New Monetary Policy Challenges

For much of the past century, since the Federal Reserve Act created the Federal Reserve and with it monetary policy, policies were quite predictable and the role of the Fed was seen as an ever present but never overreaching government body. A similar sentiment was felt toward the European Central Bank (ECB), formed in 1998 in the seventeen-member (as of 2013) Eurozone.

These perceptions have changed in recent years after both the United States and Europe experienced the worst financial crisis in nearly a century. Extraordinary times called for extraordinary efforts by the Fed and the ECB, using monetary policy beyond what is used in normal times. In the United States, the recession of 2007–2009 and the subsequent slow recovery led the Fed to take drastic actions never seen in its past. More recently, the ECB made large rescue packages for member nations that neared default on their debt, taking new drastic measures to save the euro from collapse. This section presents a brief summary of the challenges faced by the Fed and the ECB, and how both have used extraordinary powers to limit the economic impact of the crises.

The Fed: Dealing with an Economic Crisis Not Seen in 80 Years

The financial meltdown that plagued the global economy in the latter part of the last decade was caused by a perfect storm of conditions. First, a world savings glut and unusually low interest rates from 2002 to 2005 led to a housing bubble. Second, financial risk was not properly accounted for, as consumers were eager to buy homes (sometimes second homes) and banks were so eager to lend that they ignored previous lending standards. Third, investors and financial institutions (including pension funds) bought trillions of dollars of assets that depended on housing values increasing consistently over the years.

When the housing bubble collapsed, the house of cards collapsed as well. Falling home values and rising mortgage payments caused homeowners to default, leading to many foreclosures. The foreclosures caused assets dependent on housing values to plummet, resulting in trillions of dollars in losses by financial firms and investors. Banks found themselves in trouble, and the government bailed out the banks by buying up bad loans to provide capital and liquidity in order to prevent bank runs and a sharp fall in lending.

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In response to the financial crisis, the Fed used its normal monetary policy tools and some that it hadn’t used since the 1930s. By December 2008, the Fed had lowered its federal funds target rate, using its normal monetary policy tool, to essentially 0%. By this time, the Fed turned to extraordinary measures when it began making massive loans to banks and buying large amounts of risky mortgage-backed securities. The Fed’s balance sheet ballooned in size from less than $1 trillion in 2008 to over $3 trillion in 2012, a level that well exceeds that in normal times. Further, its balance sheet allocation changed dramatically from one consisting of about 90% in safe treasury securities to one comprising nearly half in more risky assets such as mortgage-backed securities.

The Fed was the prime mover in dealing with the financial crisis, once it recognized it. One can argue that it took too long for the Fed to recognize the problem, and the Fed may have encouraged the housing bubble by keeping interest rates very low for too long. Further, the government’s response in bailing out financial institutions and other industries, along with a dramatic increase in the monetary base, led some to believe that the Fed overstepped its authority by exercising powers it did not have (such as its role in buying up troubled assets from banks) and expanding the monetary base too far, risking widespread inflation in the future.

But as Fed Chairman Ben Bernanke said, if your neighbor’s house is on fire because he was smoking in bed, you deal with the fire first because if you don’t, your own house can burn down. You deal with your neighbor’s smoking problem later.

Recessions that follow a banking crisis are typically twice as long and result in nearly 4 times the loss in GDP.2 New rules imposed on financial firms since the crisis have included higher capital requirements, restrictions on leverage, and tighter regulations. The Fed was not alone in taking drastic action. The Fed’s counterpart in Europe, the ECB, took extraordinary action as well.

The Eurozone Crisis and the Role of the European Central Bank

The Eurozone was created during a 1992 meeting in the Netherlands by twelve European nations that envisioned a single currency that would reduce transaction costs and facilitate and expand trade. The meeting resulted in the signing of the Maastricht Treaty, which set the monetary criteria that each member nation had to satisfy before joining the Eurozone. These criteria included, among others:

  1. Maintaining an inflation rate no higher than 1.5% above the average of the three member countries with the lowest inflation.
  2. Maintaining long-term interest rates (on 10-year bonds) no higher than 2% above the average of the three member countries with the lowest interest rates.
  3. Maintaining annual deficits of less than 3% of GDP.
  4. Maintaining total debt of less than 60% of GDP.
  5. Having no major currency devaluation in the preceding two years.

When the euro was introduced in 1999, eleven of the twelve treaty members met the monetary criteria. Greece took two extra years to satisfy the criteria and was admitted into the Eurozone in 2001.

Why were such stringent criteria needed? When a common currency is adopted, monetary policy becomes shared by all members. Therefore, a monetary crisis in one country can quickly spread to all countries. Germany, the largest and wealthiest member of the Eurozone, traditionally had maintained low inflation and a very stable economy. Although Germany had much to gain from the Eurozone, it also faced risks by integrating its monetary policy with countries whose economies were less stable. Because of Germany’s fear of inflation, the Eurozone was set up in a way that prescribed austerity measures as opposed to monetary expansion as a cure for debt. However, the severity of the Eurozone crisis that would ensue a decade later changed this focus, as even Germany had to accept that extraordinary actions were needed.

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Still, for much of the first decade, the euro was a success, with member nations keeping their debt under control while the ECB implemented monetary policy for the entire Eurozone. However, that changed in the mid-2000s, when several member nations saw their debts rise, requiring some to sell securities (sovereign debt) on future cash revenues to keep their debt-to-GDP ratio from exceeding the Eurozone limit. However, these quick fixes worked only for a short period. A bigger crisis was brewing that would test the ability of the ECB to save the euro from collapse.

From 2008 to 2013, nearly half of the Eurozone nations faced some sort of financial crisis. In each situation, the ECB used its normal monetary policy tools in addition to extraordinary measures to lessen the economic impact of the crisis.

Ireland went from being the second wealthiest member of the Eurozone (after Luxembourg) to one facing the biggest financial crisis in 2008.
bildbroker.de/Alamy

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The Challenges of Monetary Policy with Regional Differences in Economic Performance

In late 2011, the Eurozone reached a crisis when several of its members, notably Greece and Portugal, neared default on their national debts. Others soon followed. The worry among leaders, particularly in Germany, was that the poorer members of the Eurozone might cause the euro to collapse, bringing the European economy down with it.

Many have pointed to Europe as an experiment with monetary policy integration gone wrong: Members of the Eurozone were too different, not only culturally, but also economically. Prior to its formation in 1999, the richest member of the Eurozone, Luxembourg, had a GDP per capita that was more than twice the level of that of Portugal, which at the time was the poorest member of the original eleven countries, until Greece joined in 2001. In 2007, countries in Eastern Europe began joining, further spreading the difference between the richest and poorest members, which would all share the same currency and monetary policy determined by the European Central Bank (ECB).

Although each member nation would have representation in the ECB based on population, decisions are dominated by Germany and France, the two largest members. The challenge faced by the ECB is formulating a common monetary policy that best fits the economic conditions faced by its members. This is not easy.

When one part of the Eurozone is booming (say Belgium) and would benefit from contractionary monetary policy, while another is struggling with debt (Greece) and requires expansionary monetary policy, choosing a common monetary policy involves placing the priority of one country’s economic concerns over another.

But is the situation in Europe the only one in which a common monetary policy needs to address wide variations in economic performance? The answer is no, and the best example of another monetary zone facing similar problems may surprise you…the United States.

European Central Bank in Frankfurt, Germany.
Walter Bibikow/JAI/Corbis

The United States shares many similarities with the Eurozone when it comes to monetary policy. Although the United States is one country, wide variations in economic performance still exist. In 2010, Maryland’s per capita income of $70,000 was almost twice that of Mississippi’s $36,000. Unemployment in North Dakota was less than 3% while in Nevada it was over 13%. Regions with rapid economic growth faced inflationary concerns, while struggling regions grappled with high unemployment.

Further, U.S. monetary policy also must take into account territories that use the U.S. dollar, such as Puerto Rico, whose per capita income is even lower than Mississippi’s. And finally, some countries—such as Ecuador, El Salvador, and Panama—have unilaterally adopted the U.S. dollar as their official currency, and hence U.S. monetary policy. The Fed’s decisions have a direct impact on all economies that use the U.S. dollar.

In sum, large monetary unions such as the Eurozone and the United States must weigh the priorities of one region against another when considering the policies they implement. Such a task makes the statement that monetary policy is as much art as science a realistic description facing central banks today.

In sum, the ECB took extraordinary actions that it had never taken in its history to prevent financial crises in individual countries from causing the collapse of the Eurozone. First, the ECB provided loans to banks and bought government debt, and created the ESM in 2012 to manage funds being disbursed. Second, the ECB negotiated deals with private banks and other investors to write off portions of debt and to restructure existing loans to governments. Third, it demanded that governments pass austerity measures, enact structural reforms, and be subjected to greater scrutiny. Like the Fed, the ECB’s balance sheet ballooned during the crisis, from about 1 trillion euros in 2007 to over 3 trillion euros in 2012. Why was the ECB so eager to take extraordinary actions to prevent countries from defaulting on their debt?

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Clearly, the number of Eurozone nations facing a financial crisis had reached a critical point. If any nation defaults and pulls out of the Eurozone, it could trigger a global loss of confidence in the euro. For example, investors might be less willing to invest in euro-denominated bonds and assets if the long-term stability of the currency came into question. Such a loss of confidence would itself reduce the stability of the euro, leading to a self-fulfilling prophecy. Imagine what would happen if a U.S. state became so much in debt that it chose to give up the U.S. dollar and create its own, much devalued, state currency. The impact could be significant. In Europe, it almost became reality in 2013.

However, the ECB used aggressive monetary policies to reduce the likelihood of a nation’s exit from the Eurozone. Just as the Fed stepped in to prevent regional crises in the United States by injecting financial capital and reducing interest rates, the ECB used expansionary monetary policies to help member nations facing economic crises. This is much easier said than done, as the Issue described, when different areas of a currency zone face varying levels of economic performance.

Today, many of the financial crises have stabilized for the time being, though by no means have they been resolved. Although Ireland’s banks were recapitalized and interest rates in Greece returned to normal levels, the economies of the Eurozone nations remain tenuous, which means that the ECB will likely continue to exert its influence for years to come.

In the United States, the housing market has started to recover, stock markets have set new highs, and banks have strengthened their balance sheets. Still, as in Europe, problems such as persistent unemployment and deficits remain in the United States, which means that the Fed will continue to rely on monetary tools to prevent problems from home and abroad from engulfing the economy.

The next chapter is devoted to analyzing the major macroeconomic policy challenges involving both fiscal policy and monetary policy, allowing you to use the macroeconomic tools learned thus far to sketch out solutions.

NEW MONETARY POLICY CHALLENGES

  • To control the financial panic of 2008, the Fed used its normal monetary policy tools and some that it hadn’t used since the 1930s.
  • The European Central Bank is the Fed’s counterpart in Europe, setting the monetary policy for the seventeen-member Eurozone.
  • A long and severe debt crisis occurred when several European nations neared default on their loans and came close to exiting the Eurozone, requiring extraordinary actions, including bailout loans, by the ECB to keep the effects of the crisis from spreading to the entire Eurozone.

QUESTION: The collapse of the financial markets in late 2008 resulted in the Fed reducing interest rates to near 0%. Was it likely that the U.S. economy in 2009 sank into a Keynesian liquidity trap?



Reducing interest rates to low levels to stimulate credit and the economy was probably not sufficient by itself. But as consumer spending dropped off, business avoided new investments as markets declined or disappeared, suggesting that the economy may have been in a liquidity trap. Keynesian analysis got the nod from policymakers with the $787 billion fiscal stimulus package.

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