced to zero, this might not be low enough to stimulate a weak economy (the ‘liquidity trap’). In responding to the 2008 crisis, the US, UK, Europe and Japan explored what more could be done through ‘unconventional policies’. It’s not clear how much effect America’s quantitative easing had: this graph shows little relationship between QE episodes and lower bond rates, supposedly the main channel of transmission. There is no doubt that QE has had important effects on financial market psychology, but the outcome was unpredictable and ephemeral. Central banks will be happy to end QE and hope not to have to use it again.
‘Unconventional policies’ were, in fact, measures of desperation. After the near-universal fiscal stimulus of 2009, fiscal policy shifted sharply in the direction of contraction. With the recovery still feeble, it was left to monetary policy to do what it could to boost growth. Monetary policy helped but wasn’t powerful enough to offset recessionary ‘animal spirits’, fiscal contraction and the dead-weight burden of over-leveraged balance sheets. It was a mistake to give the impression that it could do the job.
The call for monetary policy to be restructured to increase its effectiveness misses the reality that monetary policy has always been an important but limited instrument. The impact of short-term interest rate on the economy is not well calibrated or consistent.
We did learn one important lesson from 2008: that the financial sector, left to its own devices, is an accident waiting to happen, just as soon as memory of the last crisis fades. But this is not something monetary policy can fix.
Photo by Flickr user JeffreyTurner.