International Think-Tank on Innovation and Competition
Monetary Policy and the Crisis
March 30, 2009
In the last two decades most monetary authorities have formally committed to anti-inflationary policies, often adopting explicit inflation targets. Nevertheless, some of them have been also engaged in policies that were clearly aimed at output stabilization. These policies have been typically implemented through increases in the nominal interest rates in front of inflationary expectations and reductions of the same rates in front of reductions of the inflation. According to the leading view, when the reactions of the nominal interest rates are strong enough, they affect the real economy through the impact on the real interest rate (which is the difference between nominal rates and expected inflation). For instance, in front of increased inflationary expectations, a temporary increase of the nominal interest rate, which increases the real interest rate as well, is expected to reduce current consumption (and investment in business creation), which slows down the economy and tends to reduce the inflation. On the other side, in front of a slowdown, a reduction of the interest rates is expected to promote consumption (and business creation) so as to trigger the recovery.
With the Chairman Alan Greenspan and his follower Ben Bernanke, the U.S. Federal Reserve has been quite sensible to the stabilization of the American economy, implementing a tight monetary policy in booms and an expansionary one in recessions. For instance, a drastic reduction of the interest rates has been implemented in the aftermath of September 11, and another one during the last two years to contrast the current recession, arriving to nominal rates close to zero. After reaching this lower bound of the interest rate policy (nominal interest rates cannot be negative), a further expansionary policy requires a direct increase of money supply. Therefore, the Fed has implemented a form of "credit easing" by pumping new liquidity into markets. In the last months, it has expanded its discount operations in particular with the creation of special loan facilities (as the Term Asset-Backed Loan Facility), has issued direct injections of capital into the main banks some of which were in troubles, has promoted direct lending from government-sponsored enterprises and has bought corporate debt. The hope is that this aggressive intervention will manage to re-start the process of investment and business creation, and with it the recovery.
Following the Fed, all the main central banks have reduced their nominal interest rates. The Bank of England, led by Mervin King, has been the first monetary authority to announce a policy of "quantitative easing", that is to buy long-term government bonds (for planned £ 75 billion) and, at the beginning of March, it launched a reverse auction with investors as sellers, rather than buyers, of U.K. "gilts" to the central bank. In mid March, also the Fed announced it would buy long term U.S. Treasury bonds (starting with $ 300 billion). The European Central Bank, led by Jean-Claude Trichet, has reduced the interest rates in a less aggressive way, and has not adopted forms of unconventional monetary policy yet. In particular, the European monetary authority has not been engaged in outright purchases of private securities or unsecured lending to the private sector (credit easing) or in purchases of public debt (quantitative easing), but has adopted a different approach: it makes available unlimited credit to banks at the official rate (at 1.5 % at the time of writing) with short term maturities (up to six months at the time of writing). This credit is provided against eligible euro-denominated collateral defined in a very liberal way, so that there is a large short-term liquidity in the Euroarea and the unsecured overnight interbank rate is quite close to the American one. As a result, the expansion of M1 has been growing at substantially high rates, up to 13 % for the Dollar and 6 % for the Euro in March 2009. Nevertheless, at the time of writing monetary policy appears to have no traction at all on the real economy.
In front of the apparent resistance of the real economy to react to these forms of monetary stimulus, two are the possible motivations. The simplest one is that after all monetary policy is not as effective as New-Keynesian theory would claim: if this is true and the real economy follows its path in a way that is largely independent from monetary actions, central banks should rather focus on controlling the inflation rate around a favorite level. The alternative hypothesis is that a suboptimal policy has been implemented. According to many economists, during the last decade the Fed set excessively low interest rates compared to the optimal Taylor rule, and did not contrast the equity boom at the end of the 90s with a properly tight policy. This would have been at the roots of the current crisis inducing excessive debt and risk taking within the economy and generating the problems of the financial sector. Moreover, the low interest rates kept penalizing savings and postponing a solution to the current account deficit problem, which remains a critical aspect of the American situation. On the top of this, the Fed is now increasing money supply at a very high rate, which may create substantial inflation in the medium term and may also change the role of the central bank in harmful ways in the absence of a quick recovery. According to John Taylor, "the success of monetary policy during the great moderation period of long expansions and mild recessions was not due to large discretionary interventions, but to following predictable policies and guidelines that worked."
Contrary to the Fed, the European Central Bank has traditionally followed a less aggressive management of the interest rates to stabilize the economy, paying much more attention to the control of inflation in the Euro area. Even at the beginning of the financial crisis, European rates remained above the American rates for a while. Only during 2008, when residual inflationary pressures were over, the European monetary authority has started reducing the interest rates to contrast the recession, and a policy of quantitative easing has not been adopted yet. This is not surprising for a more heterogenous area where opposite shocks often occur in different member countries and where the monetary authority is largely independent (and not even backed) from fiscal authorities. In front of the current heavy recession, the European Central Bank may contemplate following the Fed and the Bank of England to buy private securities or even government bonds, even if it would be politically hard to decide which member countries' bonds to purchase.
Many economists have claimed that the current recession undermines the relevance of the neoclassical approach to macroeconomics and can only be explained within the (New-)Keynesian approach. However, we believe that the real test of the Keynesian approach will emerge from the success or the failure of the demand-based policies that are currently implemented to trigger the recovery, both on the fiscal and monetary front. As of now, the results are poor, exactly as they have been during the "lost decade" of ineffective expansionary fiscal and monetary policies in Japan. Time will give its verdict.
