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After the banking crisis: what now? Monetary, fiscal and regulatory policy. There are three problems: 1. The liquidity crisis and QE 2. QE and monetary policy when interest rates are close to zero 3. Banking regulation. The liquidity crisis and QE.
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After the banking crisis: what now?Monetary, fiscal and regulatory policy There are three problems: 1. The liquidity crisis and QE 2. QE and monetary policy when interest rates are close to zero 3. Banking regulation
The liquidity crisis and QE • The liquidity crisis was really a risk crisis. It was caused by a failure of risk management: either a failure to measure risk correctly, or a moral hazard problem due to asymmetric incentives to take on risk. • And due to bad risk assessment of one bank by another the inter-bank market dried up. • QE was designed to inject liquidity back into the system and restore the money supply.
QE and monetary policy when interest rates are close to zero • The current recession is entirely due to the financial crisis • Near zero interest rates are due to in large part to central banks trying to achieve their inflation targets by stimulating their economies. • The failure to get banks to lend – they preferred to rebuild their balance sheets – implied the need for monetary stimulation. Hence QE.
Eggertsson and Woodford argued that with perfect foresight the optimal interest rate policy under commitment involves keeping interest rates lower for longer. • QE in the UK was implemented by increasing the proportion of govt long bonds in BoE’s balance sheet in order to increase bank reserves.
QE works through 3 channels: • Buying assets increases their price. As bond prices rise, yields and borrowing costs fall. • Central bank purchases increase bank reserves and, unless sterilised, the money supply. This is expected to result in more loans to the private sector. • Asset purchases – particularly of long bonds – affects the term structure and hence inflation expectations: lower long yields indicates a commitment to keep inflation down in the long run.
Some issues and problems • Is this is a low risk solution or has the risk been transferred to the public sector? Even higher risk to the tax payer is to buy corporate bonds like the Fed. • The theory is weak. The policy works only if assets are imperfect substitutes and this allows quantities to affect prices. Tobin’s portfolio balance model comes to mind. Harrison (BoE) solves this by putting a quadratic cost due to deviations in the maturity structure of household debt in their utility function. • An alternative argument is that QE can alter the risk characteristics of private (and CB) portfolios.
Has QE worked? • The banks have not increased lending to the private sector much. Instead they have rebuilt their balance sheets. QE has solved the liquidity crisis but not the underlying problem of risk. • It has been argued that bank reserve and interest rate policy may be decoupled especially if reserves receive the same interest as the policy rate. • As the CB balance sheet should be consolidated with that of the government it is the total effect that counts. • The burgeoning UK fiscal deficit has resulted in offsetting increases in the supply of long-dated bonds. QE = £200bn=14% GDP. Increase in govt debt = 45% GDP.
Fiscal stance of the UK and ailing eurozone countries • The UK had a structural fiscal problem since 2001 but the fiscal position deteriorated sharply due to the recession in 2008. • Greece has had an unsustainable fiscal position even longer - since before joining the euro. And it too deteriorated from 2008. • Ireland had no fiscal problem until 2008 and neither did Spain.
The liquidity crisis and QE • The liquidity crisis was really a risk crisis. It was caused by a failure of risk management: either a failure to measure risk correctly, or a moral hazard problem due to asymmetric incentives to take on risk. • And due to bad risk assessment of one bank by another the inter-bank market dried up. • QE was designed to inject liquidity back into the system, restore bank balance sheets and reduce the risk of lending
Banking regulation • The problem was excessive risk taking with the public ultimately paying the price and taking on the risk. • The solution must be a re-alignment of risk, reward and liability .
