Should monetary policy lean against the wind of the expansion phase of credit upturns, in order to moderate boom conditions? Clearly, no one would question the desirability of leaning enough to reduce associated inflation pressures.
But should the reaction be stronger than that which near-term inflation control might seem to warrant? In particular, should policy be tighter than otherwise, given evidence of growing “imbalances” in the real economy or increasing systemic exposures in the financial system? Or should an alternative strategy be relied upon to deal with such problems. In particular, should monetary policy be content with trying to clean up afterwards, once the boom has turned to bust? Indeed, should central banks go even further and preemptively ease policy in order to short circuit the bust altogether?.
As a matter of logic, the answer to the lean or clean question must depend on an evaluation of the relative merits of each approach, since alternatives cannot be evaluated in isolation. The dominant view until quite recently seems to have been in favor of cleaning up afterwards. However, the practical difficulties encountered in trying to do so over the last eighteen months seem now to be altering the balance of earlier arguments.
Indeed, the current set of economic circumstances facing the official community is as difficult as any seen in the postwar period. Growth is slowing, and quite sharply in both the advanced and emerging market economies. For a time inflationary pressures were also rising, particularly in the emerging market economies, though they now seem to be receding in the face of an unexpectedly sharp slowing of near- term - growth prospects. In the major financial centers, many markets are dysfunctional and some are not operating at all. Many financial institutions have had to be closed down, nationalized or supported in some way by governments. Moreover, it cannot be ruled out that the economic and financial situation will worsen substantially before it eventually improves.
The purpose of this paper is to suggest steps that might be taken to help avoid a repeat of these difficulties in the future. Evidently, this presupposes some understanding of what caused today’s difficulties in the first place.
Liberalized financial systems seem to be inherently “procyclical”. That is, there are endogenous cycles in which some piece of good news leads to both an increased demand for and supply of credit. This affects positively both asset prices and spending, contributing to still more optimism and providing still more collateral for still more loans. Eventually, all these trends overshoot levels justified by the initial improvement in fundamentals and rational exuberance becomes irrational exuberance. In the end, the bubble bursts and the process of speculation and leverage which powered it goes into reverse. Such processes have been seen repeatedly in history. The great recessions beginning in 1825, 1873 and 1929 all shared these characteristics, as did the more recent Nordic, Japanese and South East Asia crises. Moreover, in each instance the crisis emerged suddenly and unexpectedly, and without any significant degree of accelerating inflation beforehand.
There is a great deal of evidence to support the view that we are witnessing something quite similar today. The “New Era” and “Great Moderation” proclaimed in the latter part of the 1990’s led to a variety of excesses which suddenly collapsed around the turn of the century. This was met in turn by an unprecedented degree of monetary easing in the large industrial countries, and subsequently by very easy monetary policies in many emerging market countries (accompanied by massive foreign exchange intervention) as they tried to resist upward pressure on their exchange rates. The upshot was that global interest rates, both short and long, were held at unusually low levels for much of this decade. These lower rates contributed (a demand side effect) to a massive increase in monetary and credit aggregates. A further contribution to this credit growth (a supply side effect) was made by sharply declining lending standards. These easier lending terms were said at the time to be justified, both by an overall reduction in the risks to be managed, and by improved risk management capacities. In both the advanced and emerging market countries, many borrowers obtained access to credit who would never have been able to do so in the past (subprime mortgages, for example) or did so on unusually easy terms (cov-lite corporate loans, for example). Speculation and leverage are also thought to have expanded significantly, not least through the use of new structured products with high levels of leverage imbedded in them.
These developments contributed to record high global growth rates, until quite recently. Inflation, moreover, was quiescent for an unexpectedly long period under the influence of a variety of positive supply shocks, not least the process of globalization. However, at the same time, these financial developments were also contributing to the gradual buildup of at least four major “imbalances” affecting both the financial and real sectors of the global economy. As to the former, most asset prices (not least housing) rose to unprecedented levels. The exposure of financial firms to risks of various sorts, as can now be clearly seenwith hindsight, also increased sharply. As to the latter, household saving rates in many countries (especially the English speaking ones) fell to zero or even below, while the ratio of investment to GDP in China rose to almost 50 per cent. Again, such National Income Account numbers are unprecedented in large countries in the post war world. Finally, a
number of countries with highly advanced financial systems and associated low household saving rates ran very large trade deficits. These were largely financed by capital inflows from surplus countries that had accumulated reserves in the process of resisting exchange rate appreciation.
Evidently, the period of high global growth and essentially stable prices has now come to an end. Perhaps the first overt manifestation of the effects of the long period of rapid monetary and credit expansion was the sharp rise in commodity prices. With the influence of the earlier positive supply shocks having run their course, higher commodity prices quickly fed through to headline CPI in many countries. However, lower real wages subsequently weighed on spending and growth, and this deceleration was further aggravated as the imbalances noted above began to unwind. Indeed, the slowdown has been so sharp, and the effects on commodity prices already so appreciable, that the earlier worries about inflation have increasingly been replaced by fears of near term deflation.
The tipping point in this transition was arguably the “Minsky moment” in financial markets which occurred in August of 2007. The announcement that BNP had suspended redemptions from three of their investment funds sparked a massive withdrawal of liquidity from the market for asset based securities, not least by money market mutual funds fearful of “breaking the buck”. Since then, the process of financial deterioration has continued relentlessly with a wide spectrum of asset prices falling sharply and many financial institutions having merged, gone bankrupt, or now on the verge of bankruptcy.
Due in part to tighter credit conditions and the wealth destruction arising from lower asset prices, real growth in the advanced industrial economies has also slowed sharply. However, probably more important has been the beginning of a process of mean reversion in spending patterns, in countries exhibiting such imbalances, and the spread of this effect to other countries through trade linkages in particular. The emerging market economies initially seemed somewhat immune to this slowdown, but it is now clear that they too have been caught up in this global transition.
This interactive process of deterioration between the real and financial sectors, as the various imbalances simultaneously unwind, has yet to fully run its course. Nor have we yet seen the full impact on global currency markets, or on protectionist sentiment, of the current large trade imbalances. Recognizing the potential economic costs of all these developments raises the important question of how such processes might be avoided, or at least the costs moderated, in the future? Given that the underlying problem is one of excessive credit creation, there should be a strong presumption that monetary policy will have a significant role to play in leaning against these excesses. In the same way that repairing a broken financial system may be a necessary but not sufficient condition for restoring health to the real economy after a “bust”, relying solely on regulatory mechanisms to moderate a “boom” might also prove insufficient.
