How to manage a financial crisis – why didn’t the Fed’s QE cause hyperinflation?

Because no one was spending it.

Many were worried the extreme liquidity measures of the Federal Reserve during and after the GFC would lead to hyperinflation in the US. Or that it represented a currency war, where the US was seeking to deliberately over-inflate their economy to drive down the US dollar, as well as reduce their real debt burden, at the expense of the rest of the world.

It has happened so many times through history and the world, where inflation was triggered by excessive money creation:

·         Before the American Revolution, tobacco was used as currency in Virginia, Maryland and North Carolina. And because the price of tobacco was originally greater than the cost of growing it, planters set about producing more. This caused the supply of this “currency” to expand faster than the rest of the economy, causing the price of everything for which tobacco could be exchanged to increase 40-fold.

·         When gold was widely accepted as legal tender, huge gold discoveries in Mexico and South America in the Middle Ages, and in California and Australia in the mid-19^th century, effectively increased the money supply, setting off inflation.

·         After WWI, Germany printed extraordinary quantities of money to pay the huge war reparations demanded of them under the Treaty of Versailles. So from 1914 to 1923, wholesale prices increased by a factor of 726 billion – that’s 72.6 trillion per cent inflation. The US dollar went from buying 0.2-0.25 Mark to 4-5 trillion Mark. There were stories of people in Germany carrying wheelbarrows full of cash to buy a loaf of bread, getting mugged for the wheelbarrow instead of the cash.

·         It has even been observed in prisoner-of-war camps, when cigarettes were used as currency. Upon a new delivery of cigarettes to the camp, the price of whatever they traded for the cigarettes would jump.

·         The hyperinflation in Zimbabwe and, more recently, Venezuela was also driven by excess money creation by their central banks.

The fact is, until the GFC, there was not a single example in history of a “rapid increase in the quantity of money that was not accompanied by a roughly correspondingly substantial inflation” (M&R Friedman).

But it didn’t happen this time in the US. And there were actually good reasons to know that it never would. First, a bit of theory – specifically, the Quantity Theory of Money:

%∆M + %∆V = %∆P + %∆T.

This means that the percentage change in the money supply (M) plus the percentage change in the velocity of money (V) (how many times each dollar is spent per year) is equal to the percentage change in the price level (P) (a.k.a. the inflation rate) plus the percentage growth in the size of the economy (T) (a.k.a. the economic growth rate).

Let’s put some standard numbers to the variables:

5% + 0% = 2% + 3%.

So if the central bank is expecting an economic growth rate of 3%, and for the velocity of money to remain constant (reasonable in normal times), then they need to increase the money supply by 5% to achieve their target inflation rate of 2%.

If the central bank happens to increase the money supply by, say, 10%, all this extra purchasing power in the economy will drive up inflation by 7% (assuming economic growth and velocity remain at 3% and 0% respectively).

The Quantity Theory of Money is a mathematical certainty. It has to happen. And not even necessarily with a particularly long lag. Other things being equal, an increase in the rate of money creation will inevitably result in an equal increase in the inflation rate.

It is easy for governments to blame inflation on trade unions, greedy businessmen, spendthrift consumers or anything else that seems remotely plausible. But these groups can’t produce continuing inflation for the simple reason that they don’t possess a printing press with which to affect the money supply.

As Milton Friedman said:

“Substantial inflation is always and everywhere a monetary phenomenon”

So why then, when the Federal Reserve effectively increased the money supply in the US so dramatically, did it not result in inflation and a depreciating US dollar?

Because of the one variable we’ve been assuming to be constant – the velocity of money.

A recession, by definition, occurs when there is less spending in an economy than there was before. Each dollar is being spent fewer times per year. This is the velocity of money. And during the GFC in the US, this velocity was cut, let’s say, in half. Economic growth was negative for a while too, let’s say -1%. Therefore, the equation changed as such:

%∆M + -50% = %∆P + -1%

So, in order to achieve their target 2% inflation rate, the Federal Reserve would have to increase the money supply by 51%!

These numbers are just a guide. And they’re hard to estimate in real time. So the Federal Reserve had to do a bit of guess-and-check with their liquidity injections to see how it was affecting inflation. But it does show how they were able to inject so much liquidity into the system without causing the hyperinflation or the currency war about which so many were worried. V was decreasing just as fast as M was increasing. There was minimal flow through from quantitative easing to consumer prices, barely keeping inflation above zero, and not causing the US dollar to plummet.

And this is what the Federal Reserve was trying to achieve. Not real economic growth per se. They just wanted to avoid widespread deflation (which they did), which can be devastating to an economy, rather than actual inflation. And without fiscal support from the government (which would have restored V, thereby removing the need to increase M) or a financial sector that was willing to lend out all this extra liquidity, this is the only thing that kept the US economy from tail-spinning into a deflationary depression. Even if it didn’t kick-start real economic activity. Furthermore, any currency advantage the US achieved just by avoiding deflation (not even triggering inflation) is a tactic any central bank can (and should) employ during a crisis.

A different (though inextricably linked) way to look at this is through the Liquidity Trap Hypothesis. This is the idea that once interest rates have been dropped to zero but the economy is still depressed, additional monetary stimulus has no impact on short term interest rates and therefore, provides no additional economic stimulus. It just sits there.

Fiscal policy is needed to fill this gap. Additional monetary stimulus, at best, provides additional confidence regarding the financial system’s liquidity buffers (improving inflationary expectations). And if targeted at long term interest rates, it may encourage greater borrowing by households, industry and government beyond lower short term interest rates.

Fiscal stimulus though, rather than just driving up inflation and interest rates, and crowding out the private sector (as might happen during normal times), actually has great potential to kick-start real economic activity during an economic slump. But it didn’t happen.

This is why all this quantitative easing didn’t trigger inflation in the US. Nobody was spending it.

How to manage a financial crisis - the US

In this blog, I discuss how the US’s response to the GFC compares to its response to the Great Depression. It is by no means comprehensive (this is a blog, not a thesis). But it will hopefully paint a good picture of the general situation.

The Great Depression

For much of history up to World War II, much of the world was attached to the Gold Standard of fixed exchange rates. Every currency was set at its own fixed value relative to gold.

If your economy grows strongly, money will flow into your country (more people will buy your currency) to take advantage of the investment opportunities. This causes a flexible exchange rate to appreciate. So the exchange rate is the thing that absorbs this international ‘shock’ instead of the internal economy.

Under the Gold Standard however, a high-growth economy attracts more gold. And because the exchange rate is not allowed to appreciate, the central bank must ‘sterilise’ this gold inflow by printing more money. This creates more inflation, making local investments less profitable, thereby slowing down/ stopping/ reversing the gold inflows.

The opposite is true for a weak-growth economy. If investment/ gold is flowing out of the economy and the exchange rate is unable to depreciate in response, the Central Bank must pull money out of the system and/ or increase interest rates. This causes price deflation and attracts gold/ investment back to their economy.

So under a Gold Standard, the internal economy has to absorb this ‘shock’ via the inflation rate.

Unfortunately, unions tend to be hesitant to allow their workers to accept a pay cut (I’m not blaming them, this is just their job). So wages, which are a significant part of overall prices, are downwardly ‘sticky’. So the inflation rate may not fall enough to offset these gold outflows. And this is what causes the unemployment rate to rise.

So, if you don’t allow an external measure (the exchange rate) to correct the external shock, the internal economy has to absorb it. And this happens either through the inflation rate, or through employment, or both.



Leading up to the Great Depression, the US economy was booming (aptly named “The Roaring Twenties”). Gold flowed in. But instead of sterilising these inflows by printing more money, the US wanted to hoard more gold (presumably as a buffer against future crises – oh, the irony). But by not printing money, the US inflation rate remained too low. And the exchange rate, being fixed, didn’t appreciate like a floating exchange rate would. So gold continued to leave the rest of the world and flow into the US.

The rest of the world (starting with France, I think), upon seeing this happen, attempted to protect their gold reserves and preserve their pegging to the Gold Standard. They did this by cutting back on their own money printing and increasing their domestic interest rates to make their economies more profitable for investment.

And naturally, with this increased global demand for gold, and much of the world forcing their inflation rates down by not printing money, and crippling their internal economies with high interest rates, the world was plunged into a downward deflationary spiral which would eventually become known as the Great Depression.

This, in my opinion (and many others), was the cause of the economic downturn. The 1929 Wall Street Crash was just the trigger. The usual ‘irrational exuberance’ and ‘animal spirits’ of markets and individuals, too much debt and risky investments no doubt contributed. But the system of the Gold Standard – and its improper enforcement – laid the groundwork.

But many modern academics and economists, including former head of the Federal Reserve, Ben Bernanke, acknowledge that the US Federal Reserve (other central banks in other countries too) was actually the one responsible for turning this initial downturn into what would become known as the Great Depression. The Federal Reserve could have contained the fall out with the right policies (see my previous blog). But they didn’t.

Instead of flooding the financial sector with liquidity, bailing out systemically important institutions where necessary, and dropping interest rates (you know, what a central bank is created to do during a crisis), the Federal Reserve decided to continue maintaining their pegging to the Gold Standard. To this end, they even prematurely increased interest rates on one occasion. To provide the required extra liquidity would have caused the US dollar to depreciate, breaking their pegging.

There are also those that say the Federal Reserve wanted to allow the US economy to crash to weed out the bad debt, and allow the economy to come back stronger (the very Darwinian ‘liquidationist’ view). Or maybe they were just incompetent.

Unfortunately, without this central bank support, the financial system ran out of money. Institutions collapsed, and the resultant crash took the rest of the good economy with it (contagion) – not just the parts that needed correcting. Fiscal policy was also insufficient to support a recovery until the late 1930s (a little spending spree known as World War II).

Consequently, due to a Gold Standard that set the scene, a Wall Street crash, improper Federal Reserve policy, and insufficient fiscal support, the US underwent massive economic contraction. Deflation was widespread and unemployment rose to 25%.

So it was completely unsurprising and predictable that the countries that abandoned the Gold Standard earliest – freeing up their exchange rate to depreciate and their monetary policy to support employment and economic growth – recovered the fastest.



The Global Financial Crisis

Now the GFC…

The US’s monetary response was swift and strong – emergency liquidity to keep the system operating, targeted bailouts of systemically important financial institutions, and rock bottom interest rates. There was also an initially strong fiscal response – about $1 trillion enacted by the Obama Administration. So the actual recession and price deflation was relatively short-lived. The unemployment rate peaked at 10% instead of 25%.

However, further fiscal stimulus was hindered by deficit- and debt-obsessed politicians. This was the basis of the US government shut down and debt ceiling debate in 2012. So the resultant recovery was less complete and more prolonged than it could have been. But while this lack of stimulus was a continued drag on the US economy, this political stalemate also helped avoid a Europe-scale crisis, where governments were actually cutting spending, driving their economies into another actual Depression.

But even with the less disastrous fiscal policy in the US, its insufficiency still forced further measures by the Federal Reserve to compensate for the government’s fiscal impotency. And these measures could create further problems down the line.

These extraordinary measures by the Federal Reserve included their now-(in)famous ‘quantitative easing’ – injections of monumental amounts of liquidity into the system ($85 billion per month!), beyond the emergency liquidity and bailouts of the initial panic.

As mentioned in my previous blog, this kind of liquidity doesn’t create wealth and employment, per se. It is merely designed to create confidence that the financial sector won’t run out of money in the short term, thereby avoiding a bank run that can spread to the whole economy. And by lowering interest rates, it can also encourage greater investment by households, industry and government to kick-start the real economic recovery.

The Federal Reserve also went beyond their usual purchasing of short term financial market assets (to drop short term interest rates) to purchasing longer term assets (causing long term interest rates to drop). This was intended to show potential borrowers (households, industry and government) that anything they borrowed at the time would not be subject to higher interest rates in a few years. All the more incentive to borrow money and kick-start the economy, right?

Specifically, by December 2012, because of these actions by the Federal Reserve, the US government was able to issue 10-year inflation-protected bonds at the historically low level of -0.87% (yes, negative!) interest, and 30-year bonds (only available since February 22 2010) at 0.24% interest.

After the Federal Reserve announced its plans to slow down its $85 billion-per-month bond-buying program (its quantitative easing program) in 2013, rates jumped noticeably. This was just in response to the announcement – quantitative easing hadn’t actually ended, or even slowed down yet. So quantitative easing definitely had a big impact on government borrowing costs. But even since this jump in 2013, the 10- and 30-year securities have still hovered around just 0.4% and 1.0% respectively.

Even with around $19 trillion worth of debt late last year, US federal interest payments were just 1.3% of GDP (low by international standards). With the infrastructure in which the US could have invested (or just repaired), it seems insane that they wouldn’t take this once-in-three-generation opportunity to do so. But they stubbornly refused.

This is why the Federal Reserve had to do the heavy lifting for the government, and for so much longer than ideal. So, if there is a risk from the Federal Reserve’s actions on, for example, financial stability, at least some of the blame needs to be levelled at the government. But, as mentioned in a previous blog, increasing interest rates prematurely, because of fears of financial instability, is not advisable. There is a weak link between interest rates and financial instability. Macroprudential tools should be used.

“Raising interest rates is a poor strategy for managing asset bubbles. Low interest rates did not cause the housing bubble of the early 2000s and higher interest rates would have been ineffective at preventing it. To deflate an asset bubble, interest rates would have to be raised to levels that would cause enormous damage to the labour market. Fortunately, the Federal Reserve has numerous tools besides rate increase that would be more effective and inflict less collateral damage on the nonfinancial side of the economy”. Josh Bivens and Dean Baker, The Wrong Tool for the Right Job, May 2016.

It was not ideal. Ideal would have been more fiscal support instead of more monetary support. But it was what the Federal Reserve had to do in the face of an uncooperative government. And as this extra liquidity starts being absorbed over time by the system (being lent out by the financial sector), the Federal Reserve will be able to start withdrawing it from the system to prevent inflation from rising to far. This may just require allowing all the assets they bought in exchange for this liquidity to mature/ not be rolled over.



As for the structural response required of governments and central banks after a financial crisis, a little bit of history. After the Great Depression, the Glass-Steagall Act was created to prevent a similar event in the future. Among other things, it stated that commercial banks and investment banks were not allowed to merge into a single super-entity. The logic was that, by keeping these activities separate, risky speculative investment activity (if/ when it inevitably went pear-shaped) wouldn’t risk taking down the more responsible commercial lending component of the financial sector. Contagion would be less widespread because the institutions would be more separate and less affected by each other’s idiosyncratic fortunes.

The Clinton Administration repealed Glass-Steagall in the 1990s. So there are many that suggest that by allowing investment banking and commercial lending activities to become intertwined, these new super-entities were able to get around certain financial regulations, and lend money to much more risky areas (i.e. the sub-prime mortgage market) without being subject to the same regulations as traditional banks. Furthermore, they could do it at a magnitude that wouldn’t have been possible without the resources of the combined entity. Consequently, this caused (or at least contributed to) the GFC.

But I have to disagree with this logic. If this were true, we would have expected to see commercial banks collapsing because of their investment banking activities, or investment banks collapsing because of their commercial banking activities, or both. But it didn’t really happen this way. Banks like Wachovia and Washington Mutual ran into trouble because of their lending activities; investment banks like Bear Stearns and Lehman Brothers because of their investment banking activities; AIG, the world’s largest insurer, too. There was very little overlap between commercial lending and investment banking in these institutions where Glass-Steagall would have made a significant difference. In fact, Citi was probably the only exception.

But whether it was the lack of Glass-Steagall or not, a lack of regulation and oversight was unambiguously a major cause of the GFC. So the US enacted the Dodd-Frank Act as an attempt to correct the issues that caused the crisis. Among other things, the new Act:

·         Increases capital reserve requirements for financial institutions.

·         Prevents banks from making risky bets with their own money (the ‘Volker rule’).

·         Limits fees that retailers are charged for debit card transactions (the ‘Durbin amendment’).

·         Requires brokers to act in their clients’ best interests when providing retirement advice (the ‘fiduciary rule’ – though not explicitly part of Dodd-Frank). This may alleviate some of my own concerns about the retirement village sector becoming the next financial crisis (unless it is threatened by Donald Trump).

·         Gives regulators greater ability to seize control of institutions on the brink of collapse. This will help keep systemically important institutions running and/ or cleanly unwind them, without rewarding their stockholders and bondholders (i.e. without promoting moral hazard).

·         Created the Consumer Financial Protection Bureau which prohibits financial advisers giving misleading or fraudulent sales pitches to consumers. By many accounts, it has been very effective at detecting and deterring such fraud, thereby reducing bad loans and the risks of financial crisis.

·         Established the Financial Stability Oversight Council, a collective of regulators who monitor risks and threats to the financial system. This includes ‘too big to fail’ institutions.

The Dodd-Frank Act is an important step in the right direction. It has shown good signs of success, and hasn’t prevented individuals or businesses from borrowing, despite claims by Donald Trump (banks have actually increased their consumer lending of credit cards and auto loans, and business lending).

Ben Bernanke has recently stated that the US’s financial system is now stronger, more robust, and more resilient to future crises than it was before the GFC. But by many accounts, the Act did not go far enough. Which makes it particularly concerning when the likes of Donald Trump want to get rid of the Act, because they say it hinders the economy. If there is another crisis soon, it won’t be because the Act went too far – it’ll be because it didn’t go far enough.



Conclusion:

It’s impossible to prevent financial crises with 100% certainty. There will eventually be something that escapes our attention and slips through the cracks of the system’s regulation and oversight. It’s like trying to prevent your house from burning down – you can have smoke detectors, sprinkler systems, and live next door to a fire station, but if a bomb is dropped on your house, it’s going to burn down. You can minimise the chances of a crisis. But you can’t eradicate it without stifling the entire economy (and ironically, causing a crisis). But the central bank can respond properly during a crisis to minimise its impact.

Ben Bernanke and Co. did during the GFC what the Federal Reserve failed to do during the Great Depression. He studied the Great Depression extensively throughout his lifetime. He must have been wetting himself with fear and excitement when he realised it was happening again, not just in his lifetime, but during his tenure as the head of the Federal Reserve. And this made him extra resolved to not repeat the Federal Reserve’s Depression-era mistakes, where monetary policy was impotent to respond properly lest it destroy the US’s pegging to the Gold Standard. It’s unnerving to consider how easily the US could have slipped into Depression 2.0 if the Federal Reserve had allowed it. But there was no way Bernanke was going to be known as the Federal Reserve Chairman who once again, led the US into a depression.

This unprecedented liquidity response was needed to improve confidence that the financial system wouldn’t run out of money (thereby avoiding a bank run), and to lower long term interest rates to incentivise government, households and industry to borrow and invest. The failure was not in the Federal Reserve’s attempts to incentivise the government to invest. It was in the failure of the government’s fiscal response to capitalise on these incentives.

We may even learn more if Bernanke did go too strong for too long – it’ll show us the limits of central bank effectiveness. So I believe he did the right thing, either way. Now, the GFC and the Depression represent two valuable and opposing case studies of what happens when a central bank does two polar-opposite policy responses – particularly one as significant as the US Federal Reserve.

How to manage a financial crisis

In the case of financial crises, responses should come in three stages – monetary, fiscal and structural.

MONETARY RESPONSE

First, immediate monetary response is needed, potentially including emergency liquidity, targeted bailouts, and short term interest rates.

Providing emergency liquidity (money) allows the financial sector to continue operating day-to-day. During normal times, financial institutions meet their day-to-day liquidity needs (e.g. depositor demands for cash, transactions with other financial institutions) by keeping just a small percentage of their assets on hand as cash or other highly liquid assets.

During the initial panic of a financial crisis though (such as August 2007 in the US sub-prime market), people may very suddenly start worrying about their financial institution’s creditworthiness and general ability to meet these obligations and consequently, will try to withdraw all their money while they can[1]. And because a financial institution will only keep a small fraction of its assets in a highly liquid form to meet its usual day-to-day liquidity obligations (and generally can’t quickly sell sufficient of its longer term assets for their true worth), this can cause a ‘bank run’, where even fundamentally sound and profitable financial institutions – not necessarily through any fault of their own – can suddenly find themselves without enough immediate liquidity to meet their day-to-day obligations[2].

And it’s not just depositors that suddenly increase their demand for liquidity. The institutions themselves become less willing to lend to each other because they are less confident about their ability to obtain finance themselves, making them more inclined to borrow and hoard liquidity.

If these sudden liquidity demands aren’t met swiftly, this sudden illiquidity turns into insolvency, where heavily-indebted individuals and institutions are forced to undertake destructive ‘fire sales’ – the sale of illiquid assets rapidly, at a fraction of their true worth – just to meet their short term liquidity needs. And if these individuals/ institutions are active in a number of markets, this panic can be transmitted far and wide, as liquidity needs in one market lead to the liquidation of assets in another, spreading to other financial institutions (called contagion) and potentially causing the entire financial system to freeze up, unable to operate, causing the broader economy to crash[3].

But a central bank can provide this short term liquidity, specifically in exchange for other assets from the financial sector. And not just to banks. And not just in exchange for typical high-quality bank assets. The GFC – and the preceding years of unprecedented financial innovation – showed the increasing systemic importance of – and therefore increasing necessity of supporting – other non-bank financial institutions (such as investment banks), new non-traditional markets (such as derivatives) and other assets that were of poorer quality and longer maturity than central banks normally accept as collateral. This is what the US Federal Reserve, the European Central Bank, and the Bank of England all did in reaction to the August 2007 liquidity shortfalls. And this just shows how dire the situation was, and how much further central banks were prepared to extend their support to deal with it.

Credibility is very important for a central bank. If the public (and the financial system) believes that the central bank has the will and the means to provide emergency liquidity when necessary, such a panic may be prevented before it even begins – no one will be worried about their financial institution becoming illiquid, so they won’t ‘run’ on it. But even if a bank run does occur, the central bank can nip it in the bud with a quick liquidity response before it spreads[4].

And if this liquidity response (or just their credibility) is successful, central banks may not have to resort to the next step of the monetary response – the ‘lender of last resort’.

The central bank may also need to provide targeted bailouts of systemically important financial institutions, lest their failure drag the entire system with them. This is a central bank’s fundamental role as ‘lender of last resort’. The government itself can also provide bailouts and deposit guarantees during a crisis if central bank support isn’t sufficient. Hopefully, the above general emergency liquidity will remove the need to bail out individual institutions. Furthermore, ideally, such institutions would never have been allowed to get ‘too big to fail’. But if an institution WAS allowed to get ‘too big to fail’, bailouts represent the lesser evil between: 1. Saving an institution that brought their problems upon themselves, potentially encouraging future bad behaviour in the financial sector (moral hazard) or potentially supporting insolvent institutions that end up costing more than they’re worth; and 2. Immediate widespread disaster.

Even institutions that did nothing wrong, and just got caught up in this system-wide liquidity crisis, could justifiably be provided with lender of last resort support – it surely wouldn’t be fair to let them fail over something that wasn’t their fault. Furthermore, confidentiality of central bank support during a crisis can also prevent them in the future. If the public becomes aware that an institution is receiving support from the central bank, it can spark a panic and worsen the existing liquidity crisis if other institutions are subsequently deterred from accepting central bank assistance. At the very least, public awareness could damage the institution’s reputation and increase their finance costs. This is what happened when news of Bank of England assistance to Northern Rock was leaked to the public before the Bank of England intended – which they did – to announce it, resulting in a bank run and the necessity of a government guarantee to quell. Consequently, perhaps such support in the future could be more effectively kept confidential, but only until the crisis has subsided. Transparency after the crisis is important to ensure accountability in central bank policy and/ or the use of public funds.

But moral hazard is an issue, and it is why central banks should generally be hesitant to spread their support to non-systemically important institutions, and/ or to assets of lower quality and longer length of maturity – they don’t want to encourage the financial sector to become reliant on it/ expect it in the future, thereby encouraging the sector to take unreasonable risks.

One way to minimise moral hazard risks is to exploit all private sector options first – ensure that there is no way for troubled institutions to obtain the finance they need outside of the central bank. Bear Sterns demonstrated this notion of a systemically important institution needing to be rescued because the private sector was unable/ unwilling until the US Federal Reserve provided a guarantee. Northern Rock similarly had to be rescued by the Bank of England and the UK government when private assistance wasn’t forthcoming.

Another way to reduce moral hazard is for the central bank to lend money against good quality collateral and at a relatively high interest rate, naturally to be paid back over time, to discourage implicit reliance on the lender of last resort, except in an emergency. But as mentioned above, in dire circumstances, in a widespread crisis, limiting collateral to high quality assets may not provide sufficient liquidity, and a high interest rate could actually worsen the situation.

Alternatively/ in addition, central banks could be forced to allow non-systemically important institutions to fail (even innocent ones), if it sends a message to the systemically important ones that lender of last resort support is not a given – therefore, don’t be reckless with your operations. Not ideal, but possibly a necessary sacrifice. It’s a balance of risks – save the innocent and risk incentivising bad behaviour, or sacrifice the innocent and send a message to the potentially guilty.

Support for the systemically important institutions that brought this pain upon themselves can also be made contingent on the departure of the institution’s CEO/ other executives/ board members, as well as imposing some losses on shareholders. Taking partial or entire ownership of the institution is also an option in particularly exceptional circumstances, for the purposes of controlling its restructure (making it no longer ‘too big to fail’), or just closing it down slowly at a rate that the system can handle. This makes lender of last resort support a little like health insurance – it may keep you alive, but it’s still an inconvenience to have to use, so you’re not going to deliberately get hit by a bus, just because you have this insurance.

Thirdly, if this financial crisis spills over into the real economy, a central bank must drop short term interest rates. This allows households, industry and government to meet their debt obligations more easily with lower interest payments, ideally helping to maintain current levels of consumption, investment and government spending. Lower interest rates will also encourage them to borrow more money – ideally to finance productive investments like property, technology, innovation, infrastructure, etc., rather than just debt-fuelled consumption and speculation. All this – in the immediate term – helps to prevent economic activity from crashing.

Keep in mind that these first two monetary responses (emergency liquidity and bailouts) do not generate ‘real’ wealth and employment in the short term, per se – rather, they simply create a ‘floor’ underneath the economy to keep it from tail-spinning. Even lowering interest rates only stimulates the economy indirectly via consumption, investment and government spending. But once this floor has been created and the initial panic has ended, if low interest rates have not sufficiently stimulated consumption and investment, real activity can be kick-started through the fiscal response.

FISCAL RESPONSE

Fiscal response is stage two. If the financial crisis has spread to the real economy, and low interest rates haven’t been sufficient to reverse this, targeted tax cuts, government expenditure, and infrastructure programs represent the catalyst to REAL economic momentum – actual wealth and employment will start improving while the private sector is still too nervous to make the first move. This is because during a recession, fiscal multipliers (how much an extra dollar of government spending will affect broader economic activity) are especially strong.

During normal economic times, $1 spent by the government may only represent $1 of economic activity in the short term (a multiplier of one) – maybe more in the long term if spent on productive infrastructure, maybe less if some is lost in bureaucratic inefficiencies, or if it is just transferred to wealthy individuals/ corporations – because that dollar was simply transferred from the private to the public sector. No new wealth was created in the short term – it was just reallocated. As a result, during normal times, fiscal policy tends to crowd out the private sector. In such cases, the only role this reallocation can play is for social ends, rather than economic ends.

During a recession however, fiscal policy doesn't crowd out the private sector because that spending would NOT have ordinarily occurred by the private sector – that’s why it’s a recession. Consequently, that $1 of government spending generates more than $1 of economic activity (a multiplier of more than one). In fact, the IMF estimates that during such recessionary circumstances, a government that incurs debt to pay for infrastructure spending will actually drive economic activity, and consequently government tax revenue, so much that their debt-to-GDP ratio will actually fall, not increase. In these circumstances, we would not be borrowing from future generations – the debt literally pays for itself, if not through financial profitability, then through economic growth.

And once the private sector (households, industry) sees real economic activity returning, their confidence rises and they take over as the driving force of the economy.

STRUCTURAL RESPONSE

The third stage is a structural response. Once real activity has returned to the economy following stage two, this will allow government, industry and/ or households to start gradually paying down the debt levels that triggered the crisis in the first place. Importantly, government debt reduction is NOT the priority during a financial crisis – not when the above monetary response has made it possible to borrow money cheaply, and especially not until the economy is back on track. Government debt reduction during a slump will literally make things worse – not just for the economy, but for the debt situation itself. By further slowing economic activity and therefore, government revenue, austerity during a recession can cause even more money to have to be borrowed than was saved by the initial austerity efforts (recall the fiscal multipliers above), driving debt-to-GDP (and potentially even the total debt dollar amount) up, not down.

Only when the economy is back on track can it support general efforts to reduce debt levels. Debt needs to be paid off using economic growth (or at most, austerity during STRONG economic times when the economy can handle it).

Furthermore, governments and central banks need to adequately supervise and regulate the financial sector – bank and non-bank financial institutions alike – to ensure a similar crisis does not happen again. Full recovery is impossible (or at least short-lived) if the underlying causes of the crisis are not dealt with.

This response can include higher capital reserve requirements, including liquid assets, for financial institutions to ensure they have adequate buffers to meet their day-to-day liquidity obligations during volatile times and not just normal times. Major crises may still require central bank emergency liquidity and lender of last resort support, but that’s okay – that’s what central banks are there for. Forcing institutions to keep too much liquidity in reserve will impede their ability to actually use it for productive long term investments.

The breaking up of ‘too-big-to-fail’ institutions, while it may result in some efficiency losses in the financial sector, will mean that these institutions won’t need to be bailed out during a crisis, because their failure wouldn’t jeopardise the whole system.

There also must be a creation of regulatory/ oversight organisations whose job is to monitor the financial sector as a whole, identify potential problems/ excesses, and make/ enforce recommendations to address them. These bodies don't need to be the central bank/ lender of last resort, if there are concerns over conflicts of interest, but if they are separate, information needs to flow readily between them to ensure timely and appropriate action during a crisis – this was a failure with respect to Northern Rock.

Another monetary response that was more unique during the GFC than any previous financial crisis was the need for international cooperation between central banks and national governments. Central bank support in one country doesn’t help a financial institution with vast global operations that utilise numerous currencies. For example, during the GFC, European banks experienced a lack of liquidity in US dollars. Once this shortcoming was observed, the US Federal Reserve, the European Central bank and the Swiss National Bank allowed cross-country swap arrangements to meet these international liquidity needs. Central banks also needed to make their policies consistent with each other regarding the (looser) collateral requirements they were imposing on financial institutions, so international financial institutions couldn’t ‘game’ between different central banks’ policies. This kind of cooperation is only going to become more important in the future[5].

Finally, an appropriate central bank exit strategy is needed – they need to wind back the support they provided during the crisis. The earlier liquidity responses by central banks are not long term strategies – they need to be used only during crises to buy time for the system to be properly repaired, and must be reversed over time. This means that all the assets which central banks acquired in exchange for their liquidity support need to be allowed to mature over time and not rolled over/ renewed. Their collateral requirements also need to be re-tightened to discourage moral hazard. But again – only once the system has recovered and been repaired.

These three responses – monetary, fiscal and structural – keep the system from tail-spinning, kick-start real economic activity and confidence again, and address the source of the problem to avoid a repetition.

In coming blog entries, I will discuss how Europe, the US and Australia measured up against these responses, and how this compared to the 1929 Wall Street Crash and subsequent Great Depression.

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[1] Ironically, this is actually perfectly rational behaviour – if doubt arises as to the future liquidity of the financial system, it’s perfectly rational to sell first before liquidity dries up and market failure occurs, even though the market failure may have been avoided if no one panicked in the first place.

[2] The very nature of banking – long term assets but short term liabilities – leaves them vulnerable to bank runs.

[3] Although widespread collapse of the financial sector can also occur without contagion if all institutions are hit by the same external macroeconomic shock, e.g. oil prices, war.

[4] Being careful not to trigger excessive inflation or a currency collapse – capital controls during a crisis are a potential option to reduce this risk.

[5] Unless major anti-globalisation movements around the world are successful.