G30 - Central Banking

8/20/2019 G30 - Central Banking

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FUNDAMENTALS OF

CENTRAL BANKING

Lessons from the Crisis


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ISBN 1-56708-167-3

Copies of this paper are available for US$75 from:

The Group of Thirty

1726 M Street, N.W., Suite 200

Washington, D.C. 20036

Tel.: (202) 331-2472

E-mail: [email protected], www.group30.org


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FUNDAMENTALSOF

CENTRAL BANKING

Lessons from the Crisis

Published byGroup of Thirty

Washington, D.C.October 2015


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Table of ContentsAbbreviations.....................................................................................................................................................................................................................iv

Foreword ............................................................................................................................................................................................................................... v

Acknowledgments .......................................................................................................................................................................................................vii

Working Group on Central Banking ................................................................................................................................................................ ix

Executive Summary ......................................................................................................................................................................................................xi

CHAPTER 1 The Evolving Role of Central Banks ......................................................................................................................................1

CHAPTER 2 The Global Economy Before and After the Crisis ...................................................................................................11

CHAPTER 3 The Reaction of Central Banks in the Major AMEs ...............................................................................................23

CHAPTER 4 Undesirable Side Effects and the Need to “Exit” .................................................................................................... 37

CHAPTER 5 How to Manage, Resolve, and Prevent Crises .......................................................................................................... 47

Conclusion ........................................................................................................................................................................................................................ 61

Glossary...............................................................................................................................................................................................................................63

Bibliography .....................................................................................................................................................................................................................67

Group of Thirty Members 2015.........................................................................................................................................................................75

Group of Thirty Publications ...............................................................................................................................................................................79

FIGURES

FIGURE 1. Inflation and Unemployment in the United States and Germany during the Interwar Period ..........................2

FIGURE 2. AME Inflation, Real Growth, and Real Policy Rates, 1956–85 ............................................................................................5

FIGURE 3. AME Inflation, Real Growth, and Real Policy Rates, 1985–2007 .......................................................................................8

FIGURE 4. AME Rate of Credit Growth and Nonfinancial Debt Relative to GDP, 1985–2014.................................................13

FIGURE 5. AME Level of House Prices, Equity Prices, and Volatility, 1985–2007 ..........................................................................14

FIGURE 6. EME Gross Capital Inflows and Level of FX Reserves, 1985–2007 ................................................................................17

FIGURE 7. Financial Sector Profits, 1985–2007 ...............................................................................................................................................19

FIGURE 8. Average Yield Spread of Eurozone Peripheral Country Sovereign Debt against Bundsand Private Sector Capital Net Inflows/Outflows, Q1 2004–Q2 2015 ..................................................................... 25

FIGURE 9. Real Policy Rates, 2007 to Mid-August 2015 ............................................................................................................................ 27

FIGURE 10. Central Bank Balance Sheets as a Percentage of GDP, Q1 2007–Q2 2015 ...........................................................29

FIGURE 11. Interest Rate Spreads on SME Loans in Eurozone Periphery, January 2004–July 2015 ................................. 32

FIGURE 12. Equity Prices, Prices for Bank Equity, and House Prices, Q1 2004–Q2 2015 .......................................................34

FIGURE 13. US High-Yield Spreads (against Treasuries), Peripheral Sovereign Debt Spreads (against Bunds),

and Volatility, Q1 2004–Q2 2015 .................................................................................................................................................40

FIGURE 14. EME Credit Growth, Inflation, and Level of FX Reserves, January 2004–June 2015 .......................................42


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AbbreviationsAMEs advanced market economies

BIS Bank for International Settlements

CPI Consumer Price Index

ECB European Central Bank

EME emerging market economies

FOMC Federal Open Market Committee

FX foreign exchange

GDP gross domestic product

IMF International Monetary Fund

lhs left-hand side

LTROs long-term refinancing operations

OECD Organisation for Economic Co-operation and Development

OMTs Outright Monetary Transactions

QE quantitative easing

rhs right-hand side

RORO risk on, risk off

SMEs small and medium-sized enterprises

TALF Term Asset-Backed Securities Loan Facility

VIX Volatility Index

y/y year-over-year

ZLB zero lower bound


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v

Foreword

The Group of Thirty’s (G30’s) mission is todeepen the understanding of internationaleconomic and financial issues, to explore the

international repercussions of decisions taken in thepublic and private sectors, and to examine the choicesavailable to market practitioners and policy makers.

Pursuing that important mission, the G30 decidedto undertake a major study of the evolving role ofcentral banking. That role has changed over the years,and in particular the developments around the eco-nomic and financial crisis of 2007–09 have led to areappraisal of the role that central banks play in amodern economy. The study was led by a SteeringCommittee comprised of Jacob A. Frenkel (chairman),and Arminio Fraga, and Axel Weber. They were sup-ported in their efforts by project director WilliamWhite and a Working Group comprised of sixteenmembers, all of whom are members of the G30. Thestudy continues the G30’s history and tradition of con-

tributing to public debate on policy topics of majorconcern to the global financial community.

The G30 believed that a study was needed to placerecent central bank policy actions within the histor-ical context. The study illuminates where the roles,responsibilities, objectives, and policy instruments ofcentral banks have changed and where they ought toremain the same.

Despite the institutional and conceptual changesthat have taken place, certain key principles held bycentral bankers adhered to over the years remain valid

and need to be maintained. Key among those are thatcentral banks must continue to pursue long-termprice stability. Crucially, this must be underpinned bystrong, independent central banks. This independencemust be secured. At the same time, without prejudiceto the principle of central bank independence, publicaccountability should be ensured.

Fostering financial stability must also be an import-ant part of a central bank’s mandate. The study findsthat avoiding excessive credit dynamics is instrumen-tal in achieving this objective, since the accumulationof debt over time can lead to growing imbalances inboth the real and financial sectors that can culminatein systemic financial crisis.

The report underscores the critical role of centralbanks in the management and resolution of crises.Central banks also have a vital role in maintainingfinancial stability, and in crisis prevention efforts.These tasks should remain part of the central banks’responsibilities. But central banks should not beexpected to do it alone.

The immediate and short-term benefits associatedwith conventional and unconventional monetary pol-icies are recognized. At the same time, some of thesepolicies might have unintended consequences, andhow to minimize them remains a challenge.

The study warns that the ultimate resolution ofcrises often can only be dealt with through arms ofgovernment other than the central bank. However,central bank policy actions can be supportive andcomplementary to effective government actions.

Serious risks may arise if governments, parliaments,public authorities, and the private sector assume thatcentral bank policies can substitute for the structuraland other policies they should take themselves. Failureto grasp the opportunity offered by central banksmight risk the precipitation of future crises.

The report is the product of the Steering Committeeand Working Group on Central Banking and reflectsbroad support and agreement among participantsabout the general principles and conclusions. It doesnot imply agreement with every specific observationor nuance. Members participated in their personal


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FUNDAMENTALS OF CENTRAL BANKING: LESSONS FROM THE CRISIS

vi

capacity, and their participation does not implysupport from their respective public or private insti-tutions. The report does not necessarily represent theviews of the membership of the G30 as a whole.

Jacob A. Frenkel Jean-Claude Trichet

Chairman of the Board of Trustees Chairman and CEOGroup of Thirty Group of Thirty

We hope this report adds to the debate on thelessons to be learned from the 2007–09 crisis, andthe continued role of central banks going forward asthey pursue price stability and financial stability in thecontext of a changing global economy.


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Acknowledgments

On behalf of the entire Group of Thirty (G30),we would like to express our appreciation tothose whose time, talent, and energy have

driven this project to a rapid and successful completion.We would like to thank the members of the Working

Group on Central Banking, all of whom are membersof the G30, who collaborated in our work at everystage and added their unique insight. The intellect andexperience brought to the deliberations by the sixteenmembers, which consisted of former central bank gov-ernors, regulators, and academics, was remarkableand essential to the success of the project.

No study of this magnitude can be accomplishedwithout the committed effort of a strong team. TheG30 extends its deep appreciation to William White,

who performed superbly as Project Director anddraftsman. We all appreciated his hard work on syn-thesizing the collective wisdom of the Working Groupmembers into a cohesive narrative and final report.

The coordination of this project and many aspectsof project management, Working Group logistics, andreport production were centered at the G30 offices inWashington, D.C. This project could not have beencompleted without the careful eye of our editor, DianeStamm, and the dedicated efforts of Executive DirectorStuart Mackintosh and his team, including CorinneTomasi and Stephanie Tarnovetchi of the G30 staff,and former Associate Director, Meg Doherty. We alsowish to acknowledge the able assistance provided byVolker Schieck of UBS.

Jacob A. Frenkel

Chairman, Working Group on Central Banking

Arminio Fraga Axel A. Weber

Steering Committee Steering Committee


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Working Group on

Central Banking STEERING COMMITTEEJacob A. Frenkel

Chairman of the Board of Trustees, Group of ThirtyChairman, JPMorgan Chase International Former Governor, Bank of Israel

Arminio Fraga

Founding Partner, Gávea InvestimentosFormer Governor, Banco Central do Brasil

Axel A. Weber

Chairman, UBSFormer President, Deutsche Bundesbank

PROJECT DIRECTORWilliam White

Chairman of the Economic and Development Review Committee,Organisation for Economic Co-operation and Development

Former Economic Adviser and Head of Monetary and EconomicDepartment, Bank for International Settlements

WORKING GROUPJean-Claude Trichet

Chairman and CEO, Group of ThirtyFormer President, European Central Bank

Leszek Balcerowicz

Professor, Warsaw School of EconomicsFormer President, National Bank of Poland

Geoffrey L. Bell

Executive Secretary and Treasurer, Group of ThirtyPresident, Geoffrey Bell and Company, Inc.

Jaime Caruana

General Manager, Bank forInternational Settlements

Former Financial Counsellor,International Monetary Fund

E. Gerald Corrigan

Managing Director, Goldman Sachs Group, Inc.Former President, Federal Reserve

Bank of New York


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Guillermo de la Dehesa

Vice Chairman and Member of the ExecutiveCommittee, Grupo Santander

Chairman, Aviva Grupo Corporativo

Jacques de LarosièrePresident, EurofiFormer Governor, Banque de France

Richard Debs

Advisory Director and Former President,Morgan Stanley International

Former COO, Federal Reserve Bank of New York

Martin Feldstein

Professor of Economics, Harvard University

President Emeritus, National Bureauof Economic Research

Philipp Hildebrand

Vice Chairman, BlackRockFormer Chairman of the Governing

Swiss National Bank

Guillermo Ortiz

Chairman of the Advisory Board,Grupo Financiero Banorte

Former Governor, Banco de México

William R. Rhodes

President and CEO, William R.Rhodes Global Advisors

Former Senior Vice Chairman,Citigroup and Citibank

Kenneth Rogoff

Thomas D. Cabot Professor of Public Policyand Economics, Harvard University

Former Chief Economist andDirector of Research, IMF

Tharman Shanmugaratnam

Deputy Prime Minister & Ministerfor Finance, Singapore

Chairman, Monetary Authority of Singapore

Masaaki Shirakawa

Special Professor of International Politics,Economics, & Communication,Aoyama Gakuin University

Former Governor, Bank of Japan

Adair Turner

Chairman of the Governing Board, Institutefor New Economic Thinking

Former Chairman, Financial Services Authority, UK

EXPERTSStuart P.M. Mackintosh

Group of Thirty

Volker Schieck

UBS

Board,


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Executive Summary INTRODUCTIONAlmost from their beginnings, over three centuriesago, the ultimate objective of central banks has beento support sustainable economic growth through thepursuit of price stability and financial stability. Overtime, however, the balance of each goal has fluctu-ated according to existing cultural, economic, andpolitical pressures.

In the immediate decades prior to the 2007–09economic and financial crisis, the policy pendulumswung strongly toward favoring price stability, withthe focus on the relatively short term. The GreatModeration—a period of apparent relative economiccalm and stability—occurred in the advanced marketeconomies (AMEs). This economic stability supporteda theoretical view and mindset that saw the economyas being inherently self-stabilizing, and efficient in itsallocation of scarce resources. This view prevaileddespite building evidence of underlying tensions or

imbalances, and the proliferation of localized eco-nomic and financial crises. In hindsight, the economiccalm obscured a credit bubble that was growing andbecoming precarious. When the bubble collapsed,the crisis erupted and central banks and governmentsresponded swiftly.

During the response to the economic and financialcrisis, central banks played an essential crisis man-agement role alongside governments. Central banksin the major AMEs reacted with vigor. Policy rateswere reduced essentially to zero, forward guidance

was used to help lower medium-term rates, and thebalance sheets of central banks expanded enormously,while their composition altered significantly. Centralbanks fought to restore financial stability, and aggres-sive unconventional policy action was necessary andeffective in the crisis response phase, in particular.

Collectively, central bank policies since the outbreakof the crisis have made a crucial contribution to restor-ing financial stability.

In 2015, eight years on since the eruption of thecrisis, the central banking community still faces manydifficulties and challenges as it surveys possible exitstrategies from their current policy stances and grap-ples with the possible medium-term impacts. Whilethe short-term benefits associated with conventionaland unconventional monetary policies are self-evi-dent, the costs of the unintended consequences arenot. Only time and further policy measures will revealthe magnitude of such costs.

In light of the crisis and the subsequent policyresponses, important questions have arisen as to theproper roles, duties, and obligations of central banksin the years ahead.

This report seeks to illuminate central banking

lessons from the pre-crisis period, the crisis itself,and the subsequent policy responses, and to add tothe important process of delineating central bankingroles and responsibilities, and how they have beenreinforced and modified. Central banks and theirleaderships are continuing a process of self-criticalassessment, what should be learned from the crisis,the policy responses, and the outcomes, positive andnegative, intended and unintended, that have resultedfrom those policies.

The report finds that while some of the earlier

beliefs held by central bankers need to be modified,there are key pillars that constitute the foundations ofcentral banking that must be maintained. The reportidentifies three key principles and ten key observationsdealing with the Frameworks to Manage and ResolveCrises, and Financial Stability and Crisis Prevention.


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KEY PRINCIPLESThe three key principles that are indispensable facetsof central banking today and going forward are:

1. Longer-term price stability is the most important

contribution central banks can make to ensuringstrong and sustainable growth. Both high inflationand significant deflation can entail heavy eco-nomic costs. Maintaining price stability, frequentlyunderstood as a low, stable inflation rate over themedium term, will also contribute to stabilizingbusiness cyclical fluctuations in economic activitythrough a solid anchoring of inflation expectations.

2. Fostering financial stability should also be an

important part of a central bank’s mandate.

Avoiding excessive credit dynamics is instrumental

in achieving this objective, since the accumulationof debt over time can lead to growing imbalancesin both the real and financial sectors that can cul-minate in systemic financial crisis. Central banksshould be given responsibility for identifying suchsystemic threats and for trying to offset relatedrisks to long-term price stability. This implies thatcentral banks must have ultimate authority overall the relevant policy tools, including macropru-dential instruments.

3. It is crucial that the independence of central banks

be maintained. Central banks must be able to focuson policies orientated toward longer-term objec-tives. They must be kept free from undue politicalor popular pressures to provide short-term stimulusor other policy actions that are ultimately incon-sistent with this core mandate. The indispensableaccountability should be ensured without prejudiceto the principle of central bank independence.

KEY OBSERVATIONS

In addition to the three key principles, the report makesten key observations addressing the Frameworks toManage and Resolve Crises, and Financial Stabilityand Crisis Prevention. The report recognizes theimportant role that central banks must play in themanagement and resolution of crises, as part of theirresponsibility to contribute to the stability of the finan-cial system as a whole. But central banks should notbe overburdened and cannot do it alone. Governments

should also play an important role in crisis resolution,management, and prevention. Governments have aresponsibility to address structural, regulatory, andother weaknesses in the real economy that might oth-erwise contribute to the gestation of future crises.

Frameworks to Manage

and Resolve Crises

1. The principal lesson to be drawn from the eco-

nomic and financial crisis that erupted in 2007

is that serious economic and financial crises can

happen, even in low inflation advanced market

economies. Thus, all countries must prepare by

putting in place frameworks both to manage and

to resolve crises. Central banks need to be cog-nizant of the lessons of economic history, and beready to explore various analytical frameworks thatwould help anticipate the emergence of such crises.This would also contribute to preventing crises.

2. Central banks have a crucial role to play in crisis

management and, in particular, in ensuring the

stability and smooth functioning of the financial

system. Preparations beforehand, in associationwith other government bodies, are of crucialimportance in ensuring the crisis does not spin outof control. Central banks must also have flexibilityand, where necessary, be strengthened in their flex-ibility and powers to act to deal with unexpectedand rapidly changing circumstances. This includesnot only the traditional instrument of Lender ofLast Resort, but also the powers to deploy uncon-ventional monetary instruments like those used inrecent years.

3. However, the ultimate resolution of crises that

have their roots in excessive credit creation and

debt accumulation often can only be accom-

plished through arms of government other than

the central bank. Preparations made beforehand,such as legislation concerning bankruptcies, arecrucial.

4. Supportive actions by central banks can be

useful, but there are serious risks involved if gov-

ernments, parliaments, public authorities, and

the private sector assume central bank policies

can substitute for the structural and other pol-

icies they should take themselves. The principal


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risk is that excessive reliance on ever more centralbank action could aggravate the underlying sys-temic problems and delay or prevent the necessarystructural adjustments.

5. While unconventional policies such as quanti-

tative easing, off-balance-sheet commitments,

and forward guidance have played an import-

ant role in the management of recent crises,

deeper studies are still needed to ascertain their

longer-term overall benefits and unintended

consequences. In particular, the possibility thatsuch unconventional policies might encourageexcessive risk taking, and appropriate means tocounter such risks, should be considered.

Frameworks for Financial Stability

and Crisis Prevention

The report underscores the important role playedby central banks regarding financial stability andcrisis prevention. At the same time, it highlights thechallenges that might arise as central banks seek tocarry out their responsibilities using conventional andunconventional policies that might have potentiallyunintended consequences over the medium term.

1. Central banks have a primary responsibility to

ensure the efficiency and stability of the global

payments and settlements systems. Failures inthe function of such systems would likely haveserious systemic implications for the economy.

2. Macroprudential policies have a role to play

in crisis prevention, especially in dealing with

credit-supported booms, particularly those in

the housing sector. However, the effectiveness ofthese tools will have to be carefully monitored andevaluated. Microprudential polices, designed toimprove the health of individual financial insti-tutions rather than the system as a whole, might

also be useful in reducing the magnitude of bothcredit booms and subsequent busts. While thereis a growing consensus that central banks shouldplay a key role in ordinary bank supervision, opin-ions differ on whether central banks should takeon a larger role in microprudential supervisionmore generally.

3. There is broad-based consensus that flexible

exchange rates are the best way to minimize the

international repercussions of domestic mone-

tary policies. In order to avoid having to resortto administrative measures to deal with such

“spillover” effects, central banks should supportstructural measures to improve the functioning oftheir domestic financial markets and to increasetheir resilience to external shocks.

4. Central banks must be transparent in explaining

their policy actions. This will increase the capacityof markets to understand monetary policy deci-sions, and thereby contribute to financial stability.

5. While macroprudential policies are the preferred

choice to address financial stability concerns,

there is no consensus as to whether monetary

policy should be used to lean against excessive

credit expansion and the resulting buildup of

(noninflationary) “imbalances” in the economy. While “leaning against the wind,” that is, usinginterest rates in order to do so, could play a usefulrole, it would lead to prices undershooting near-term desired levels. Therefore, the price stabilitytarget should be set over a longer horizon, withless near-term precision than is currently the case.At the least, care should be taken to ensure thatmonetary policy is conducted more symmetrically

over a financial cycle.

CONCLUSION

Central banks worked alongside governments toaddress the unfolding crises during 2007–09, andtheir actions were a necessary and appropriate crisismanagement response. But central bank policies aloneshould not be expected to deliver sustainable economicgrowth. Such policies must be complemented by otherpolicy measures implemented by governments. At

present, much remains to be done by governments,parliaments, public authorities, and the private sectorto tackle policy, economic, and structural weak-nesses that originate outside the control or influenceof central banks. In order to contribute to sustainableeconomic growth, the report presumes that all otheractors fulfill their responsibilities.


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CHAPTER 1

The Evolving Roleof Central Banks

SYNOPSISAlmost from their beginnings, over three centuries

ago, the ultimate objective of central banks has beento support sustainable economic growth throughthe pursuit of price and financial stability. However,the balance of emphasis on these two intermediateobjectives has varied over time. Early on in centralbank history, the objective of financial stability hadprimacy. However, by the eve of the crisis that eruptedin 2007, the balance had swung almost totally in thedirection of seeking price stability, and that over a rela-tively short policy horizon. The magnitude, scope, andlong duration of this unexpected crisis now demandsa reevaluation of how central banks might best con-tribute to the pursuit of strong and stable growth.While many of the pre-crisis beliefs held by centralbankers need to be maintained, not least of which isthe pursuit of longer-run price stability, others need tobe adapted or even rejected to ensure their continuedappropriateness in light of the continuing evolution ofthe global economy. There are important lessons to bedrawn from recent events, but the lessons suggested bythe longer sweep of central banking history must notbe forgotten. One key lesson is that central bankingshould be guided by medium-term rather than short-

term considerations, which implies that central banksshould avoid fine-tuning policies.

INTRODUCTIONCentral banks were first established in the 17thcentury, with the primary purpose of providing warfinance to governments and managing their debts.

Their role in the economy has since evolved in a verydifferent direction. The pursuit of sustainable eco-nomic growth became fundamental to their activities

from the early 19th century onward. Nevertheless,views about the relative importance of price and finan-cial stability in contributing to these broader objectiveshave fluctuated over time. Nor can it be said thatcentral banks have always successfully achieved theirbroader objectives, since periods of relative successhave been punctuated by periods of significant eco-nomic instability. However, these periods generallyled to a transitional phase of reflection about what hadgone wrong and how to fix it. A common finding ofthese reflections was that the economy itself had been

evolving, either endogenously or in response to previ-ously taken policy initiatives. Given a gap between thetheory and reality of how the economy works, theoryhad to give way to reality. Central bank practices havehad to evolve, as well.

In light of the global economic and financial crisisthat began in 2007, and whose impact continues tobe felt, we have clearly entered another such transi-tional period. Previously held beliefs about how theeconomy works, and how central banks should behavein pursuit of their objectives, are now being seriouslyquestioned. New hypotheses are being proposed anddebated. This report will highlight areas of currentconsensus in this debate, and also areas where therecontinue to be significant disagreements.

A critical finding is that the pursuit of longer-termprice stability continues to be an indispensable guidefor central banks going forward. Both high andvariable inflation and significant deflation can haveheavy costs, including periods of both economic and


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financial instability (see figure 1). Central Europe inthe 1920s, and recurrent events in Latin America,

provide good examples of the former, while the UnitedStates in the 1930s is a good example of the latter.Since history teaches that such periods have often ledto social and political instability, as well, they areclearly best avoided.

At the same time, the simple observation of sus-tained price stability is no guarantee that economicand financial instability will be avoided. History indi-cates that other dangerous imbalances often build upunder the calm surface of price stability, only to eruptwith devastating consequences. It is notable that therewas no significant inflationary pressure in the United

States prior to the 1929 Great Depression, nor in Japan prior to its Great Recession, nor in SoutheastAsia prior to the crisis of the late 1990s. Centralbanks need to keep their minds open to the disqui-eting possibility that stability of one sort can breed

instability of another sort.1 Indeed, history is repletewith major economic and financial crises that have

occurred under a wide range of circumstances. Thatsaid, a unifying theme throughout history seems tohave been “booms,” driven by a rapid rate of growthof credit, followed by a “bust” whose seriousness washighly correlated with the magnitude of the boom thatpreceded it.2

Similarly, the indispensable role of central banksin helping manage and contain periods of financialinstability needs to be recognized and continued.Over the centuries, central banks have been able toreact flexibly to constrain market disruptions. Notonly have they provided lender-of-last-resort facilities,

but they have also used their extensive knowledge offinancial structures and market practices to ensure themaintenance of essential financial services. Given theeconomic costs associated with the loss of such ser-vices, this has been a crucial function. Nevertheless,

FIGURE 1. Inflation and Unemployment in the United States

and Germany during the Interwar Period

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.030.0

35.0

1 9 2 5

1 9 2 6

1 9 2 7

1 9 2 8

1 9 2 9

1 9 3 0

1 9 3 1

1 9 3 2

1 9 3 3

1 9 3 4

1 9 3 5

1 9 3 6

1 9 3 7

1 9 3 8

1 9 3 9

1 9 4 0

German CPI, % y/y US CPI, % y/y

German unemployment rate US unemployment rate

SOURCES: Mitchell International Historical Statistics; UBS.

1 The classic statement on this is Minsky (1986).

2 For overviews of such episodes, see Jorda, Schularick , and Taylor (2014), Kindelberger and Aliber (2005), and Reinhart and Rogoff (2009).


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as with all such public sector interventions, centralbank support could also encourage private sector par-ticipants to behave imprudently in the future. Thisissue of potential moral hazard generated by publicpolicies needs significantly more attention than it has

received to date.In a complex and evolving world, there is not likely

to be a single template for how central banks shouldbest behave, nor for how best to allocate responsi-bilities between central banks and other arms ofgovernment. Local conditions, institutions, stages ofdevelopment, and history must all matter. However,there are some key principles that are universal, andthey involve the division of responsibility betweengovernments and central banks. It is of particularimportance that governments do not overburden

central banks in trying to make the economy workbetter. There are limitations to what monetary policyalone can do. This applies not only to the preventionof future crises but, perhaps particularly so, to themanagement of the current one.

SOME HISTORICALPERSPECTIVEEarly central banks were commonly set up to providefinance to help fund wartime governments. In return,

they were given certain advantages that initiallyenabled them to become the largest commercial bank,the manager of government debt, and the main issuerof currency notes.3 As a large private bank, they alsocame to occupy a central position facilitating inter-bank transactions and providing an array of servicesto correspondent banks. It was from this central posi-tion that lender-of-last-resort facilities developed,since central banks provided emergency funds tobanks caught up in recurrent banking panics. Evenin these early years of central banking, it was recog-nized that financial instability was incompatible with

stability in the real economy, and perhaps with pricestability, as well.

Similarly, central banks began conducting mone-tary policy through discounting debt securities offeredby other banks. The interest rate established on thesecollateralized loans then became the fulcrum for creditconditions throughout the economy. The need for such

a governance mechanism stemmed from the recog-nition that an economy with a developed bankingsystem is profoundly different from a barter economy.In a barter economy, there can rarely be investmentwithout prior saving. However, in a world wherea private bank’s liabilities are widely accepted as amedium of exchange, banks can and do create bothcredit and money. They do this by making loans, orpurchasing some other asset, and simply writing upboth sides of their balance sheet.

On the one hand, such a system provides a welcome

form of lubrication for the real economy, fosteringboth investment and economic growth. On the otherhand, unfettered monetary and credit creation hasthe potential to generate inflation4 and create unsus-tainable distortions in both the financial sector andthe real economy. In fulfilling their monetary policyfunction, central banks have always been confrontedwith the need to find the balance between these con-tradictory forces. In the end, their credibility rests ontheir being able to resist the temptation to seek short-term benefits at the expense of longer-term costs.

Central banking was at its simplest from around

the 1870s to 1914, under the classical gold standard.This regime was based on a credible commitment ofthe central bank to exchange its notes for gold at afixed price, and to follow the rules of the game whenfaced with either international inflows or outflowsof gold. The gold standard ensured the stability ofthe price level over time, albeit at the expense of longswings in prices both up and down. These swings,however, were not thought of significant concern giventhe flexibility at that time of both prices and wagesthroughout the economy.

Moreover, the regime made a significant contri-bution to financial stability, as well. Recourse to

3 See Goodhart (1988) and James (2013).

4 For decades, monetary theory revolved around the equation MV = PY, which linked money (M) direc tly to prices (P) if V (the velocity ofcirculation of money) and Y (real output) were assumed constant. While it is recognized today that V can be highly variable, as a longer-runproposition, the equation has a timeless allure.


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lender-of-last-resort lending, in the face of bankingpanics, was only possible because it did not lead tocapital flight encouraged by fears of longer-terminflationary finance. The fact that policy rates weregenerally raised at the same time provided further

support for this belief. Given the credibility of theregime, the expansion of the central bank’s balancesheet was judged a temporary expedient only. Thatsaid, there were major bouts of financial instabil-ity during this period, not least in 1873 and 1907.Generally, they had their roots in positive real sideshocks that eventually led to excessive exuberance,often made worse by financial innovations havingunexpected consequences.5

The gold standard was overwhelmed by the financ-ing needs of governments during World War I. As

central banks were forced to revert to their originalfunction of buying government debt, inflation rosesharply in all the belligerent countries. Moreover,in the postwar period, a combination of recessions,hyperinflation, and exchange rate instability furtherindicated the costs of losing control over the monetarysystem. This in turn led to efforts to reestablish theprewar gold standard, but these efforts failed for avariety of reasons.

Perhaps the most important reason was that thecredibility of the commitment to gold convertibilitywas never reestablished in the postwar period. For

countries short of gold, like Great Britain, increasinglyinflexible labor markets implied that honoring thecommitment would likely result in unacceptable levelsof unemployment. In contrast, the United States, whilea recipient of gold inflows, sterilized these inflows,violating the agreed rules of the game. This reactionwas not surprising given that, in the 1920s, domes-tic monetary and credit growth was already veryrapid, that banks were engaged in increasingly riskybehavior, and that US stock prices were hitting recordhighs.6 In short, domestic preoccupations everywhere

eventually overwhelmed international commitments.The failure of these commitments ushered in the

1929 Great Depression, which was characterized by

sharply falling prices and financial instability on avast scale. Neither of the intermediate objectives thensought by central banks had been realized. Whetherjustified or not, central banks and the financial systemwere apportioned a significant part of the blame. In

many countries, including the United States and GreatBritain, the monetary policy function of the centralbank was increasingly taken over by the Treasury, anddomestic financial systems became subject to a signifi-cant degree of regulation. Not surprisingly, the first ofthese acts led to significant inflation during and afterWorld War II. However, the suppression of domesticfinancial systems, together with deposit insurance andnew safety net features in many countries, sharplyreduced the number of bank failures and incidences offinancial instability between the 1940s and 1980s.7 As

an unexpected side effect, however, domestic financialrepression led many large banks to engage in regula-tory arbitrage and to expand internationally, with aview to avoiding restrictions in their home markets.

Central banks began to recover some of their mone-tary policy functions in the 1950s, and initially focusedon pursuing the objective of price stability. This was alsodeemed consistent with the rules of the game under theBretton Woods system of fixed but adjustable exchangerates set up in 1944. However, the United States was atthe very core of this new international system, whichwas referred to as the US dollar exchange standard,

and it gradually reverted to the pursuit of inflationarypolicies deemed to be in its own national interest. Therewas at the time a widespread belief in the United Statesthat unemployment could be permanently lowered atthe cost of only a slight increase in inflation (referredto as the Philips curve relationship). Nevertheless, thesehigher inflation levels discomforted other countries,some of which announced their intention to exchangedollars for gold. Germany, whose central bank had formany years strictly pursued price stability through thelens of the monetary aggregates, was instrumental in

this development. The Bretton Woods system endedformally in 1971, when President Nixon closed thegold window.

5 See Schumpeter (1934) and The Economist (2014) for an overview of some earlier crises. What is striking is the pervasive interaction throughtime of real and financial innovations.

6 James (2013) notes that the Federal Reserve did lower its policy rate in 1927 to help relieve downward pressure on the British pound, but thisalso gave impetus to a further sharp increase in stock prices.

7 For a review of this, see Bordo et al. (2001).


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The breakdown of the Bretton Woods system wasfollowed by a sharp acceleration of inflationary pres-sures worldwide and a deep recession beginning in1974. Freed from international constraints, manycentral banks focused their monetary policy on reduc-

ing unemployment, which had risen sharply after thefirst oil price shock of 1973. However, as inflationaryexpectations quickly ratcheted up, many central bankscame to the unpleasant realization that they had trulyopened a Pandora’s box. In a number of countries, ashort-lived attempt was made to try to stabilize theserising inflationary expectations through the introduc-tion of monetary targets. However, this stratagemfoundered as new technological developments led tolarge shifts in demand for money functions that hadpreviously seemed quite stable. By 1979, when the

second oil price increase occurred, most central bankshad become significantly more focused on containingits inflationary effects rather than leaning against itseffects on unemployment (see figure 2).

Perhaps of equal significance, as a result of the twooil price shocks of the 1970s, there was a perceived

need to “recycle” internationally the receipts of theoil producers back into the hands of the oil consum-ers. Given the relatively low spending propensities ofthe oil producers, overall global demand could not bemaintained otherwise. As it happened, this recycling

was done primarily through loans to emerging marketeconomies (EMEs) whose capacity to repay becamemore doubtful when policy rates began to rise in theearly 1980s. In this manner, concerns about finan-cial stability, so long quiescent, once again became anissue with the solvency of large, internationally activebanks being increasingly questioned.

In fact, central banks and others had in the mid-1970s already been given a forewarning about thepotential problems associated with the internation-alization of commercial banking activity. The failure

in 1974 of two banks, the Franklin National Bankin the United States and Bank Herstatt in Germany,not only had international causes but also significantinternational implications. As a result, central bankscooperated closely at the international level to mitigatethe fallout from these events, and also took cooperative

FIGURE 2. AME Inflation, Real Growth, and Real Policy Rates, 1956–85

-5

0

5

10

15

1 9 5 6

1 9 5 7

1 9 5 8

1 9 5 9

1 9 6 0

1 9 6 1

1 9 6 2

1 9 6 3

1 9 6 4

1 9 6 5

1 9 6 6

1 9 6 7

1 9 6 8

1 9 6 9

1 9 7 0

1 9 7 1

1 9 7 2

1 9 7 3

1 9 7 4

1 9 7 5

1 9 7 6

1 9 7 7

1 9 7 8

1 9 7 9

1 9 8 0

1 9 8 1

1 9 8 2

1 9 8 3

1 9 8 4

1 9 8 5

Advanced economy real policy rate, %

Advanced economy real GDP, % y/y

Advanced economy CPI, % y/y

SOURCES: International Monetary Fund; UBS.


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6

steps to reduce the prospective costs of future crises.8 In particular, they established the Basel Committeefor Banking Supervision. Attended by both regulatorsand central bankers, the Basel Committee continuesto be active to the present day. Moreover, the rather

particular circumstances surrounding the failure ofBank Herstatt motivated central banks to pay muchmore attention to problems in the payments and set-tlement systems, both domestic and international.9 Over subsequent decades, significant improvementshave been introduced under the general guidance ofthe Committee on Payments and Settlements Systems,also based at the Bank for International Settlements(BIS). These ongoing improvements to the “plumbing”have been an invaluable contribution by central banksto the stability of the international financial system.

Central banks have a primary responsibility to

ensure the efficiency and stability of the global

payments and settlements systems.

However, by the late 1970s, banking problemswere not the only concern of central bankers. Thecontinued acceleration of inflation in many advancedmarket economies (AMEs) had taken it to uncomfort-

ably high levels. Crucially, this indicated the falsity ofsome earlier beliefs. Most important, the facts madeit clear that unemployment could not be permanentlydecreased by accepting only a slight increase in infla-tion. Moreover, somewhat earlier, Milton Friedman(1968) and Edmund Phelps (1968) had also providedtheoretical justification for arriving at the same con-clusion. These insights led central banks to sharplyreorient their policies back toward the achievementof price stability. At first, emphasis was placed on sta-bilizing inflation, but as central banks increasingly

recognized the harm generated by high inflation, thefocus of AME central banks shifted during the 1980sto reducing inflation back down to low levels. Central

banks in many Latin American and Central Europeancountries drew similar lessons, as did the central bankin Israel.

Longer-term price stability is the most importan

contribution central banks can make to ensuring

strong and sustainable growth.

This renewed and primary focus on maintain-ing low inflation continued through to the onset ofthe crisis in 2007. It was supported, as well, by theadoption of inflation targeting regimes in many coun-tries. These regimes had official targets (or bands) forinflation, and strong commitments and incentives

(mandates, explicit powers, and political account-ability) to achieve them. They became particularlypopular in countries, both advanced and emerging,whose record of controlling inflation in the past hadnot been so good. In effect, these regimes consti-tuted attempts to build institutional credibility andto shock down inflationary expectations. In general,these efforts proved successful, not least due to targetgoals being accompanied by legislation that assuredthe functional independence of central banks.

It is crucial that the independence of central

banks be maintained.

At a more technical level, most central banks cameincreasingly to rely on an assessment of the size of theoutput gap (the gap between aggregate demand andpotential supply) in determining the extent of infla-tionary or disinflationary pressures in the economy.It also became general practice for central banks to

set their policy instrument, commonly a short-termpolicy rate, to be consistent with a forecast for infla-tion that was “on target” over a two-year horizon. In

8 James (2013).

9 Bank Herstatt was declared insolvent around noon, European time. At that point, Bank Herstatt had already received payments in Deutschemarks in Frankfurt , but time zone differences meant it had not yet set tled with dollar payments to counterparties in New York. These creditorswere then left unpaid, a possibility that is now known as Herstatt risk. This experience led central bankers in virtually all major countriesto introduce Real Time Gross Settlement Systems, which ensure that payments between banks a re made simultaneously in real time and aretreated as final and irreversible.


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this process, the use of a Taylor rule, linking policyrate changes to the output gap, and deviations of infla-tion from targeted levels, became common practice.10

It is, moreover, also notable that three of the world’smost important central banks—the Federal Reserve,

the European Central Bank, and the Bank of Japan—have not committed to a rigid inflation targetingregime. Moreover, as will be made clearer in subse-quent chapters, central bank policies have sometimesdiffered, as well, even in the face of seemingly similareconomic circumstances. In part, this reflects the dif-ferent financial structures faced by central banks indifferent parts of the world.11

Different central banks have also commonly empha-sized different indicators in assessing the appropriatestance for monetary policy.12 The Federal Reserve

has a dual mandate comprising both unemploymentand inflation, and focuses on the output gap to gaugeboth. The European Central Bank also assesses themedium-term inflationary pressures through its eco-nomic analysis pillar, but has a second monetary pillarto which it pays significant attention. The Bank of

Japan also puts great weight on the output gap but,from the early 2000s until recently, also had a secondperspective. In effect, it stated that the Bank of Japanwas committed to avoiding a repeat of the Japaneseexcesses of the 1980s. That said, from the 1980sthrough to the onset of the current crisis, all of these

central banks made price stability the central objectiveof their monetary policy actions. Further, they seemsince then to have undergone a process of conceptualconvergence,13 which, while it stopped short of explicitinflation targeting, had the effect of establishing 2percent as the generally desired price stability goal.

Pursuit of the objective of price stability wasremarkably successful in most of the AMEs, and ofmany EMEs. Both the level and volatility of infla-tion fell sharply (see figure 3). Moreover, followingthe deep recession that accompanied the beginning

of disinflation in the early 1980s, recessions in manycountries (particularly the United States) also becameless frequent and less severe. The confluence of thesetwo developments was increasingly referred to asthe Great Moderation. At the same time, financial

instability again became much more of a problem.Rapid credit growth, often linked to the markets forhouses and commercial property, seemed to be theproximate cause. Underlying this development wasthe process of financial deregulation that began in the1980s. However, increased risk taking by financialinstitutions and other lenders might also have beenencouraged by the success of successive public sectorattempts to moderate cyclical downturns. This issueis returned to below.

In the early 1980s, as the loans made to emerging

markets to recycle oil revenues began to deteriorate,the solvency of the banks granting the loans wasincreasingly called into question. Regulatory forbear-ance through the 1980s, together with faster economicgrowth and a series of restructuring plans, eventuallyresolved that problem. Yet, even as this was happen-ing, other financial problems were emerging. In theUnited States, the removal of the regulatory cap ondeposit rates at savings and loan associations in the1980s led to a greater reliance on short-term fundingfor fixed-rate 30-year mortgages. Not surprisingly, bythe early 1990s, this had resulted in many bankrupt-

cies. A sharp stock market decline in the United Statesin 1987 also led to similar price decreases in a numberof other countries. In the Nordic countries and Japan,rapid credit growth related to rising property pricesculminated in severe crises in the early 1990s, whicheventually required wholesale restructuring of theirbanking systems.

Similarly, the banking systems of many countriesin Southeast Asia were threatened in 1997 by matu-rity and currency mismatch problems. Restructuringwas required, accompanied by a massive recession in

10 See Taylor (1993).

11 For example, in Europe the financial system is largely based on intermediation by banks, whereas in the United States, direct financing throughmarkets plays a much more important role. It is not surprising then that the ECB and the Fed have different views about the effectiveness ofvarious instruments of monetary policy.

12 These are not the only reasons why central bank policies can differ. They can have different biases in responding to the risks of inflation asopposed to the risks of unemployment. Different tradeoffs between near-term risks and longer-term risks are also common. See White (2011)for a general treatment of these issues. For a more focused assessment of differences between the Federal Reserve and the European CentralBank, see Fahr et al. (2011).

13 Trichet (2013).


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many countries. Still further problems arose in thefinancial systems of AMEs when a large hedge fund,Long-Term Capital Management, had to be unwoundby a consortium of its counterparties. Finally, in 2001,

stock exchanges around the world fell sharply after anunprecedented price boom, noted particularly in thetechnology, media, and telecommunications sectors.However, policy rates were subsequently loweredby unprecedented amounts and with unprecedentedspeed, and the subsequent recession in fact provedquite moderate.

All these financial developments might haveprompted the major central banks to ask whethermonetary policy had any role to play in helping preventsuch crises. Apart from the fact that the two-yearhorizon of inflation targeting was in many countriesextended to a medium-term duration, central banks’beliefs in the correctness of their policy approach hard-ened. The contention that price stability was necessaryfor stability in the real and financial sectors seemedtransformed into the contention that price stabilitywas actually sufficient to avoid most macroeconomic

problems. It took the crisis that began in 2007 to cat-alyze another fundamental rethink.

CENTRAL BANKERS’ BELIEFSON THE EVE OF THE CRISISWhat did central bankers believe on the eve of thecrisis and why did they believe it? While the beliefs ofcentral bankers differed in various ways, there was arough consensus on certain fundamental principles.14 These were suggested by the long historical experi-ence referred to above, and ongoing developments ineconomic theory.

First, there was the belief that price stability (a lowbut positive inflation rate) should be the core mandate

for central banks. The experience of the AMEs withinflation in the 1970s left a huge scar. High inflationhad inflicted major costs to the real economy, reduc-ing growth and raising volatility. While inflationaryexpectations had proved easier to shock down thanearlier feared, it was recognized that this might notalways be the case. Moreover, sporadic experience

FIGURE 3. AME Inflation, Real Growth, and Real Policy Rates, 1985–2007

-1

0

1

2

3

4

5

1 9 8 5

1 9 8 6

1 9 8 7

1 9 8 8

1 9 8 9

1 9 9 0

1 9 9 1

1 9 9 2

1 9 9 3

1 9 9 4

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

Advanced economy real policy rate, %

Advanced economy real GDP, % y/y

Advanced economy CPI, % y/y

SOURCES: International Monetary Fund; UBS.

14 A helpful reference in this regard is the chapter by Blinder in Blinder et al. (2013).


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with very high inflation in certain EMEs indicated thepossible magnitude of the damage when a fiat moneysystem was allowed to get totally out of control. In con-trast, the restoration of price stability had ushered inthe Great Moderation, as indeed many had predicted.

Evolving mainstream macroeconomic theory alsocontributed to this belief. It essentially said that overthe long run monetary policy could only affect prices,not real variables. Thus, targeting real variables was notonly impractical, but impossible. Further, in the face ofa demand-side shock, there was no conflict betweenthe pursuit of full employment and the pursuit of lowinflation. In effect, too-high inflation indicates thatunemployment has been unsustainably low. Finally, itwas generally believed that the search for protectionagainst high inflation led to speculative excesses, not

least in housing, and financial instability, in turn.Second, there was the belief that central banksshould be free from political interference in pursuingthe objective of price stability. Such pressure seemed,from historical experience, always to be exerted in thedirection of easing monetary policy and encouraginginflation. Closely related, central banks should notprovide financing to governments that was in any wayinconsistent with their chosen monetary policy stance.Above all, history showed that fiscal dominance hadto be avoided.

At the same time, it was also generally accepted that

central banks had to be accountable for their actionsto those democratically elected. Nevertheless, therealso remained different legislation, views, and prac-tices concerning the relative roles of the central bankand the government in setting the specific mandate orthe level of the inflation target. Similarly, methods ofensuring central bank accountability varied widelyacross countries. In the case of the United Kingdom,the level of the inflation target was decided by thegovernment, the Bank of England having only “instru-ment independence.”15 In contrast, in the United States

and in the euro area, the central banks defined forthemselves what price stability meant.

Third, it was crucial that central bank com-mitments were credible. That is, it was not onlyimportant that a central bank was institutionallycapable (above all independent) of action, but also

that it was thought willing to do what was requiredto honor its commitments. Historically, the interwarperiod had shown the damage that could result whencredibility was lost. Economic theory also indicatedthat credible commitments could have direct effects

on inflationary expectations, thus reducing the eco-nomic costs of higher unemployment in keepinginflation under control.

Fourth, it was believed that credibility would beenhanced by transparency and clear communication,both about the central bank’s objectives and how itintended to achieve them. Further, clear commu-nication about policy intentions would give ampletime for portfolio protection and would thus supportfinancial stability.

Fifth, clear communication and accountability

are only possible when the central bank’s mandate issimple. Thus, central bank concerns about financialstability should essentially be limited to crisis manage-ment, including the exercise of the lender-of-last-resortfunction. While central banks were clearly concernedabout financial stability, and their warnings could alsobe useful, primary responsibility for action should restelsewhere to avoid the central bank having conflictingobjectives. Should central banks have a supervisoryfunction with respect to financial institutions, fire-walls should be erected to ensure monetary policycontinued to focus primarily on price stability.

Sixth, central banks should leave credit allocationto markets that are allocationally efficient and capableof managing risks. Thus, central banks should rely onpolicy instruments without allocational effects. Thesize and composition of assets on central bank balancesheets should be commensurate with those required tocarry out its basic functions. As a corollary, regulationshould be light touch only.

Seventh, to avoid monetary policies being overbur-dened in the pursuit of low inflation, central banksshould advocate the supportive use of fiscal, regula-

tory, and structural policies. The loss of wage and priceflexibility after World War I had carried a heavy price.

Eighth, if each country were to keep its own housein order, a system of floating exchange rates would beconsistent with growing trade and the efficient alloca-tion of capital internationally.

15 This phrase was first suggested in Debelle and Fischer (1994).


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* * *

Many of these pre-crisis beliefs remain valid today,such as the fundamental importance of longer-runprice stability, and the need for independence from

political constraints and the associated credibility ofcentral bank promises.16 However, the crisis has alsotaught us that not all of what we previously believedwas true, or at least remained true, given changes inthe economy itself. In a constantly changing economy,such an adaptation of beliefs to new realities wouldseem not only necessary, but simple common sense.Accordingly, the following chapters focus on the char-acter of the crisis, and the lessons we might draw fromit against the backdrop of history.

This process of reevaluation should also serve toremind us of how complex and adaptive the economyactually is. In turn, policy makers might become morehumble in assessing how much (or little) they actu-ally know about how the economy works or about

the uncertain effects of policies over time. Policiesthat offer short-term solutions, but at the expense ofaggravating longer-term problems, clearly need to becarefully assessed in terms of their net benefits. In thisprocess, the temptation to assume that longer-termeffects that are uncertain must also be inconsequentialmust be firmly resisted.

16 The credibility of central banks and their operation rests fundamentally on their being viewed as being free from undue political interferenceand influence. This independence must be maintained. In this regard, the Working Group underscores that efforts by political actors to auditthe U.S. Federal Reserve Board or otherwise limit its independence of policy action should be opposed, because they are not conducive toensuring the continued effectiveness of the US central bank.


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CHAPTER 2

The Global EconomyBefore and After the Crisis

SYNOPSISThe economic stability observed in the major

advanced market economies (AMEs) during thedecades preceding the crisis led to the period beingcalled the Great Moderation. Observation of this sta-bility supported a theoretical view of the economyas being both inherently self-stabilizing and efficientin its allocation of scarce resources. This mindsetprevailed despite accumulating evidence of under-lying tensions (imbalances) and a growing numberof localized economic and financial crises. Furthersupporting this mindset, specific improvements wereidentified in the productive capacity of the globaleconomy, in the management of monetary policy, andin the provision of financial services. Only with hind-sight did it become clear that the optimism generatedby this combination of “improvements” had helpedcreate a credit bubble of significant proportions. Oncetriggered, the crisis spread rapidly, leaving the globaleconomy with misalignments and vulnerabilities thatendure today.

INTRODUCTIONThis chapter focuses on the continuing economic and

financial crisis in the global economy. It is a three-partchronology. The first section looks at the economicand financial market environment in the two decadespreceding the crisis that began in 2007, and suggestsreasons why a crisis might have been expected, andwhy it nevertheless failed to be predicted. The secondsection looks at how the crisis began, triggered by

problems in the US market for subprime mortgages,and how it spread to other financial markets, theglobal real economy, and economic agents of many

sorts. The third section describes the macroeconomicand financial setting around the end of 2014. This pro-vides a backdrop against which to assess the conductof monetary policy going forward.

What emerges from this assessment of the recentpast is that domestic economies are complex, adaptivesystems of interacting agents, and that this applieseven more so to the international economy. Thedomestic complexity arises from the rich interactionswithin the economic and financial sectors, and thetwo-way influences between the real and financial

sectors. The international complexity partly reflectsfinancial linkages between the economies of bothadvanced and emerging market countries. However,it also reflects other factors such as trade ties, immi-gration patterns and, perhaps most important, sharedinformation and instantaneous communication linksbetween economic agents everywhere.

The fact that the global economy is adaptive canbe inferred from the almost constant process of struc-tural change observed over the last century. Moreover,these changes have been accelerating over the lasttwenty years or so. The search for increased efficiencyhas been relentless. Recent and dramatic changeshave occurred in the real, financial, and monetaryspheres, often in response to changes going on else-where. Evidently, such ongoing processes of changefundamentally affect the environment in which centralbanks work, and they have equally important impli-cations for policy.


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THE GREAT MODERATIONThe period between the mid-1980s and the start of thecrisis in 2007 became known as the Great Moderation,for reasons described in Chapter 1. However, the Great

Moderation was not only a state of affairs, a set ofempirical observations; it gradually became a state ofmind, as well. As memories of the Great Depressionfaded, the neoclassical school of macroeconomicthought gradually became the conventional wisdomin academia. Moreover, through the influence of staffeconomists trained in that school of thought, its influ-ence also spread to central banks. This school essentiallyheld that the economy had strong self-stabilizing prop-erties, and that the economy would quickly return tofull employment if shocked away from that position.17 Inflation was thought to be largely determined by infla-

tionary expectations, which a determined and focusedcentral bank (like the Federal Reserve under ChairmanVolcker) could control. Moreover, these properties ofmild cycles and low inflation provided the best envi-ronment for promoting rapid and sustainable growth.The empirical characteristics of the Great Moderationthus supported a particular school of thought abouthow the economy works.

In a similar zeitgeist, prices of financial assets wereassumed to be determined by markets in an efficientmanner on the basis of underlying fundamentals. In

any event, over most of this period, developmentsaffecting credit, money, and financial markets wereconsidered a side show to developments affecting thereal economy. With a few notable exceptions, econo-mists used models with financial sectors that extendedno further than a policy rate and, sometimes, a lon-ger-term “risk-free” rate connected to the policy ratethrough a term structure equation. Correspondingly,regulators of financial institutions and markets in themajor financial centers were encouraged to continuethe dismantling of the heavy regulatory infrastruc-

ture set up in the wake of the financial problems ofthe 1930s. Self-discipline and market discipline, albeitsupported by some capital requirements, were increas-ingly thought sufficient to ensure stability within thefinancial sector.

Given this combination of theory and supportingfacts, the intellectual mindset prior to 2007 was thatserious crises in AMEs were highly unlikely, if notimpossible. This had a number of important practi-cal implications.

First, few economists actually foresaw the turmoilto come. Second, no attempt was made to tighteneither monetary or regulatory instruments to eitheravoid or help mitigate the prospective damage. Third,no measures were taken ex ante to allow a crisis tobe better managed when it did arrive. In particular,many countries did not have adequate deposit insur-ance schemes, special legislation for quickly resolvingtroubled financial institutions, or adequate agreementsabout interagency cooperation during a crisis. At theinternational level, the preparatory shortcomings were

even worse. Not least, little if any practical progresswas made in how to resolve large financial institu-tions with global reach. As will be explored further inChapter 5, such shortcomings are important becausethey increase the likelihood that central banks willbecome overburdened in trying to resolve problemsthey are inherently incapable of resolving.

The power and tenacity of the mindset was suchthat it allowed most analysts to ignore or downplaytwo sets of important developments. The first of thesewas empirical. There was a growing list of statisticalindicators and actual crises supporting the view that

problems might be building up under the surface of theGreat Moderation. The second was a configuration ofstructural changes that provided an alternative expla-nation to received theory about the reasons for theGreat Moderation. Both should have led to the con-clusion that the current, welcome state of economicaffairs might not extend into an indefinite future.

INDICATORS AND INCIDENTSAs for indicators of underlying problems, over the

whole period in question, the relatively rapid growthof broad money and credit supported strong increasesin the ratio of nonfinancial debt to GDP (see figure 4).Many prewar and some postwar economists would

17 While plausible in principle, the models developed by this school of thought generally failed to incorporate a well-developed financial sector. Seealso Grant (2014) for a discussion of the US recession of 1921, described by the author in the book’s subtitle as “The Crash that Cured Itself.”


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have seen this as contributing to unwarranted increasesin asset prices as well as imbalances in the realeconomy.18 Either or both would eventually renormal-ize with the potential for serious negative implicationsfor output and employment, a typical boom-bustcycle. The fact that in some countries a substantialproportion of the credit growth emanated from foreignsources (that is, capital inflows) should also have beenseen as a further sign of latent instability.

Two sets of countries seemed most affected inthis regard. The English-speaking countries began to

exhibit a number of boom-like indicators and most,not least the United States, began to run large currentaccount deficits. In the United States, however, thestatus of the dollar as the global reserve currencyserved to alleviate concerns about a future dollarcrisis. The peripheral countries in the Eurozone also

exhibited similar symptoms as a result of massivecapital inflows intermediated through core Europeancountries. Rising current account deficits, and declin-ing competitiveness, were nevertheless ignored. Thisreflected the generally held belief, now proven false,that current account crises could not occur within acurrency union such as the Eurozone.

These global developments were accompanied bysharp increases in the prices of equity and houses ina number of countries during the 1990s (see figure5). However, a still broader inflection point for asset

prices was observed after 2003, when policy rates inthe AMEs reached their lowest level. House pricesincreases in the United States began to accelerate,as did house prices and commercial property pricesin most AMEs and EMEs. Global financial marketsalso surged. Equity prices rose still further, while

FIGURE 4. AME Rate of Credit Growth and Nonfinancial

Debt Relative to GDP, 1985–2014

160

210

260

310

360

410

-4

-2

0

2

4

6

8

10

12

14

Q 1 - 8 5

Q 4

- 8 5

Q 3

- 8 6

Q 2 - 8 7

Q 1 - 8 8

Q 4

- 8 8

Q 3

- 8 9

Q 2 - 9 0

Q 1 - 9 1

Q 4

- 9 1

Q 3

- 9 2

Q 2 - 9 3

Q 1 - 9 4

Q 4

- 9 4

Q 3

- 9 5

Q 2 - 9 6

Q 1 - 9 7

Q 4

- 9 7

Q 3

- 9 8

Q 2 - 9 9

Q 1 - 0 0

Q 4

- 0 0

Q 3

- 0 1

Q 2 - 0 2

Q 1 - 0 3

Q 4

- 0 3

Q 3

- 0 4

Q 2 - 0 5

Q 1 - 0 6

Q 4 - 0 6

Q 3

- 0 7

Q 2 - 0 8

Q 1 - 0 9

Q 4

- 0 9

Q 3

- 1 0

Q 2 - 1 1

Q 1 - 1 2

Q 4

- 1 2

Q 3

- 1 3

Q 2 - 1 4

Advanced economy credit growth, % y/y (lhs)

Advanced economy nonfinancial debt as a % of GDP (%, rhs)

US economy nonfinancial debt as a % of GDP (%, rhs)

SOURCES: Haver; UBS.

18 For a review of the prewar literature, see Haberler (1939). For an important postwar insight based on Japanese experience , see Koo (2003).


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high-yield and sovereign spreads, along with theVIX,19 fell to record lows by 2007. Evidently, as theprices of all assets rose, their value as collateral alsorose, supporting still further recourse to credit. Thisin turn supported both asset prices and more spendingin what appeared to be a virtuous circle.

Further, this credit growth led to a gradual butsteady increase in the leverage ratios of lenders andthe debt levels of borrowers (especially households)

in many countries. While regulators at the time gen-erally expressed little concern, Minsky (1986) wouldhave seen the former as foreshadowing a “Minskymoment” when financial institutions would cease to

lend, especially to each other. As for high debt levels,both Fisher (1936) and Koo (2003), after the onsetof the Great US Depression and the Great JapaneseRecession, respectively, highlighted debt as a seriousimpediment to future borrowing and sustainablegrowth.20 In short, such a period of rapid creditgrowth could culminate in a situation where borrow-ers no longer wished to borrow and lenders no longerwished to lend.

There were also indicators in the real economy ofpotential problems associated with excessive creditexpansion. In many AMEs, not least the English-speaking ones, household savings rates dipped to

19 The Volatility Index (VIX) is a contrarian sentiment indicator that helps to determine when there is too much optimism or fear in the market.When sentiment reaches one extreme or the other, the market typically reverses course (http://www.investinganswers.com/financial-dictionary/ stock-market/volatility-index-vix-872).

20 Fisher was focused almost entirely on how Consumer Price Index deflat ion would make nominal debts unserv iceable. Koo was concerned aswell with the effects on solvency of falling asset prices.

FIGURE 5. AME Level of House Prices, Equity Prices, and Volatility, 1985–2007

0

10

20

30

40

50

60

0

200

400

600

800

1,000

1,200

1,400

1,600

Q 1 - 8 5

Q 4 - 8 5

Q 3 -

8 6

Q 2 - 8 7

Q 1 - 8 8

Q 4 - 8 8

Q 3 -

8 9

Q 2 - 9 0

Q 1 - 9 1

Q 4 - 9 1

Q 3 -

9 2

Q 2 - 9 3

Q 1 - 9 4

Q 4 - 9 4

Q 3 -

9 5

Q 2 - 9 6

Q 1 - 9 7

Q 4 - 9 7

Q 3 -

9 8

Q 2 - 9 9

Q 1 - 0 0

Q 4 - 0 0

Q 3 -

0 1

Q 2 - 0 2

Q 1 - 0 3

Q 4 - 0 3

Q 3 -

0 4

Q 2 - 0 5

Q 1 - 0 6

Q 4 - 0 6

Q 3 -

0 7

Advanced economy house price index Q185 = 100

Advanced MSCI Index: Share Price Index (US$ Dec-31-76 = 100)

Volatility index (rhs)

NOTE: MSCI Index = Morgan Stanley Capital International Index.

SOURCES: Haver; Oxford Economic Forecasting; UBS.


31/100

GROUP OF THIRTY

15

unprecedentedly low levels. Closely related, risingimports led to current account deficits and risinglevels of external debt. In many AMEs, not least theperipheral countries of Europe, easy access to mort-gage credit also led to significant increases in the size

of the construction sector. In China, a country with avery high domestic savings rate but a repressed finan-cial system, the construction sector also expandedmassively with housing, commercial property, andinfrastructure all benefiting. Investment rose to over40 percent of GDP just prior to the crisis, a proportionvirtually without historical precedent.

Finally, and perhaps more contentious analytically,over most of this period, there was a widening gapbetween a generally falling policy rate, measured inreal terms, and the generally rising rate of growth of

global potential. In terms used by Knut Wicksell,21

this implied that the financial rate of interest wasfalling increasingly below the natural rate of interest.He would have interpreted this as foreshadowing aneventual resurgence of inflation. For reasons discussedbelow, inflation was not a problem over most of theGreat Moderation. However, just prior to the crisis,inflationary pressures were clearly on the rise, withfood and energy prices most affected.

As discussed in Chapter 1, there were also a numberof specific incidents that clearly indicated that under-lying imbalances could culminate in serious economic

and financial difficulties. These incidents did lead toa growing interest in financial stability and measuresthat might be taken to improve the stability of thefinancial system. Nevertheless, they failed to changethe fundamental view that the major AMEs were notsimilarly exposed. Nor did they lead to the conclusionthat measures should be taken to lean against the windof credit expansion. Indeed, prior to the crisis, this issuewas not directly engaged. Rather, it was confoundedwith the much narrower issue of whether monetarypolicy should prick asset price bubbles. Framed this

way, the proposal was more easily rejected and extantbeliefs more easily maintained.

A number of reasons were put forward to dis-count the importance of these incidents for the majorAMEs. First, it was noted that many of these crises

had occurred in EMEs where the efficiency of marketsand the quality of macroeconomic and regulatory pol-icies were more questionable than elsewhere. Second,some crises had occurred in the wake of a process offinancial deregulation. This pointed to transitional

problems only. Third, many suggested that policy errorrather than inherent instability was the problem—most notably in the Japanese case. Finally, a great dealof comfort was taken from the responsiveness of majorAMEs to the easing of monetary policy whenever realor financial instability threatened during the period ofthe Great Moderation. This encouraged the belief thatleaning against rapid credit growth was not necessary,since cleaning up any undesired side effects wouldalways be possible.

AN ALTERNATIVEEXPLANATION FOR THEGREAT MODERATIONThe confluence of low and stable inflation and highand stable growth was unusual and demanded expla-nation. The most commonly held view was that highand variable inflation in the 1960s and 1970s had heldback growth, and that the resolute squeezing out ofinflation by the global community of central bankshad delivered the benefits it had promised. There is

clearly an element of truth to this, though it must benoted that the benefits promised were supposed tobe permanent rather than only temporary. However,there was an alternative (or perhaps) complementaryexplanatio

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