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Central Bank Lessons from the Global Crisis

Stanley Fischer

Governor, Bank of Israel *

During and after the Great Depression, many central bankers and economistsconcluded that monetary policy could not be used to stimulate economic activity ina situation in which the interest rate was essentially zero, as it was in the UnitedStates during the 19 !s " a situation that later became known as the li#uidity trap$ %n the United States it was also a situation in which the financial system wasgrievously damaged$ %t was only in 19& , with the publication of 'riedman andSchwartz(s Monetary History of the United States that the profession as a whole 1

began to accept the contrary view, that )*he contraction is in fact a testimonial tothe importance of monetary forces)$ +

uch later, in 19- , .en .ernanke presented the view that it was the breakdown of the credit system that was the critical feature of the Great Depression " that it wasthe credit side of the banks( balance sheets, the failure or inability to make asufficient volume of loans, rather than the behavior of the money supply per se ,that was primarily responsible for the breakdown of the monetary transmissionmechanism during the Great Depression$ *he .ernanke thesis gained adherentsover the years, and must recently have gained many more as a result of the Great/ecession$

%n this lecture, % present preliminary lessons " nine of them " for monetary andfinancial policy from the Great /ecession$ % do this with some trepidation, since itis possible that there will later be a tenth lesson0 that given that it took fifty years for the profession to develop its current understanding of the monetary policytransmission mechanism during the Great Depression, ust two years after the2ehmann .rothers bankruptcy is too early to be drawing even preliminary lessonsfrom the Great /ecession$ .ut let me oin the crowd and begin doing so$* This paper will be presented as the Brahamananda Lecture at the Reserve Bank of India, Mumbai, onFebruary , !" # It is a revised version of a lecture delivered to the $yprus %conomic &ociety at the$entral Bank of $yprus, 'icosia, on (ctober !), !" "# I am rateful to collea ues at the Bank of Israel withwhom I have discussed and lived throu h the issues of monetary policy durin the last five years, and to+oshua &chneck of the Bank of Israel for research assistance# I am also rateful to thanasios (rphanides,

-overnor of the $entral Bank of $yprus, and his collea ues for their hospitality and for the lively discussionwhich followed the lecture in $yprus#

The .ualification relates to the fact that some researchers, for e/ample $lark 0arburton, had emphasi1edthis view before the publication of Friedman and &chwart12s work# 3&ee for e/ample the papers reprinted in$lark 0arburton, 4epression, Inflation, and Monetary 5olicy6 &elected 5apers, 789: 79;, +ohns

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Lesson 1 : Reaching the zero interest lower bound is not the end of expansionary monetary policy.

Until this crisis, the te3tbooks said that when the nominal interest rate reaches

zero, monetary policy loses its effectiveness and only fiscal policy remains as ane3pansionary policy instrument " the pure 4eynesian case$ 5ow we know thatthere is a lot that the central bank can do to run an e3pansionary monetary policyeven when it has cut the central bank interest rate essentially to zero " as did the'ed, the .ank of 6ngland, the .ank of 7apan, and other central banks during thiscrisis$

%n the first instance there is the policy of #uantitative easing " the continuation of purchases of assets by the central bank even when the interest rate is zero$

8lthough this does not reduce the short term interest rate, it does increase li#uidity$'urther, by operating in longer term assets, as in :6+, the central bank can affect

longer term interest rates, which may have an additional impact on the privatesector(s demand for longer term assets, including mortgages and corporateinvestment$

During the crisis several attempts were made to calculate how much #uantitativeeasing was needed at a particular point in time$ *he calculation used a *aylor /uleto calculate what the ;negative< interest rate should have been in the givencircumstances, combined that with an estimate of the increase in the money supplyor central bank assets that would normally be needed to reduce the interest rate byone percentage point, and thereby calculated the needed increase in central bankassets$ *his is a logical approach, but we should note that it e3trapolates economic

behavior far beyond the range of the e3perience on which the estimated *aylor ruleis based$ =

Second, there is the approach that the 'ed unsuccessfully tried to name )crediteasing) " actions directed at reviving particular markets whose difficulties werecreating ma or problems in the financial system$ 'or instance, when thecommercial paper market in the United States was collapsing, the 'ed entered ona ma or scale as a purchaser, and succeeded in reviving the market$ Similarly itplayed a significant role in keeping the mortgage market alive$ %n this regard the'ed became the market maker of last resort$

%n a well known article, 7ames *obin in 19&>

asked in which assets the centralbank should conduct open market operations$ ?is answer was the market for capital " namely the stock market " since that way it could have the most directeffect on the cost of capital, later known as *obin(s #, which he saw as the main

8 +an & %conomics nalyst -oldman &achs -lobal %$&Research,March !""7#

9 +ames Tobin, A n %ssay on the 5rinciples of 4ebt Mana ementA, in his %ssays in %conomics, Colume I,Macroeconomics, Markham 5ublishers 3$hica o=, 7@#

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price through which the central bank could affect economic activity$ 8lthoughcentral banks have occasionally operated in the stock market " most notably the?ong 4ong onetary 8uthority in 199@ " this has not yet become an accepted wayof conducting monetary policy$ &

Lesson 2 : The critical importance of having a strong and robust financialsystem.

*his is a lesson that we have all thought we understood for a long time " not leastsince the financial crises of the 199!s " but whose central importance has beenreaffirmed by the recent global crisis$

*his crisis has been far worse in many of the advanced countries " among themthe United States, the United 4ingdom, and some other 6uropean countries " thanit has been in the leading emerging market countries$ *his was not the situation in

the financial crises of the 199!s, and % must confess that % had not e3pected thatthis would happen$

*he critical difference between countries that have suffered from e3ceptionallydeep crises and those that had a more or less standard business cycle e3perienceduring this crisis traces to what happened in their financial sectors$ *hosecountries that suffered financial sector crises had much deeper output crises$

%n their important book, )*his *ime %s Different), Aarmen /einhart and 4en /ogoff @

document the fact that over many centuries, downturns that also involve a financialcrisis are more severe than those that do not$ *his is not coincidental, for the

collapse of the financial system not only reduces the efficiency of financialintermediation but also has a critical effect on the monetary transmissionmechanism and thus on the ability of the central bank to mitigate the real effects of the crisis$

%f the financial system is intact, the standard anti cyclical monetary policy responseof cutting interest rates produces its response in the encouragement of purchasesof durables, ranging from investment goods and housing to consumer durables$*his happened during this crisis, in that many countries that did not suffer from afinancial crisis but had cut interest rates sharply to deal with the negative effects of the global crisis returned to growth more rapidly than other countries, and soon

found asset prices, particularly the price of housing, rising rapidly$ 8mong thesecountries are 8ustralia, Aanada, Ahina, %srael, 4orea, 5orway and Singapore$

) It is sometimes obDected that such actions would re.uire e/cessively detailed intervention by the central bank, since it would have to decide which companies2 assets to buy# niversity 5ress, !""7#

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*he ne3t #uestion is what needs to be done to maintain a strong and robustfinancial system$ Some of the answers to this #uestion are to be found in theblizzard of recommendations for financial sector and regulatory reform coming outof the .asel Aommittee " now e3tended to include all the G +! countries plus a

few more " and the 'inancial Stability .oard ;the 'S.

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%t is not clear whether the inclusion of a responsibility for ;or contributing to