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 nineteen-member (as of 2016) Eurozone.

These perceptions have changed over the past decade 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 or from members leaving the Eurozone. 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 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 in the future.

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 former Fed Chair 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.

The U.S. economy has mostly recovered from the financial crisis, but current Fed Chair Janet Yellen has remained cautious, allowing monetary policy to remain accommodative as economic growth improves.

The Fed was not alone in taking drastic action during the financial crisis. The Fed’s counterpart in Europe, the ECB, took extraordinary action as well.

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:

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. Moreover, the euro established itself as a major reserve currency, giving it significant clout among world financial institutions.

However, conditions began changing in 2007 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 and to prevent nations from defaulting on their debt. A summary of key events faced by individual Eurozone members follows.

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 by 2013. 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.

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.

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Today, most of the Eurozone countries that faced financial crises have recovered with some countries such as Ireland and Slovenia experiencing rapid economic growth. The exception is Greece, which continued to face challenges in 2016. But overall, economic growth remains tenuous throughout the region. This is not unlike the recovery pattern experienced in the United States.

In the United States, the housing market has mostly recovered, employment growth has been strong, stock markets have set new highs, and banks have strengthened their balance sheets. Still, as in Europe, problems such as deficits and weak growth remain, 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.