DEPARTMENT OF ECONOMICS

UNIVERSITY OF STELLENBOSCH

FINANCIAL MARKET STABILITY:

A MONETARY POLICY CHALLENGE IN THE AFTERMATH OF

A GLOBAL FINANCIAL CRISIS

by

Pieter Eduard Roux

Assignment presented in partial fulfilment of the requirements for the degree of Masters of

Philosophy in Economic Policy at the University of Stellenbosch.

SUPERVISOR: PROF G A SCHOOMBEE

March 2012

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Declaration

I, the undersigned, hereby declare that the work contained in this assignment is my original work

and that I have not previously in its entirety or in part submitted it at any university for a degree.

Signature……………………

Date:………………………..

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Contents

1 INTRODUCTION ....................................................................................................................... 1

2 ANATOMY OF THE GLOBAL FINANCIAL CRISIS ............................................................. 4

2.1 The scale of the crisis ............................................................................................................ 4

2.2 The dynamics of the financial market crisis .......................................................................... 5

2.3 From financial crisis to a global recession .......................................................................... 10

2.4 Initial monetary policy responses to the crisis .................................................................... 10

2.5 Summary ............................................................................................................................. 12

3 THE STRATEGIC FRAMEWORK OF MONETARY POLICY ............................................. 13

3.1 The ultimate objectives of monetary policy ........................................................................ 13

3.1.1 Internal price level stability.......................................................................................... 13

3.1.2 Balance of payments and exchange rate stability ........................................................ 14

3.1.3 Employment and income stability ................................................................................ 15

3.1.4 Financial market stability ............................................................................................. 15

3.2 The intermediate targets of monetary policy ....................................................................... 16

3.3 Operational variables and policy instruments ..................................................................... 17

3.4 The transmission mechanisms of monetary policy ............................................................. 18

3.5 Summary ............................................................................................................................. 21

4 POST-CRISIS CHALLENGES FOR MONETARY POLICY ................................................. 22

4.1 Monetary policy and asset price bubbles ............................................................................ 22

4.2 Dichotomy between monetary policy and financial stability policy ................................... 24

4.3 The independence of the monetary policy authority ........................................................... 25

4.4 A need for more international co-ordination of monetary policy ....................................... 26

4.5 Summary ............................................................................................................................. 27

5 CONCLUSION .......................................................................................................................... 28

6 BIBLIOGRAPHY ...................................................................................................................... 31

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Figure 1: Initial subprime losses and declines in world GDP and world stock market capitalisation . 4

Figure 2: TED Spread showing subprime crisis and Lehman collapse ............................................... 8

Figure 3: The transmission mechanism of monetary policy (Bank of England) ............................... 19

Figure 4: Quantitative Easing transmission channels ........................................................................ 20

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1 INTRODUCTION

Triggered, amongst other events, by the collapse of one of the largest and oldest global investment

banks, Lehman Brothers, in 2008, a financial crisis has spread across the globe, branching out first

into a global economic crisis, and at the time of writing, into a sovereign default crisis in the

European Union. This has immersed advanced as well as developing economies in a recession, and

there is a real threat of sovereign default in the European Union if Greece fails to meet its scheduled

debt repayments.

The global scope of the financial crisis has prompted the G20 (a multilateral meeting finance

ministers and central bank governors of the world’s largest economies) to establish a Financial

Stability Board to co-ordinate efforts towards improved financial oversight policy. The United

Nations commissioned a report under the chairmanship of Joseph Stiglitz, a Nobel laureate

economist. This report (Stiglitz, 2010) is critical of the G20’s efforts at addressing the problem,

citing the G20’s poor representivity of the developing world, which is bearing the brunt of the

global crisis, as a major flaw in the system.

Hindsight being an exact science, there is no shortage of opinion as to what should have been done

different in the past. Much of the blame has been laid before the door of agencies responsible for

financial oversight, in many instances the central banks of sovereign nations, who maintained what

became known as “light touch” oversight during the period known in monetary policy circles as

“The Great Moderation” typified by stability in all the ultimate objectives of monetary policy.

It is in a sense also inevitable that at least some of the blame for the crisis would have been assigned

to the central banks specifically in their capacity as monetary authorities, for the manner in which

they have conducted monetary policy in the period preceding the crisis. In its more extreme

manifestation, such criticism has given rise to views that all previous assumptions regarding

monetary policy have been discredited irrevocably, that monetarism has finally been put to rest, and

that monetary policy has, as a result, been thrown into crisis.

However, as was rather eloquently phrased in a letter written by the British Academy in response to

an enquiry from Her Majesty the Queen (The British Academy, 2009), as to why no one saw the

crisis coming, many economists and policy makers foresaw aspects of the crisis but not necessarily

the exact timing and ferocity, nor the combined effect of all developments that, with hindsight, are

now seen as having formed an integral part of the developing crisis. Part of the problem in

foreseeing the development of a crisis of this nature and scope, is the fact that much of what is now

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regarded as key elements of the failure, were at the time seen as key benefits of an increasingly

sophisticated and innovative financial system from which not only households, but many nations

benefited substantially.

Opinions vary widely as to how the events of the past four years impact the future conduct of

monetary policy. Very few would argue in favour of an unqualified “business as normal”

declaration with regard to monetary policy. Furthermore, there are many proponents of the

argument that the tools of monetary policy to prevent a recurrence of the events of the past four

years are limited. Yet Mishkin (2010) argues that those who question the effectiveness of monetary

policy during the global crisis have to put forward convincing counterfactual arguments, that is,

they have to argue convincingly that monetary policy intervention during and in response to the

crisis was not instrumental in preventing a bigger disaster (such as a full-blown depression) from

materialising. In fact Mishkin argues that those severe criticisms of monetary policy as being

ineffective in response to the crisis, are “just plain wrong” (Mishkin, 2009). In fact, arguing that

monetary policy is ineffective in a crisis is dangerous because it would imply that there is no point

in using it in a crisis.

It is, nevertheless, of more than academic interest to understand how monetary policy will be taken

forward as a result of lessons learned from the crisis, and to understand the reach, as well as the

shortcomings, of traditional monetary policy instruments and nominal anchors in attaining the

objective of financial market stability. It has, for example, been pointed out (Goodhart, 2010) that

the period leading up to the global crisis was characterised by low inflation globally and that

certainly inflation as a monetary anchor for price stability, provided no early warning that the global

economy was overheating.

Monetary policy had also been grappling for some time with the phenomenon of asset bubbles and

what the appropriate response to the development of such bubbles ought to be. The extreme view,

i.e. to pop asset bubbles, was perceived to be too damaging to households. On the other hand, only

cleaning up after an asset bubble had burst has proved to be extremely expensive to the fiscus.

Consensus existed somewhere between “leaning against bubbles developing” and “cleaning up after

a bubble had burst” approach (Mishkin, 2011).

A strong view is also now emerging that the financial sector plays a far more important role in

economic activity than had previously been understood. At the same time there are market

information asymmetries in the financial sector, with lenders often having less information than

borrowers as to the risks inherent in financed assets. These asymmetries make it difficult for

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monetary authorities to determine whether credit in the financial sector (also described as “private

money creation”) and risk are being priced correctly, thus making intervention difficult. The limited

tools available to monetary policy also make it difficult to target only areas where trouble may be

brewing, unless an innovative means (other than the official bank rate) can be found to enable

monetary authorities to intervene in fragile financial markets.

The paper will pursue its review of monetary policy in the wake of the crisis along the following

lines:

Firstly it will review the anatomy of the global financial crisis in terms of its dynamics and impact

on the global economy.

Secondly, the framework of monetary policy will be reviewed to form an understanding of how

monetary policy impacts the economy, and how this framework was applied during the financial

crisis.

Thirdly, it will be necessary to review the generally accepted understanding of the transmission

mechanisms of monetary policy, once again in order to establish an understanding of where the

leverages as well as limitations are for monetary policy to influence financial markets, and whether

perhaps the global crisis has brought with it new insights into the transmission mechanism.

Fourthly, some specific new challenges for monetary policy will be considered in more detail.

Finally, conclusions will be drawn with regard to how the financial crisis will influence the future

conduct of monetary policy in pursuit of financial stability as well as the traditional ultimate

objectives of monetary policy.

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2 ANATOMY OF THE GLOBAL FINANCIAL CRISIS

This chapter will aim to provide an overview of how the financial crisis of 2007/08 started in the

financial markets of the USA and then became global. It will track the response of monetary policy

authorities to the crisis, and it will show that the need to re-establish stability in financial markets

required non-conventional monetary policy responses, in addition to the conventional monetary

policy responses which had been deployed at the onset of the crisis.

2.1 The scale of the crisis

IMF chief economist Olivier Blanchard (Blanchard, 2009) provides a sobering overview of how,

between October 2007 and October 2008, an asset bubble in the US subprime housing market

escalated into a financial crisis of staggering global proportions. Using data obtained from the IMF

Global Financial Stability Report, the IMF World Economic Outlook and the World Federation of

Exchanges, the following figure is drawn by Blanchard:

Figure 1: Initial subprime losses and declines in world GDP and world stock market

capitalisation

Source: (Blanchard, 2009: 3)

Describing himself as “…an economist who, until recently, thought of financial intermediation as

an issue of relatively little importance for economic fluctuations…” (Blanchard, 2009: 3) Blanchard

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points out that the localised US subprime crisis (registering a loss of $250 billion) multiplied 20

times into IMF world GDP loss estimates of $4,700 billion, and 100 times into a decrease in global

stock market capitalisation estimated at $26,400 billion.

This multiplication effect points to a fragility in world financial markets which had been

underestimated almost universally, and it clearly puts the question of financial market stability as a

desirable outcome of macroeconomic policy in general, and monetary policy in particular, in the

forefront of current policy deliberation across the world.

There have been overt attempts by some notable economists to lay the responsibility for the crisis

before the door of monetary policy for not doing what was necessary or not doing enough, to avoid

the crisis (Krugman, 2010). However, Mishkin (2010: 4) is of the view that the US subprime crisis

simply happened to be the trigger mechanism - like a vibration or noise triggering an avalanche if

the snow conditions on a mountain slope are right - which revealed the fragility of the global

financial system. Mishkin believes that, absent the subprime crisis, some other seemingly minor

financial event might very well have triggered the crisis.

In terms of scale, the crisis is not over and has subsequently transformed into a European monetary

crisis that has not been resolved. The monetary union is under threat from an expected debt default

by Greece, and the increased vulnerability of Italy, Spain and Ireland, and even Germany and

France. At the time of writing, details of a final rescue plan have not yet been made available on a

resolution to the European crisis. The current European crisis does seem to confirm the notion that

there are deep-rooted problems in the world’s financial market system and political economy, and

that a major crisis has been in the making for some time.

In order to make sense of the scale of the global economic crisis resulting more directly from the

US subprime crisis, it is necessary to review the dynamics of the crisis and how it transmitted into

the global economy at the rate and magnitude depicted above.

2.2 The dynamics of the financial market crisis

Rajan finds the dynamics of the crisis in the unsustainable imbalances that have come to define the

global political economy of our time. One of the major “fault lines” he sees running through the

global political economy, “…emanates from trade imbalances between countries stemming from

prior patterns of growth.” (Rajan, 2010: 7). He goes into some detail of how post- WWII economic

growth in Japan and Germany, resulting in those two economies becoming the second and third

largest in the world after the USA, became defined as export-driven growth, with very high internal

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savings rates and very poor domestic consumption. This resulted in the largest economy, the USA,

taking on the role of a net consumer of goods produced by those exporting economies. This

imbalance in consumption and production between the world’s largest economies was being fed

even further by the savings emanating from Japan in particular, which made it possible for

Americans to finance their consumption far beyond what they could afford, but by doing so, were

providing the engine for this unbalanced global growth. Eventually, during the first decade of the

21st century, this unsustainable imbalance revenged itself by manifesting in a subprime housing

asset bubble in the USA. When it burst, this bubble contaminated the world’s financial system

through a plethora of financial instruments designed to dilute the risk, but in doing so created

perverse incentives for financial institutions to take on tail risk1 which eventually eroded and then

destroyed their balance sheets.

To the extent that Rajan does blame US monetary and financial authorities for the crisis, it is that on

the one hand the Federal Reserve erroneously thought that it could respond to a lacklustre economy

by lowering interest rates (a “conventional” monetary policy instrument that had worked in past

slowdowns) and not heeding warnings that a domestic property asset bubble was in the process of

building up, driven by consumers who could not actually afford to buy their own homes.

Continuing to lower interest rates in the midst of such a developing bubble was like pouring oil on

troubled waters. On the other hand financial oversight was lax or non-existing and, responding to

government incentives as well as an easing of monetary policy, predatory bond originators

exploited the vulnerable by making loans to people with no income, no jobs and no assets – the so-

called “NINJA-loans” (Rajan, 2010: 7).

Moving now to a more specific financial market analysis of the dynamics of the crisis, Mishkin

(2010) divides the development of the financial market crisis into two phases.

The first phase of the crisis, and already referred to a number of times above, is the subprime

mortgage crisis in the USA. During 2007 and 2008 a run on the shadow banking system (the system

through which banks borrow from one another) started to develop. Because a bank’s assets are the

long term loans it issues, whereas its liabilities are the short-term deposits it holds, it has to finance

1Rajan (2010: 137) uses the term “tail risk” to denote risks that occur “in the tail of the probability distribution – that is,

very rarely”. These tail risks played a significant role in the erosion of the balance sheets of financial institutions.

Having created these mortgage backed securities, the risk management strategy was to sell these securities in the global

financial market, thereby diluting the risks of default to a single institution. However, once these securities were

created, and insured through companies such as AIG, they received AAA ratings by ratings agencies. This led financial

institutions creating them in the first place, to assume, erroneously, that the probability of risks materialising was very

low. Therefore, instead of creating them and then selling them off, many financial institutions either retained large

quantities of these mortgage-backed securities, which had become lucrative investment vehicles (due to the fact that

insurers were prepared to cover them), or by repurchasing them back onto their balance sheets.

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its liquidity requirements through repurchase agreements via interbank lending, also known as the

shadow banking system. These short term repurchase agreements are liabilities that have to be

secured by offering longer-term assets like mortgage-backed securities as collateral. It is common

practice for borrowers in the shadow banking system to have to post collateral valued at more than

the amount of the loan. This is known as “taking a haircut”. When it became clear that these

mortgage-backed securities contained subprime housing loans, and when it furthermore became

apparent that homeowners were starting to default on their mortgage payments, the shadow banking

system started to demand bigger “haircuts” (as much as 50 % of the mortgaged backed securities

being offered as collateral). This logically led to a devaluation of the underlying assets, forcing

banks to deleverage by selling off assets. Selling those assets had the immediate effect of further

eroding the value of those asset classes, forcing further sell-offs, and setting off a “fire-sale”

dynamic (Mishkin, 2010: 2).

A good indicator of how banks perceive the risk of lending to one another, is the so-called TED2

Spread graph (the difference between the interest rate on interbank loans – specifically the three-

month London Interbank Offered Rate or “LIBOR” - , and on three-month US Government

Treasury bills). At the onset of the financial crisis (second half of 2007), the spread increased to 200

basis points. As this fire-sale dynamic began to settle in, in March 2008 investment bank Bear

Stearns became the first casualty of this credit squeeze in the shadow banking system as its short

term financing dried up. As can be seen from Figure 2 below, the TED spread climbed to just over

200 basis points following the collapse of Bear Sterns. The Federal Reserve intervened in the failure

of Bear Stearns, by facilitating the purchase of Bears by another investment bank, JP

Morgan/Chase. In order to stabilise the financial market the Fed effectively moved into the domain

of non-conventional monetary policy by taking $40 billion of Bear Stearns’ subprime assets onto its

own balance sheet, effectively becoming a “lender-of-last-resort”. In addition the Fed opened new

repurchase lending facilities to banks, which it offered through anonymous auctions. This appeared

to calm the financial markets and the TED spread dropped below 100 basis points again.

Mishkin points out that, at this point, it started to look as if the Fed’s unconventional intervention

had been successful and that the financial crisis could be contained. There was even talk that

inflation was on the rise and that “…the easing phase of monetary policy might have to be reversed

in order to contain inflation.” (Mishkin, 2010: 3).

2 Acronym formed from T-bill and Eurodollar (ED) futures. The Baa spread in the graph refers to the difference

between long term corporate bond rates and the 10-year constant maturity US Treasury bond rate.

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The second phase of the crisis centres on the collapse of Lehman Brothers, one of the oldest and

most prominent investment banks in America and the world. This event helped turn the subprime

crisis into a global financial crisis, due to the global reach of the markets served by Lehman. It is

marked on the TED spread graph in Figure 2 by a rise in the TED spread to more than 600 basis

points. There is a popularised view that the US Treasury and Federal Reserve’s decision to allow

Lehman Brothers to go bankrupt, was responsible for the global financial crisis which followed.

However, Mishkin argues that three other events played as much of a role in globalising the crisis -

two on the day following Lehman’s collapse, and the third playing out over the weeks following the

Lehman collapse (Mishkin, 2010: 4).

Figure 2: TED Spread showing subprime crisis and Lehman collapse

Source: Mishkin (2010: 29)

Firstly, allowing Lehman to go bankrupt was not the first option for the regulatory authorities;

however, negotiations for a takeover of Lehman by Barclays Bank of the UK were not successful.

In fact, it became apparent in the proceedings of the United States Bankruptcy Court during 2009,

that Lehman employed fraudulent accounting practices to hide its leveraged position (Mishkin,

2010: 5). This asymmetric information, still hidden at the time of the takeover negotiations, could

well have caused the collapse of Barclays Bank, had the deal succeeded. The decision to allow

Lehman to fail was also motivated from a fear of moral hazard, given the fact that the Federal

Reserve had already taken toxic assets from Bear Stearns onto its balance sheet, and government

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had already taken over Freddie Mac3 and Fannie Mae

4. It was considered important at the time, to

force financial institutions to reduce their risk taking.

The second event, i.e. the failure of AIG5 on the day after Lehman came as a shock to the market

and the regulatory authorities who did not know that AIG had taken aboard enormous risk in the

form of credit default swaps, in effect insurance policies over the securitised subprime mortgages.

When it became apparent that these policies would have to pay out, AIG went into a cash crisis and

short term funding dried up. On the same day, a run on the “Reserve Primary Fund”, a large money

mutual market fund which held $785 million of Lehman paper, caused the fund to collapse. This

immediately contaminated other money market funds, which in turn affected banks, to which

money market funds were a significant source of funding.

The third event following Lehman’s bankruptcy occurred on 19 September 2008 when US Treasury

Secretary Hank Paulson arrived on Capitol Hill with “an infamous three-page document” asking the

US Congress to authorise the Treasury to spend $700 billion on the purchase of troubled subprime

mortgage assets (Mishkin, 2010: 7). The document, known as the Troubled Asset Relief Program

(TARP) contained no accountability clauses in respect of spending this money. When it was voted

down by Congress on 29 September 2008, this event raised serious doubts in the world’s financial

markets that the US fiscal and monetary authorities had the ability to manage the crisis. When a

revised proposal was eventually tabled, and signed into law by the new president, President Obama,

it contained “…numerous ‘Christmas-tree’ provisions such as a tax break for makers of toy wooden

arrows.” (Mishkin, 2010: 7). The reputational damage to the credibility of those in charge of the

biggest economy in the world had been done.

In concluding this discussion of the dynamics of the financial market crisis, it is worth noting the

amplification mechanisms of the crisis as described by Blanchard (2009). The first amplification

mechanism, the run on the shadow banking system, has already been discussed above.

The second amplification mechanism identified by Blanchard, which is distinct from the first one,

comes from the need for financial institutions to maintain capital adequacy ratios, either in response

to increased regulatory requirements, or to convince investors that they are taking steps to reduce

their risk of insolvency. They have two options available in achieving this: firstly to raise more

capital (a challenge in the midst of a financial crisis) or “deleverage” by selling-off assets; secondly

3 The Federal Home Loan Mortgage Corporation (FHLMC)

4 The Federal National Mortgage Association (FNMA)

5 The Financial Products Unit of American International Group reinsured mortgage-backed securities (using “credit

default swaps”) based on the triple-A investment ratings granted to these securities by ratings agencies.

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by reducing their lending to other financial institutions. This caused a second round of fire sale

erosion of asset prices. Indeed, Blanchard argues that the second amplification mechanism was

responsible for the translation of the crisis into the economies of emerging market countries which

had absolutely nothing to do with the origins of the crisis and, in some instances, did not even have

sophisticated financial markets but simply fell victim to a global credit squeeze which had set in

(Blanchard, 2009: 11).

2.3 From financial crisis to a global recession

Mishkin (2010: 10-11) identifies three mechanisms by which the financial crisis translated into an

economic recession.

Firstly, credit spreads widened (as illustrated in Figure 2 above). This simply meant that, even if

monetary policy had been relaxed and official interest rates fell, the cost of borrowing for

businesses and households actually increased and this had the immediate effect of slowing the

economy down.

Secondly, the erosion of asset prices which has already been explained above as one of the

amplification mechanisms of the crisis also held true for non-financial businesses and households.

This means the non-financial sector (businesses and households) also had less ability to borrow.

Businesses could therefore not get funding for expansion and households could not incur

consumption spending. Demand for, and supply of goods and services fell, causing a further

contraction.

Finally, the market uncertainty that came with the financial crisis increased the information

asymmetry between lenders and borrowers: it became more difficult for lenders to assess the risks

associated with investment opportunities and therefore the allocative efficiency of the market, i.e.

its ability to direct financial resources to productive opportunities, was compromised. This caused

further contraction.

2.4 Initial monetary policy responses to the crisis

Given the operational variables at its disposal (the interest rate, and control over the cash base of the

economy), conventional views about the ultimate objectives of monetary policy - internal price

level stability, balance of payments and exchange rate stability, and employment and income

stability - did not include financial market stability, at least not as an explicit ultimate objective.

Surprisingly there has been no shortage of economists blaming the “easy” monetary policy of the

early 21st century, for the financial crisis of 2008. Most prominent among such critics is Paul

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Krugman, who has been using his column in the New York Times extensively, to criticize monetary

policy, sometimes for causing the crisis (Krugman, 2010), and other times for not doing enough to

prevent it (Krugman, 2008). J.K. Galbraith even suggested that the crisis was a signal of the final

demise of monetarism and the beginning of “the next life of Keynes” (Galbraith, 2011).

Yet it can hardly be argued that the science of monetary policy had been ignorant or dismissive of

the importance of financial market stability in the modern-day global economy. In a paper delivered

to a conference on monetary policy arranged by the South African Reserve Bank in 2001, Jozef

Van’t dack, adviser at the Bank for International Settlements, identified the inter-linkages between

monetary and financial stability as an important challenge for monetary policy (Van't dack, 2001).

Referring to asset price bubbles, Mishkin (2011: 18) points out that extensive research is available

on the need for monetary policy to respond in some way to the development of such bubbles in

order to mitigate the risk of such eventualities.

Both Mishkin (2010) and Blanchard (2009) highlight important monetary policy responses to the

crisis without which the initial damage to financial markets may have been even worse.

Blanchard (2009: 16) points out that, policy-wise, monetary policy was successful in dampening the

first amplification mechanism by expanding the monetary base (especially since there was no

danger of high inflation), thus making it unnecessary for financial institutions that were otherwise in

good standing, to sell of their assets at fire sale prices. This was successfully done by monetary

authorities, who acted as “lenders of last resort” to banks, but also in that they widened the type of

institutions they were prepared to lend to, as well as the type of assets they were prepared to accept

as collateral. This approach became known as “quantitative easing”.

This liquidity provision and asset purchase strategy is referred to by Mishkin (2010: 12) as two of

three “unconventional” monetary policy measures deployed during the crisis. A third

unconventional policy measure was in the form of expectation management when the Federal

Reserve announced that it would maintain “exceptionally low” interest rates “for an extended

period” (Mishkin, 2010: 15). These measures are believed to have contributed to narrowing the

credit spread considerably.

As a final point, Mishkin (2009) argues that criticisms of how conventional monetary policy was

being conducted during the crisis as being recessionary or even depressionary in nature, were “just

plain wrong” because without the aggressive lowering of interest rates at the onset of the crisis, the

economic impact of the financial crisis may very well have been much worse.

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2.5 Summary

This chapter has shown how a subprime housing market in the USA resulted in a housing asset

bubble which, linked to excessive risk taking by investment banks, and later also other financial

institutions, in pursuit of higher yield, escalated into a global financial crisis. This specific financial

crisis has illustrated more than past crises, the importance of financial intermediation in the modern

global economy. This poses a challenge for monetary policy authorities (mostly the central banks of

countries) in that the conventional pursuit of price level stability, Balance-of-Payment and

exchange rate stability, did not include financial market stability as an explicit ultimate objective of

monetary policy. Although conventional monetary policy responses probably averted a bigger

crisis, it was not enough to return financial markets to a level of functionality essential to the pursuit

of modern day economic activity, and non-conventional policy measures had to be deployed.

The next chapter will pursue the policy options of monetary policy in the face of a global financial

crisis such as the one referred to, in more detail.

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3 THE STRATEGIC FRAMEWORK OF MONETARY POLICY

In this chapter the ultimate objectives, intermediate targets, operational variables and policy

instruments available to the monetary authority, will be reviewed to establish how the objective of

financial stability could be pursued within the conventional strategic framework of monetary policy.

Under each heading the limitations of the conventional monetary policy framework in achieving

financial market stability, will be highlighted.

The chapter concludes with a discussion of the conventional transmission mechanism of monetary

policy and the introduction of a transmission mechanism to illustrate the operation of non-

conventional monetary policy in pursuit of financial market/system stability.

It also needs to be pointed out that, for the purpose of discussing the conventional monetary policy

framework, it is assumed that the central bank is also responsible for the execution of monetary

policy and that it enjoys implicit or explicit independence in giving effect to monetary policy (the

objectives of which may be set by government). It will be pointed out in chapter 4 that this identity

between the central bank and the monetary authority may itself be problematic.

3.1 The ultimate objectives of monetary policy

3.1.1 Internal price level stability

Where Goodhart (2010) argues that the main characteristic of the strategic framework of monetary

policy since the 1980’s is the triumph of the market (that is, monetary authorities use their policy

instruments to participate, rather than intervene, in the market), Van’t dack (2001: 6) emphasises

the fact that this period also saw the overriding objective of monetary policy as being the pursuit of

price stability. A further development in the debate of this period was the recognition that “a

credible commitment to a nominal anchor – i.e., stabilization of a nominal variable such as the

inflation rate, the money supply, or an exchange rate – is crucial to successful monetary policy

outcomes.” (Mishkin, 2011: 10). Furthermore, during this period an increasing number of monetary

authorities have settled on inflation targeting with the inflation rate as its nominal anchor, and the

repurchase rate, together with its clear communication of intermediate inflation targets, as the

operational variable most suited to be used as a mechanism to achieve its policy objective of low

inflation.

Conventional monetary policy responded to the developing financial crisis by keeping the nominal

interest rate low due to low inflationary pressures. It has been argued elsewhere in this paper that

this response was not only correct in the conventional sense, but that it played a meaningful role in

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dampening the first amplification if the financial crisis, despite the fact that monetary authorities

attracted criticism for keeping rates low in the midst of a developing asset bubble. Had nominal

rates not been kept low, the credit squeeze might have been even worse, and fundamentally sound

assets held by financial institutions might have been eroded even more. This does not, however,

constitute a good argument that price level stability through inflation targeting will ensure financial

market stability.

It is fairly common knowledge that the 2007/08 financial market crisis was preceded by a high

degree of price level stability and low inflation globally. Mishkin (2011: 29) therefore concludes

that price level stability in itself does not ensure financial stability. On the contrary, “…central

banks’ success in stabilizing inflation and the decreased volatility of business cycle fluctuations,

which became known as the Great Moderation, made policymakers complacent about the risks from

financial disruptions.” (Mishkin, 2011: 30). What this therefore says is not that inflation targeting as

a means towards achieving price stability is bad, but simply that low inflation in itself is a poor

indicator of financial market stability, and that, in fact, financial market instability and low inflation

can co-exist (Borio and Lowe, 2002).

3.1.2 Balance of payments and exchange rate stability

Managing the national accounts (BoP stability) and maintaining the value of the national currency

remain important ultimate objectives of conventional monetary policy. Countries have to cover

deficits on the national account through borrowing, or through the inflow of portfolio capital. This

continues to pose significant challenges for open, emerging economies that are almost obliged to

accept deficits in order to fund development, because it makes them dependent on portfolio

investment to cover the deficit, which poses the risk of flow reversals and resultant “sudden stops”

during economic downturns.

Once again the conventional operational variable to manage the Balance of Payments is the official

interest rate. The official rate can be increased to check a widening of a deficit on the Balance of

Payments in that excessive borrowing is curtailed, but also in that a higher interest rate stimulates

portfolio inflows from economies with low interest rates. This, however, leads inevitably to

appreciation of the local currency. For this reason, open economies that pursue inflation targeting

and BoP stability have little choice but to accept a floating currency that is often also fluctuating in

response to global economic events.

Much has been made by economists, following the financial crisis, about global imbalances in

savings and consumption as being one of the root causes of the crisis. Summarised by Borio et al

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(2011: 1) this view entails that emerging economies that adopted a “growth-through-export”

strategy after WWII, such as Germany and Japan (Rajan, 2010) resulted in a net flow of savings

from these countries, into “deficit economies” it eased financial conditions, exerted downward

pressure on interest rates, and helped to fuel a credit boom and risk taking, and thus sowing the

seeds of a financial market crisis. The implicit criticism is then that monetary authorities are in

default not to respond to such unsustainable global imbalances. This matter of imbalances caused

by “excess savings” will be returned to later. (See 4.4)

However, as an instrument of monetary policy there are no clear examples of capital account

management or exchange rate management having had a meaningful impact on stability in the

balance of payments or exchange rate and, although adverse capital flows can be disruptive to

emerging market economies, using the balance of payments, or the exchange rate, as nominal

anchor for monetary policy can be costly.

3.1.3 Employment and income stability

Whilst employment and income stability are recognised as being important ultimate objectives of

monetary policy it is today widely accepted that the instruments of monetary policy are not best

suited towards achieving these objectives. This is particularly so since it was established that there

is no long-term trade-off between unemployment and inflation (the so-called Philips curve).

3.1.4 Financial market stability

It is, perhaps, appropriate at this juncture to pause for a moment and reflect on an operational

definition of “financial market stability”. A universally agreed definition appears to be elusive and

it is therefore advisable to adopt a pragmatic operational explanation of the concept. The Bank of

England (2011) states its core purposes as being the achievement of monetary stability (i.e. stable

prices and confidence in the currency) as well as the achievement of financial stability (detecting

and reducing threats to the financial system as a whole) as being its contribution to a healthy

economy. This mission statement, particularly in referring to the achievement of financial stability,

suggests that financial stability is a state of vigilance, and an awareness of threatening impediments

to the proper functioning of the financial system as a whole.

How then, can conventional monetary policy be applied in pursuit of financial market stability?

Borio et al point out that “While the empirical evidence is broadly consistent with the idea that

monetary instability can cause financial instability, the interpretation of this evidence, and the

policy conclusions that follow, are arguably subtler than is sometimes recognised.” (2002: 18). Put

differently, it is less easy to prove the extent to which monetary stability (i.e. stability in the

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traditional ultimate objectives of monetary policy listed above) will give cause to financial stability,

than it is to argue that monetary instability can create the context for financial market instability.

It can be broadly summarised from the above exposition that conventional monetary has provided,

and will in future continue to provide, a solid base for economic stability in the absence of which

disruptions, including financial market disruptions, will be more violent and destructive.

At the same time, the fact that it appears, from the financial crisis, that a large degree of monetary

stability (especially low inflation) can co-exist with a high level of vulnerability in financial

markets, therefore poses the question as to what type of monetary policy strategic framework is

most likely to lead to the establishment of monetary as well as financial stability.

This challenge will be addressed in more detail under the next heading.

3.2 The intermediate targets of monetary policy

In order for a monetary policy framework to achieve credibility, it has to be able to refer to

intermediate targets, which would indicate that the policy framework is having the desired effects in

terms of achieving the ultimate objectives which the policy has set out to achieve. Typically an

intermediate target would be an inflation forecast, the money supply, credit extension to the private

sector, or the exchange rate.

Borio points to a possible paradox inherent in a monetary policy framework that enjoys a high

degree of credibility, and which therefore only needs to respond to clear signs of inflationary

pressures, in that inflationary pressures may only become apparent in the development of

imbalances in the financial system, and not in the goods and services market. Under such conditions

“…central banks with a high degree of credibility need to remain alert to the possibility that

inflationary pressures first become evident in asset markets, rather than in goods markets.” (Borio

and Lowe, 2002: 22).

The risk is therefore that a monetary policy regime focused only on inflation targeting may not be

vigilant enough to emerging threats to financial stability coming from inflationary pressures in asset

markets. This suggests that an inflation targeting regime may have to respond not only to deviations

from the inflation forecast, but must also be prepared to respond (by raising the interest rate) to

signs of financial market imbalances (rapid credit growth or asset prices rising too quickly). This

does, however, raise the question whether the use of one instrument (the interest rate) to achieve

two goals (monetary as well as financial stability) is not a violation of the Tinbergen rule which will

inevitably compromise one of the ultimate goals. An obvious answer to this dilemma, according to

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Borio, would be a prudential policy framework to achieve the outcome of financial market stability

(Borio and Lowe, 2002: 24). It also provides context for the argument in favour of non-

conventional monetary policy.

3.3 Operational variables and policy instruments

Goodhart (2010: 5) argues that the period of monetary policy spanning 1980 to 2007 can be

described as the “triumph of the markets”. That is, “the almost universal reliance on market forces

[emphasis in the original] and the competitive price mechanism in organising real and financial

activity.” (Van't dack, 2001: 2). This simply means that policy instruments are also market oriented,

or indirect, in that the monetary authority acts through participation in the market, instead of

intervening in the market.

In terms of price level stability (inflation targeting) the operational variable used by the monetary

authority is the repurchase or overnight lending rate against which banks borrow from the central

bank. However, the response of monetary authorities (notably the US Federal Reserve) during the

financial crisis also demonstrated that the monetary authority (being the central bank) can use its

own balance sheet as an operational variable, in this instance to counteract the fire sale dynamic in

asset prices, by purchasing troubled assets in the financial market which caused the amplification of

the financial crisis.

Interestingly, Goodhart (2010: 9) argues that the manipulation of its balance sheet in order to create

liquidity is more central to the essence of central banking than manipulating the interest rate,

quoting Lord Cobbold, a former Governor of the Bank of England, for saying that “a central bank is

a bank, not a study group.” What Goodhart is, in essence, suggesting, is that a central bank (as the

monetary policy authority) which is responsible for financial market stability as an ultimate policy

objective, is better placed to use its balance sheet as the policy variable towards achieving this

objective, than the interest rate it uses to lend to banks. It has already been suggested above that the

interest rate may be a suboptimal operational variable towards achieving financial market stability.

Goodhart therefore in effect argues that the most appropriate operational variable to achieve

financial market stability would be the balance sheet of the central bank (as has been illustrated in

the non-conventional response of monetary authorities to the financial crisis). The implication of

this insight is twofold. Firstly, the notion of a separate “prudential regulation authority” would

imply that such authority would have to be given authority over the central bank’s balance sheet, if

such authority were to be made responsible for liquidity management. The prudential regulator

would effectively become the central bank.

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18

In preference to this scenario Goodhart suggests that the central bank, managing liquidity through

its balance sheet, should have primary responsibility for the ultimate objective of financial market

stability, and that the management of the inflation target ought to be separated from the central

bank, so long as there was an agreed reaction function to restore equilibrium after some adverse

inflationary shock. This function could easily be done by a “study group”.

This does raise the problem alluded to at the beginning of the chapter, i.e. a role confusion or even

false identity between the “central bank” and the “monetary authority. At best, it means that

conventional monetary policy emphasises the monetary authority role of a central bank, whereas

non-conventional monetary policy emphasises its role as a bank. This problem will be returned to in

chapter 4.

3.4 The transmission mechanisms of monetary policy

The analysis of monetary policy in the context of the financial market crisis thus far, has identified

the interest rate set by the monetary authority (conventional monetary policy), and the central

bank’s balance sheet (non-conventional monetary policy), as the most likely two key operational

variables in the pursuit of monetary stability (low inflation) and financial market stability

respectively. It therefore follows that account has to be given of how these two operational variables

will transmit into the economy as low inflation, and into the financial market as stable asset prices

etc.

The traditional (Bank of England) transmission mechanism of monetary policy illustrates how the

first operational variable (the official bank rate) transmits to the ultimate policy objective of price

level stability (low inflation) and is reproduced in Figure 3 below. In this transmission mechanism,

domestic inflationary pressure (indicated via one of the intermediate targets, such as credit growth

in the private sector) may prompt the monetary policy committee of the central bank to raise the

official rate at which the central bank lends to other banks. This has the immediate effect of

increasing the rates at which banks lend to consumers and firms. The effect on all categories of

asset values is that of downward pressure, but the effect on expectations or confidence could be

positive or negative. An interest rate hike could, for instance, signal to the market that the monetary

authority is expecting growth to exceed forecasts and which could be inflationary. This could spur

confidence in the economy on. The impact of a bank rate increase on the exchange will depend on

many external factors but all things being equal, raising the interest rate will attract foreign portfolio

investment. This creates demand for the local currency, and will lead to an exchange rate

appreciation. Whereas higher market rates and asset price devaluation may lead to reduced domestic

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19

demand, an exchange rate appreciation may lead to reduced external demand for local goods and

services. A reduction in total demand will relieve domestic inflationary pressure, and the interest

rate increase would have transmitted into downward pressure on inflation. (The Monetary Policy

Committee, 1999)

Figure 3: The transmission mechanism of monetary policy (Bank of England)

Source: http://www.bankofengland.co.uk/images/from_int_inf2.gif

To the extent that the central bank (as declared by the Bank of England in its mission statement

referred to earlier) is also responsible for the policy outcome of financial market stability, this

transmission mechanism is able to show how the interest rate could be used to influence asset prices

(for example, to deflate asset prices in reaction to the development of an asset bubble) but it is also

a good illustration of why the interest rate might be an inappropriate operational variable through

which to achieve financial market stability during periods of low inflation, since the mechanism

shows that it is impossible to avoid the other transmission channels of an interest rate increase.

Market rates, expectations, and the exchange rate will also be affected even if there is no

inflationary pressure. It will take a very brave central bank to raise interest rates in the absence of

any inflationary pressures, simply to avoid an asset price bubble from developing. More

importantly, it illustrates the significance of the “Tinbergen rule” relating to the difficulties of only

having one tool with which to achieve two (sometimes opposing) objectives.

It is clear that another transmission mechanism is needed to understand how the central bank’s

balance sheet could be used to as a non-conventional monetary policy instrument to achieve the

ultimate policy objective of financial market stability. Such a transmission mechanism has been

ventured by the Bank of England in its latest Quarterly Bulletin and is reproduced below in Figure

4. (Joyce and Woods, 2011).

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Figure 4: Quantitative Easing transmission channels

Source: Bank of England Quarterly Bulletin 2011 Q3

The line of reasoning in this asset purchase transmission mechanism should be viewed against the

likelihood that conventional monetary policy (the interest rate) may have reached its lower bound. It

can therefore no longer respond to a dysfunctional financial market, and there is a real threat of

inflation breaching the lower limit of the inflation target.

Once conventional policy reaches its lower bound, non-conventional policy interventions are

required to respond to financial market instability. As an example of what happens next, one may

wish to consider the setting in of a “fire sale dynamic” in the financial system (in particular a run on

the interbank lending mechanism) as a result of a breakdown of trust in assets offered as collateral

against short term funding requirements (described in more detail in 2.2 above). The central bank

then steps in by using its balance sheet to purchase the troubled assets. This creates confidence in

the underlying value of the assets and sends an important signal to the financial market. The

liquidity problem is also addressed in that the asset sales to the central bank make money available

to the markets (i.e. the quantity of money is increased). In addition, the sellers of the troubled assets

may use the money to rebalance their portfolios by purchasing better quality assets. This activity

serves as an encouragement for more participants to move back into the market, and asset values

improve, stimulating more bank lending (due to improving collateral). Total wealth is increased, the

Bank of England

asset purchases

Portfolio rebalancing

Policy signalling

Confidence

Market

liquidity

Money Bank

lending

Asset price and the

exchange rate

Cost of

borrowing

Total wealth

Spending

and income

Inflation at

2%

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21

cost of borrowing is lowered, spending and income both rise, and the lower limit of the inflation

target is supported (in that the increased quantity of money is inflationary).

It is acknowledged by the Bank of England that the results of its “quantitative easing”6 is not

unequivocal in all respects, and the eventual release of assets back into the market will be

conducted under different conditions, and may therefore have effects on a different scale. It has

however been calculated (Joyce and Woods, 2011: 210) that the impact of quantitative easing on

real GDP in the UK may have been between 1.5 and 2 per cent, and the resulting increase in

inflation was between 0.75 and 1.5 per cent. It was further calculated that the economic impact of

this non-conventional monetary policy instrument was the equivalent of a 150 to 300 basis point cut

in the official bank rate.

3.5 Summary

This chapter has shown that in terms of conventional monetary policy, the era preceding the recent

financial crisis was a golden era of price stability and low inflation. Even at the onset of the

financial crisis, conventional monetary policy was successful in dampening the first amplification

of the crisis. As it reached the lower limits of its effect on the financial market, there was a need for

non-conventional monetary policy (termed “quantitative easing” by the Bank of England) to

stabilise financial markets and return them to their essential role of facilitating a modern global

economy. This necessitated some new thinking on the tools available to monetary authorities – in

most cases the central banks – and led to a need to understand the transmission mechanisms of such

non-conventional monetary policy instruments.

It has also become apparent that there are possible challenges in the dual role of central banks as

monetary policy authorities, which require further discussion in the chapter to follow.

6 “The instrument of monetary policy shifts towards the quantity of money provided rather than its price (Bank Rate).

But the objective of policy is unchanged - to meet the inflation target of 2 per cent on the CPI measure of consumer

prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.” (The Bank

of England, 2011).

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4 POST-CRISIS CHALLENGES FOR MONETARY POLICY

Having traversed the dynamics of the 2007/08 financial market crisis and subsequent global

economic crisis, as well the broad science and pursuit of monetary policy, this chapter aims to distil

some direct insights into the issue which this thesis set out to address: What are the implications of

this crisis for the science and conduct of monetary policy, and how are the agents of monetary

policy going to be affected by the crisis?

De Gregorio, commenting on Peter Stella’s paper: “Minimising monetary policy” (Stella, 2010)

provides an intriguing perspective by claiming that, firstly, financial crises are rare events and that,

secondly, the most recent financial crisis has been well handled, “though poorly anticipated” (Stella,

2010: 28). Mishkin, quoted extensively in this paper, has argued convincingly in favour of the

statement that from a monetary policy perspective, the crisis was handled well. Whether or not the

crisis was poorly anticipated, is a view which does not appear to be borne out by the literature

entirely.

In a paper presented to a South African Reserve Bank Conference in 2002 (also quoted in this

paper) Jozef Van’t dack identified three significant challenges for monetary policy. These were:

firstly, “to understand how asset price cycles interact with monetary policy and what role monetary

policy could or should play in trying to moderate the asset cycles”; secondly “formulating an

effective monetary policy in conditions of financial market fragility”, and thirdly, “the inter-

linkages between monetary and financial stability” (Van't dack, 2001: 11). What has been set out as

challenges for monetary policy science in 2001, has been occupying the minds of monetary policy

scientists ever since the financial crisis of 2007/08.

These policy challenges will be summarised under four headings, i.e. the issue of how monetary

policy ought to respond to asset price bubbles, the monetary policy/financial stability dichotomy,

questions relating to the independence of monetary policy authorities, and finally challenges

relating to the global nature of monetary policy and financial market stability in the finance-driven

global economy of our day.

4.1 Monetary policy and asset price bubbles

One of the key issues in what has been written about the financial crisis, and the response of

monetary policy to the financial crisis, is how monetary policy can and should respond to the

development of asset price bubbles which, when they burst, cause the kind of financial crisis

experienced by the world since 2007/08. It is identified as a key issue because with hindsight, the

development of an asset price bubble in the subprime residential property market in the USA is seen

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as the trigger which set of a global financial and economic crisis. It therefore stands to reason that

the obvious question to be asked is: How could monetary policy have foreseen this bubble

developing, and what could therefore have been done to stop it from destroying the world’s

economy?

The problem of asset price bubbles, and how to deal with them, is not new to the science of

monetary policy. Given the preponderance of price level stability as the most important monetary

policy goal in the period 1980 to 2007, and the associated operational variable of the official

interest rate, at face value it seems logical to expect monetary authorities to use the interest rate to

“lean against” the development of asset bubbles. This assumes that there is always a simple causal

relationship between low interest rates (easy credit) and the development of asset bubbles.

However, Mishkin points out that there are asset bubbles which can also be referred to as “irrational

exuberance bubbles” (Mishkin, 2011: 40), the “dot.com-bubble” of the late 1990s being a good

example.

It is, however, correct to identify asset bubbles which result from easy credit, as the dangerous type

of asset bubble, provided there is a positive feedback loop between the easy credit and the further

development of the bubble. This causes lenders to focus less on the underlying risks of borrowers

not being able to repay their loans, and more on the appreciation of the assets, to shield them from

losses (Mishkin, 2011: 39). Whereas the first type of asset bubble very seldom causes serious

damage to the financial system, it is now known that the latter type of asset bubble can be

devastating to the financial system, and very costly to clean up.

Does this leave monetary policy with no choice but to “lean” against the development of credit-fed

asset price bubbles (by raising interest rates and making credit more expensive)? Mishkin argues

that monetary policy may have to live with the lesser of two evils. Using one policy variable (the

official interest rate) to achieve two objectives (financial as well as price stability) is a

contravention of the Tinbergen rule. A better option, according to Mishkin, would be for macro-

prudential supervision to deal with financial stability, while monetary policy focuses on price and

output stability. Unfortunately “prudential supervision is subject to more political pressure than

monetary policy because it affects the bottom line of financial institutions more directly.” (Mishkin,

2011: 44). The point here is that financial institutions collectively are powerful and use this power

effectively to influence policy making. For Mishkin, there is little chance to get away from a trade-

off between the pursuit of financial stability and the pursuit of price level stability, in the presence

of dangerous asset bubbles but the threat to weakening the nominal anchor of monetary policy (the

inflation target) remains real.

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Interestingly, in an article written in July 2002 (and therefore predating the financial crisis) Borio

and Lowe addressed this sub-optimal choice between monetary and financial stability in the face of

an asset bubble, by insisting on greater co-operation between monetary and prudential authorities,

not only in responding to crises, but also being vigilant in preventing them from developing (Borio

and Lowe, 2002: 27). In simple terms, monetary policy needs to respond to threats identified

through the system of macro-prudential regulation.

4.2 Dichotomy between monetary policy and financial stability policy

Mishkin points out that, even before the crisis, monetary policy authorities were aware of the fact

that disruptions in financial markets could have an impact on the economy. This is borne out by the

fact that many central banks published financial stability reports in order to monitor potential threats

in the financial system. However, “the general equilibrium modelling frameworks at central banks

did not incorporate financial frictions as a major source of business cycle fluctuations. This

naturally led to a dichotomy between monetary policy and financial stability policy in which these

two types of policy were conducted separately. Monetary policy instruments would focus on

minimizing inflation and output gaps. It would then be up to prudential regulation and supervision

to prevent excessive risk taking that could promote financial instability.” (Mishkin, 2011: 17)

One of the important lessons learned from the crisis, according to Mishkin, is that “monetary policy

and financial stability policy are intrinsically linked to each other and so the dichotomy between

monetary and financial stability is a false one.” (Mishkin, 2011: 46). Therefore, Mishkin concludes,

“Coordination of monetary and macro-prudential policies becomes of greater value when all three

objectives of price stability, output stability and financial stability are pursued.” (Mishkin, 2011:

47). So, it is not so much that monetary policy changes, but rather that the central bank takes on a

dual, coordinating role between the ultimate objectives of monetary policy and that of financial

stability regulation.

Stella goes considerably further, by ascribing this dichotomy between monetary and financial

stability policy, to a false identity equating central banking with monetary policy (Stella, 2010: 11).

Simplified, “monetary policy” should refer to “interest rate policy”, whereas central banking should

refer to the participation of the central bank in specific markets or institutions (open market

operations), using its balance sheet to improve the functioning of the market, by affecting relative

prices, or providing liquidity. This view is consistent with that of Goodhart: “A central bank is a

bank, not a study group.” (Goodhart, 2010: 9).

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25

It would appear, therefore, that the focus of the debate should shift away from the dichotomy

between monetary and financial sector policy (it has been argued quite convincingly by many

scholars that the policies, and ultimate objectives, are interlinked) and towards the future role of

central banks as monetary authorities as well as financial market regulators.

4.3 The independence of the monetary policy authority

The debate around the independence of the monetary policy authority or central bank depends to a

large extent on how you view the monetary policy-financial stability policy dichotomy. Referring

again to the false identity between central banking and monetary policy, Stella argues that “The

global consensus stressing the benefits of independent monetary policy that has emerged over the

past two decades is worth preserving.” (Stella, 2010: 21). However this refers to the conduct of

monetary policy in pursuit of price level and output stability, using the operational variable of the

official bank rate, to influence price stability through the intermediate objective of an inflation

target. The case for the autonomy of the central bank is much weaker inasmuch as it concerns the

participation of the central bank in the financial market through its balance sheet, given the fiscal

implications of such activities. Stella argues for an independent Minimal Monetary Authority

(MMA) and a less-independent (because of its need for a substantial balance sheet, supported by the

fiscus) Market Liquidity Maintenance Corporation (MLMC). Stella concludes that one can only

protect monetary policy independence by recognising that central banking is not the same as

monetary policy and that, therefore, central banking ought not to be independent but should be

accountable to parliament.

Goodhart, albeit indirectly, comes to a similar conclusion regarding central bank independence

when he argues for the separation of functions between central banking and setting the interest rate.

Whereas the first activity, being a systemic stabilisation role, calls for close cooperation with

government, this close cooperation could open the way for undue government influence in the

management of the interest rate by the central bank. Hence Goodhart also considers the possible

need to assign management of the inflation target to a different committee than the monetary

authority (or to a coven of Druids casting runes over the entrails of a chicken!) (Goodhart, 2010: 9-

13).

In this regard the financial crisis will also have altered the design of the monetary authorities of the

future.

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4.4 A need for more international co-ordination of monetary policy

Having illustrated the global nature and impact of the financial crisis, it stands to reason that

changes have to be made to the manner in which monetary policy is conducted globally. Particular

insight is derived from the Borio and Disyatat paper (Borio and Disyatat, 2011), especially their

reminder that the modern global economy is a monetary economy in which credit creation plays a

central role. They discard the “unsustainable imbalances/excess savings” criticism argued by Rajan

(2010) and others, since it confuses saving (which is a national account concept) with financing,

which is a cash-flow concept and distracts from the complex underlying patterns of global

intermediation, which is where the real challenges originate.

The issue is “excess elasticity” as being the fundamental weakness in the international monetary

and financial system. Elasticity in this context is defined to refer to “the degree to which the

monetary and financial regimes constrain the credit creation process, and the availability of external

funding more generally. Weak constraints imply a high elasticity.” (Borio and Disyatat, 2011: 24).

Although a high elasticity can facilitate expenditures and production, is can also accommodate the

build-up of financial imbalances where economic agents are subject to asymmetric information, and

their incentives are not aligned with the public good (i.e. there are negative externalities).

Whereas international policy efforts to revamp prudential regulatory and supervisory frameworks

following the financial crisis go some way towards reducing this elasticity, Borio points out that “It

is monetary policy that underpins the term structure of market [emphasis in the original] interest

rates ...In other words, it is monetary policy that ultimately sets the price of leverage [emphasis in

the original] in a given currency area. The central bank’s reaction function, describing how market

interest rates are set in response to economic developments, is the ultimate anchor in the monetary

regime. This has implications for policy at the domestic and the international level.” (Borio and

Disyatat, 2011: 24).

One of the challenges facing global financial markets is that international policy, because it is

dependent on consensus between sovereign entities, may find it difficult to define strong anchors to

prevent the kind of financial imbalances which can lead to serious financial strains and harm the

world economy. “Reducing this elasticity requires that anchors be put in place in the financial and

monetary regimes, underpinned by prudent fiscal policies.” (Borio and Disyatat, 2011: 27). Putting

down such anchors at international level will be politically challenging but at the minimum,

frameworks have to be adopted that stress the externalities involved. Such frameworks should

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27

highlight the fact that no individual country can be safe unless the world as a whole is safe (Borio

and Disyatat, 2011: 27)

These sentiments are echoed in the Stiglitz Report (Stiglitz, 2010: 68), with particular reference to

the negative externalities of financial markets resulting from imperfect information, that bear social

costs for taxpayers, homeowners and workers, and across international boundaries into the

developing economies of the world.

4.5 Summary

The chapter endeavoured to answer the questions: What are the implications of this crisis for the

science and conduct of monetary policy, and how are the agents of monetary policy going to be

affected by the crisis?

The answer to the first question is firstly, that in the midst of a financial crisis caused by asset

bubbles with a direct link to low interest rates, conventional monetary policy may have little choice

but to choose between the lesser of two evils, i.e. to “lean” against the development of such bubbles

by raising interest rates despite low inflation, in order to avoid the bigger damage which may be

inflicted by the eventual collapse of asset values. Secondly, given the interwoven nature of the

modern global economy and the elasticity of credit creation in the international financial market

system, monetary policy may, in the future, require stronger nominal anchors based on international

consensus, however difficult that may be to achieve.

The answer to the second question is that there needs to be a much clearer distinction (which

appears not to have been important prior to the financial crisis) between central banking on the one

hand and the pursuit of monetary policy on the other hand. In fact, much of the perceived

dichotomy between the objectives of monetary stability and financial market stability may be

ascribed to a false identity between the monetary authority and the central bank. In a sense the fact

that, institutionally, both functions were performed by the same institution in the past is incidental.

The financial crisis has brought into sharper focus the fact that they are separate. This has

implications for the notion of central bank/monetary policy independence. Whereas monetary

policy independence is a prerequisite for policy credibility, central bank independence is

problematic in the sense that its balance sheet impacts the fiscus and it ought to be accountable to

parliament for this reason.

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5 CONCLUSION

Many economists and financial institutions have been worried for some time about the fragility of

the world’s financial system, which is the backbone of the modern global economy, yet very few

were prepared for the ferocity with which this fragility revenged itself on the global economy, once

the right trigger mechanism was activated.

With the benefit of some hindsight setting in in relation to the initial events that allowed a relatively

isolated subprime housing bubble in the USA to infect almost the entire global financial system, it

has to be said that monetary authorities everywhere in the world, responded admirably to the crisis,

given what it had been designed to do. Conventional monetary policy (the management of internal

price level stability) was deployed more effectively than what is generally being credited, to prevent

an even deeper recession or even depression, and three years after the onset of the crisis most

economies are showing positive growth again however small. Central banks also did not hesitate to

utilise the tools it had available, to deploy non-conventional monetary policy in the form of their

balance sheets, to arrest the rapid decay in asset values which threatened to bring the global

financial system down altogether.

Yet it was to be expected that the crisis would also show up shortcomings in the global financial

system, and in the policies and regulatory frameworks that are needed to support the system.

Dichotomies and institutional shortcomings that may have been unimportant in the past have been

brought to the fore. This will have implications for monetary institutions (often perceived as

bastions of consistency and tradition) which have to trade off independence in their central banking

functions, whilst at the same time it is not inconceivable that management of the inflation target

may even be moved elsewhere.

The crisis has been a sobering reminder that there are no received truths on how to manage the

global political economy and that our knowledge of the market is evolutionary.

Mishkin highlights one piece of good news to come out of the crisis: “The field of macro/monetary

economics has become a hell of a lot more exciting. We are now faced with a whole new agenda for

research that should keep people in the field busy for a very long time.” (Mishkin, 2011: 48). In this

regard it has been encouraging, in reading for this paper, to discover the existence of cutting edge

research around the challenges facing monetary policy. Far from the images favoured by the

populist mass media, which often cast monetary authorities as conservative ivory towers of dogma

and inflexible ideology, monetary science, driven by monetary policy scientists and practitioners

often closely associated with the monetary authorities in the countries where they work, remains

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29

incisive in its pursuit of a better understanding of the challenges facing the global political economy

in general, and monetary policy in particular.

Much of what is often perceived as inadequacies in the theory and practice of monetary policy, is in

fact a function of the complexities of the global political economy within which the objectives of

monetary policy are being pursued. These include, to name but a few, the complexities of a

bipartisan political system of government of the United States of America, the enormous challenges

facing Europe in coming to grips with the inevitable implications of monetary union for fiscal and

political union as well, and the challenges of a developing world, including China as the future

economic powerhouse of the world.

Therefore the policy and institutional challenges facing the science and pursuit of monetary policy

are significant but they are being pursued in a modern world that values the flow of information and

the incessant move towards an open global economy. Institutions are becoming more robust and

open to change. There can be little doubt that monetary authorities will adjust to the new challenges

brought to the surface by this recent crisis. Many monetary authorities are already adjusting. There

will, however, be new challenges and new crises in the future.

The pursuit of monetary stability and financial market stability will continue. Perhaps the final

conclusion of this thesis on the importance of monetary and financial market stability is best

summarised by Davis and Green in the following description of the financial market system we

have almost come to take for granted:

Societies become so used to the availability of stable currency, the ability to make payments

both domestically and internationally, and the existence of banks and other financial

institutions through which to save and borrow that it is easy to forget that each of these is a

purely social construct, fundamentally based on trust, albeit bolstered by legislation…

Banking itself is a fragile business because a bank depends on the confidence of its

depositors that it will be able to repay their deposits whenever they want them, even though

it has lent them out at longer terms to borrowers. The maturity transformation that banks

carry out is in that sense a confidence trick…

All developed economic activity is dependent on this fragile financial infrastructure, which

requires its numerous constituent players to play their parts as expected: the provider of

currency must avoid issuing it at such a pace that it is devalued; those making payments

must deliver them to the intended recipient; savings should be made available to sustain

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investment and loans provided to sustain business activity, house purchase, or consumer

spending. (Davies and Green, 2010: 9)

Word count: 11306

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