Martin Wolf on Monetary Policy Mishaps

Martin Wolf has a great column on how monetary policy in the early-to-mid 2000s contributed to the buildup of economic imbalances that in turn led to the current economic crisis. Here are some key excerpts with my comments interspersed:

Just over five years ago, Ben Bernanke, now chairman of the Federal Reserve, gave a speech on the “Great Moderation” – the declining volatility of inflation and output over the previous two decades. In this he emphasised the beneficial role of improved monetary policy. Central bankers felt proud of themselves. Pride went before a fall. Today, they are struggling with the deepest recession since the 1930s, a banking system on government life-support and the danger of deflation. How can it have gone so wrong?

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First, John Taylor of Stanford University, a former official in the Bush administration, argues that the Fed lost its way by keeping interest rates too low in the early 2000s and so ignoring his eponymous Taylor rule, which relates interest rates to inflation and output. This caused the housing boom and the subsequent destructive bust.

Prof Taylor has an additional point: by lowering rates too far, the Fed, he argues, also caused the rates offered by other central banks to be too low, thereby generating bubbles across a large part of the world. In retrospect, for example, the autonomy of the Bank of England was much smaller than most imagined: the wider the interest rate gap vis-a-vis the US, the more “hot money” flowed in. This induced a lowering of standards for granting credit and so a credit bubble.

David here. Martin Wolf and John Taylor are correct, but there is an even stronger argument to made here about the Fed: it is a monetary superpower because it manages the world's reserve currency. As a result, many countries either formally or informally peg to the dollar and import their monetary policy from the Fed. This means the Fed's easy monetary policy in the early-to-mid 2000s created a global liquidity glut. The ECB and the Bank of England, therefore, not only had to keep an eye on low U.S. interest rates, but also on low interest rates in the dollar block countries lest their European currencies appreciated too much. In short, the Fed's easy monetary policy at this time was exported across the globe. Back to Martin Wolf:

Second, a number of critics argue that central banks ought to target asset prices because of the huge damage subsequent collapses cause. As Andrew Smithers of London-based Smithers & Co notes in a recent report (Inflation: Neither Inevitable Nor Helpful, 30 April 2009), “by allowing asset bubbles, central banks have lost control of their economies, so that the risks of both inflation and deflation have increased”.

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Finally, economists in the “Austrian” tradition argue that the mistake was to set interest rates below the “natural rate”. This, argued Friedrich Hayek, also happened in the 1920s. The result is misallocation of resources. It also generates explosive growth of unsound credit. Then, in the downturn – as the American economist, Irving Fisher, argued in his Debt-Deflation Theory of Great Depressions, published in 1933 – balance-sheet deflation will set in, greatly aggravated by falling prices and shrinking incomes.

Whichever critique one accepts, it seems clear, in retrospect, that monetary policy was too loose.

David here. One can reasonably incorporate all three views, a kind of hybrid Keynesian-Austrian perspective where the Fed tries to stabilize nominal spending while monitoring systemic risk in the financial system. George Selgin has some good ideas on how to stabilize nominal spending while the folks at the BIS, particularly Claudio Borio, have some interesting ideas on a macroprudential approach to economic policy. I really hope that as observers cotinue to reflect over what caused this crisis the role of monetary policy will not be ignored.