Bank crisis is not just about monetary policy – 03/28/2023 – Martin Wolf

So who, or what, is responsible? Why, 15 years after the start of the last financial crisis, are we perhaps seeing the beginning of another?

For many, a long period of very low interest rates imposed by central banks is to blame. For others, the problem lies in the cult of rescue operations.

We need not look very far to find the intellectual origins of these views. They are in the Austrian economic school. As Brad DeLong points out in his excellent book “Slouching Towards Utopia”, the position is that “the market gives, the market takes away; blessed be the name of the market”. The Austrians are not completely wrong, but neither are they completely right.

The essence of the argument is that the transatlantic financial crisis of 2007-2015 was the product of excessively loose monetary policy. Consequently, such a policy, in addition to rescue operations, thwarted the creative destruction that would have more vigorously restored health to the economy.

Finally, after Covid, another explosion of loose monetary policies, combined with aggressive fiscal policies, caused high inflation and even greater financial fragility. Now, it’s time to pay the price.

The story is simple. But it’s wrong.

Let’s start with the period leading up to the financial crisis. The UK has been issuing index-linked government bonds since the early 1980s. The most notable feature of the series is the huge drop in real yields: from a peak of 5% in 1992 to 1.2% in 2006, and then 1.4% negative in 2013 and 3.4% negative in 2021.

Central banks alone, however insane they might have been, could not have produced more than eight percentage points of decline in real interest rates over three decades. If this huge drop were incompatible with the needs of the economy, we would certainly have seen a rise in inflation.

What was going on then? The major fundamental changes were financial liberalization, globalization and China’s entry into the world economy. These last two have not only lowered inflation. They also introduced a country with a huge savings surplus into the world economy.

Furthermore, rising inequality in high-income countries, combined with aging populations, has created huge surplus savings in some of them, especially Germany.

As a result, to balance world demand and supply, exceptional investment fueled by credit became necessary, mainly in housing. Fortunately or unfortunately, financial liberalization facilitated this credit boom.

All of this exploded into the financial crisis. The decision taken at that time was not to allow a new Great Depression. I have no regrets in my support of this obviously sensible decision, but given the realities of the world economy and the impact of the crisis, the need subsequently emerged for either continued fiscal support or very loose monetary policy. The first possibility was ruled out. So there was only the second left.

Data on base money show why both very low interest rates and quantitative easing were vital.

After the financial crisis, there were prolonged periods when the private contribution to base money growth was negative because credit was contracting. If interest rates had been higher and central banks had not expanded the monetary base, as they did, the money supply would have collapsed.

I don’t believe in our ability to stabilize demand by stabilizing the money supply, but letting it implode is another matter. Milton Friedman would have considered central bank actions essential to stabilize broad base money growth after the financial crisis. I share the same opinion.

Then came Covid. At that point, the monetary and fiscal authorities made mistakes, which we later discovered were serious. Money growth exploded. According to the IMF (International Monetary Fund), the structural fiscal deficit of the major G7 economies also rose by 4.6 percentage points between 2019 and 2020 and barely declined in 2021.

This combination fueled an increase in demand greater than what supply could satisfy, given the repeated lockdowns in China and the Ukraine War. The result of this was an increase in inflation, which we hope will be temporary, and a rise in interest rates, which has given a new shock to our fragile banking system.

In short, central banks were not the evil puppeteers that some like to imagine, but puppets under the control of more powerful forces.

Yes, they made mistakes. Perhaps monetary policy should have “stepped the wind” before the financial crisis, quantitative easing ended a little too soon after the crisis, and monetary support was withdrawn faster than it should have in 2021. However, given our liberalized financial system and huge shocks to the world economy, I am skeptical that any of these things could have made much of a difference. Crises were inevitable.

Of course, the legions of critics need to explain exactly what they would recommend as an alternative and what effects they would expect from their proposals.

We need specific and quantified alternative proposals. How much should interest rates have been raised? How big would the financial meltdown, economic recession and high unemployment be after the financial crisis? Why do they think companies would have invested more if interest rates had been higher? Even if productivity had been increased by killing zombie companies, why would that have been a good thing if the costs included a drop in production for an extended period?

Like all human institutions, central banks are imperfect and sometimes incompetent, but they are not crazy.

The opinion that everything that has gone wrong in our economies in recent decades is primarily related to loose monetary policy is without substance. It depends on the illusion that there is a simple solution to the failures of our financial systems and real economies. Things wouldn’t be wonderful if central banks had sat idly by. We cannot abolish democratic politics. Economic policy needs to be adapted to our world, not the 19th century.

Translated by Paulo Migliacci