We now have three ‘monetary policy functions’, all lodged at the Bank of England: ‘normal’ monetary policy, financial stability policy and ‘macro-prudential’ policy. The first concerns the setting of interest rates. The second concerns the avoidance of financial risk. The third concerns the use of regulatory levers to manage the business cycle in lending and finance. Similar frameworks are busily being put in place across other parts of the developed world.
The assumption behind all this new paraphernalia is that the recent Great Recession was entirely the fault of the financial system, and specifically the banks. Only on this basis would it make sense to interfere so actively in markets and consequent prices, since otherwise all one would need would be normal monetary policy and the usual eye on potential systemic dangers. Furthermore, since one would not need macro-prudential intervention, one would note that it is highly distortionary of market processes, and for this reason should not be used as it is actively damaging to the economy.
Yet when one looks for evidence that the Great Recession was the result of the financial system, it is extremely hard to find. Several papers claim that financial shocks were what caused it, but on inspection it turns out these studies assumed the very mechanisms that generate this conclusion. In recent work at Cardiff we found that when the same models were estimated so as to fit the data and also to mirror the variety of shocks present, the share of the downturn accounted for by financial shocks is less than a fifth (Le et al 2012, 2013). This work matches work by Stock and Watson (2003) who look at the full sweep of relationships in this recession and find that it was little different in the shocks causing it than previous ones; the Great Recession simply was caused by the same types of shocks as before, but on average turning out bigger than usual on this occasion.
When we then turn to just why the financial shocks this time did occur, we are forced to ask whether it was the banks or the central banks themselves that precipitated them. During the second half of 2007 there was a breakdown in the inter-bank market which central banks did little to offset. On the contrary, central bankers spread the blame for the upset then on banks’ ‘moral hazard’; they ignored their own part in encouraging the prior credit boom and they also forgot their own responsibility to keep the banking system stable. However, from the end of 2007 through 2008 central banks were beginning to restore order in the inter-bank market. The financial crisis erupted with full force in September 2008 with the collapse of Lehman over the weekend of 13th-14th September. For reasons that are still not clearly explained the Federal Reserve Board allowed the collapse (Lehman declared itself bankrupt in the small hours of Monday morning), even though there was a huge counterparty problem; and indeed AIG immediately collapsed which in turn forced the Fed into a massive bailout.
Again it seems that central banks were unwilling to save the banking system because some banks had shown moral hazard. The politicians too entered the game, declaring their disapproval of banks. Yet, approval or disapproval, central banks that terrible weekend should have thought about the banking system and how to save it. Cooperation between central banks was poor; in particular the Bank of England prevented Barclays from being involved in buying parts of Lehman and so contributing to a solution. Why did the Fed and other central banks not defer the Lehman action and search for a less damaging solution? Instead they suddenly threw in the towel over the weekend.
Now it is true that over the next few months central banks and governments put together bailout schemes to clear up the mess. But in retrospect it is puzzling why the mess was allowed to occur in the first place, especially after the great efforts that had been made to stabilise the system after the sub-prime crisis of August 2007 (itself the first conspicuous failure of central bank management).
To summarise all this, we find that over the whole period the financial crisis was just one component of the Great Recession and that this component itself can be put down mainly to central bank incompetence. Yet the new Regulatory framework is put forward as the way to prevent future crises, even though it will only remove a small component of crisis-causing shocks and is also highly damaging to the flow of credit and finance through the economy.
One must hope that, in time, sense will prevail and the monstrous new system put in place will be somewhat unwound and reduced in scale. The Bank of England has published its ambitious plans for research on these areas; so maybe it will learn the error of these ways from this new programme.
Meanwhile monetary policy is being kept remarkably easy, to try to offset the effects on credit growth of the New Regulation. This is a case of two wrongs not adding up to a right. The difficulty, as we have argued before, is that new forms of credit (so far not reliably measurable) are being created via internet peer-to-peer networks. Plainly, the UK economy is now growing strongly and wages are starting to rise, reflecting the strength of employment growth. What we have found in other recent work at Cardiff is that monetary policy alone has all the tools required to stabilise the economy in the face of potential crises (Le et al 2014).
In the US, the Fed is now starting to talk about tightening. We think the Bank of England will have to do the same here. Once the Fed starts markets will start to view Bank reluctance with concern. So interest rates should start to rise here as in the US before the end of this year. If the Bank refuses to tighten, then it is running risks of losing control of the inflationary process; this does not look a threat today but the fall in commodity prices will soon drop out of the inflation numbers and then the threat will become more apparent.
Conclusions
There has been a tendency on the part of policymakers to blame banks for the recent ‘financial crisis’ and to use this blame to justify a mass of new regulation, on the grounds that this will prevent future crises. Recent work in Cardiff and elsewhere does not support this view. The crisis was caused by the usual suspects- mainly commodity price spikes and other real shocks. The financial part of the crisis was caused by the failure of central banks to prevent banks’ liquidity difficulties overflowing into the large-scale Lehmann default, with no protection for counterparties; before the crisis monetary policy was unacceptably loose. Looking ahead, future crises will be as frequent as ever because they have little to do with financial events. However, the new mass of bank regulation will continue to distort the operation of financial markets, with costs to the recovery and the efficiency of the financial system. It would be better if the central banks looked to the beam in their own eye, rather than examining the mote in the eye of private banks. They should pay attention to a properly stabilising monetary policy and scale back the new policies of direct regulation, which are both disruptive and unnecessary.
References
Le, V P M, D Meenagh and P Minford (2012) “What causes banking crises? An empirical investigation”, CEPR Discussion Paper 9057; Cardiff Economics Working Papers E2012/14, Cardiff University, Cardiff Business School, Economics Section.
Le, V P M, D Meenagh, P Minford and Z Ou (2013) “What causes banking crises? An empirical investigation for the world economy”, CEPR Discussion Paper 7648; Cardiff Economics Working Papers E2013/03, Cardiff University, Cardiff Business School, Economics Section.
Le, V P M, D Meenagh and P Minford (2014) “Monetarism rides again? US monetary policy in a world of quantitative easing”, CEPR Discussion Paper 10250; Cardiff Economics Working Papers E2014/110, Cardiff University, Cardiff Business School, Economics Section.
Stock, J H and M W Watson (2012) “Disentangling the channels of the 2007-2009 recession”, Brookings Papers on Economic Activity.
