So, who, or what, is to blame? Why, 15 years after the start of the last financial crisis, might we be seeing that of another? For many, it is the fault of a long period of ultra-low interest rates imposed by central banks. For others, the cult of the bailout is at fault. We do not need to look far to find the intellectual origins of such views. They lie in Austrian economics. As Brad DeLong puts it in his excellent book, Slouching Towards Utopia, the view is that “the market giveth, the market taketh away; blessed be the name of the market”. The Austrians are not altogether wrong. They are not altogether right either.
The essence of the argument is that the transatlantic financial crisis of 2007-15 was the product of over-loose monetary policy. Thereupon, over-loose monetary policy, plus bailouts, thwarted the creative destruction that would have returned the economy to vigorous health. Finally, after Covid, another burst of over-loose monetary policy, combined with aggressive fiscal policy, caused high inflation and still more financial fragility. Now, all the chickens are coming home to roost.
The story is simple. But it is wrong.
Start with the run-up to the financial crisis. The UK has been issuing index-linked gilts since the early-1980s. The most remarkable feature of the series is the huge fall in real yields from a peak of 5 per cent in 1992 to 1.2 per cent in 2006, then minus 1.4 per cent in 2013 and minus 3.4 per cent in 2021. Central banks alone, however demented they may have been, could not deliver a decline of more than eight percentage points in real interest rates over three decades. If this huge fall in real interest rates were incompatible with the needs of the economy, one would surely have seen surging inflation.
So, what was going on? The big background changes were financial liberalisation, globalisation and the entry of China into the world economy. The latter two not only lowered inflation. They also introduced a country with colossal surplus savings into the world economy. In addition, rising inequality within high-income countries, combined with ageing populations, created huge surplus savings in some of them, too, notably Germany. It then needed exceptional credit-fuelled investment, notably in housing, to balance global demand and supply. Happily or not, the financial liberalisation facilitated this credit boom.
All this blew up in the financial crisis. The decision then made was not to have another great depression. I do not regret my support for that self-evidently wise decision. But, given the realities of the world economy and the impact of the crisis, there then needed to be either ongoing fiscal support or ultra-loose monetary policy. The former was ruled out. So, it had to be the latter.
Data on the money supply show why both ultra-low interest rates and quantitative easing were vital. After the financial crisis, there were extended periods when the private contribution to the growth of the money supply was negative, because credit was contracting. If interest rates had been higher and central banks had not expanded base money, as they did, the money supply would have collapsed. I am not a believer in our ability to stabilise demand by stabilising the money supply. But letting it implode is another matter. Milton Friedman would have considered the actions of central banks in stabilising the growth of broad money after the financial crisis essential. Certainly I do.
Then came Covid. At this point, the monetary and fiscal authorities made what turned out to be big mistakes. Monetary growth exploded. According to the IMF, the structural fiscal deficit of the group of seven leading economies also jumped by 4.6 percentage points between 2019 and 2020 and barely shrunk in 2021. This combination fuelled a surge in demand greater than supply could meet, given China’s repeated lockdowns and the Ukraine war. The result was, we hope, a temporary surge in inflation and rising interest rates, which has caused another shock to our fragile banking system.
In sum, the central banks were not the evil puppet masters of some imaginings, but puppets under the control of more powerful forces. Yes, they made mistakes. Maybe monetary policy should have “leaned against the wind” rather more prior to the financial crisis, QE ended a bit sooner after that crisis, and monetary support been withdrawn faster in 2021. But, given our liberalised financial system and the huge shocks to the world economy, I am sceptical whether any of this would have made a huge difference. Crises were inevitable.
Certainly, the legion of critics need to spell out precisely what they would have recommended instead and what effects they would expect their alternatives to have had. We need the counterfactuals specified and quantified. How high should interest rates have been? How big a financial collapse, economic slump, and rise in unemployment would they have then expected after the financial crisis? Why do they imagine businesses would have invested more if interest rates had been higher? Even if productivity would have been raised by slaying “zombie” firms, why would this have been a good thing if the costs included lower output for a prolonged period?
Like all human institutions, central banks are imperfect and sometimes incompetent. But they are not crazy. The view that what has gone wrong with our economies in the past few decades is mainly loose monetary policy is a cop out. It rests on the delusion that there is a simple solution to the failings of our financial systems and real economies. Things would not be wonderful if central banks had stood idly by. We cannot abolish democratic politics. Economic policy must be adapted to our world, not to the 19th century.
martin.wolf@ft.com
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