[Text/Martin Wolfe, translated by Liu Xiaoyun]
Who is the real initiator of the banking crisis? After 15 years, why is the financial crisis likely to return? Many blame the crisis on ultra-low interest rates imposed by central banks for a long time; Others argue that excessive financial aid caused the crisis.
This view clearly stems from Austrian economics – as Brad DeLong points out in Slouching Towards Utopia, Austrian economics believes that "the market gives, the market takes, and the name of the market is lucky." The Austrian view of economics is not without merit, but it is not necessarily correct.
At the heart of this doctrine is the idea that the transatlantic financial crisis of 2007-2015 was the product of excessively loose monetary policy. Creative destruction could have restored the economy to health, but excessively loose monetary policy and financial aid have hampered that process. Then, after the pandemic, a new round of excessively loose monetary policy and proactive fiscal policy led to higher inflation, making the financial sector more vulnerable, and ultimately causing the bitter consequences today.
Such a narrative is simple, but not the truth.
Let's start with the analysis on the eve of the financial crisis. Since the early 80s of the 20th century, the UK has been issuing index-linked gilts. Its most striking feature is the sharp decline in real yields: from a peak of 5% in 1992 to 1.2% in 2006, -1.4% in 2013 and -3.4% in 2021. No central bank, no matter how unscrupulous, can single-handedly reduce real interest rates by more than 8 percentage points in 30 years. If a sharp drop in real interest rates does not match the needs of the economy, inflation is bound to surge.
Since the eighties, the real yield of UK index-linked bonds has fallen sharply (Source: FT)
Under the premise that the inflation rate is not high, the nominal interest rates of Britain, the United States, Japan and Germany tend to be close to 0
So, what exactly happened then? At that time, the background of global finance underwent three important changes, namely financial liberalization, globalization and China's integration into the world economy. The latter two not only curbed inflation, but also introduced a country with huge surplus savings into the world economy. Moreover, as inequality and aging populations in high-income countries have risen, some high-income countries, such as Germany, have also generated large surplus savings. In this context, balancing global supply and demand requires more credit-driven investment, especially in housing. Financial liberalization contributed to this credit boom, intentionally or unintentionally.
Changes in central bank policy rates over the past three decades
All hidden dangers were detonated with the advent of the financial crisis. At the time, we firmly believed that another Great Depression must be avoided, a wise decision, and I have no regrets about that choice. The problem is that, given the realities of the world economy and the impact of the financial crisis, sustained fiscal support or extremely loose monetary policy must be introduced. Given that the former option has been ruled out, loose monetary policy is the only way out.
From the data on the money supply, it is not difficult to see the importance of ultra-low interest rates and quantitative easing. After the financial crisis, the private contribution to money supply growth was chronically negative due to the credit crunch. If the central bank had not lowered interest rates and expanded the base money at that time, the money supply would have collapsed. In my opinion, we cannot stabilize demand by stabilizing the money supply, but at least not by collapsing it. I agree with Milton Friedman that actions by central banks to stabilize broad monetary growth after the financial crisis are crucial.
Core inflation rates in the UK, US, Japan and EU over the past two decades
Then came the outbreak of the new crown epidemic. At this time, the monetary and fiscal sectors took a very wrong approach. The currency is exploding. The G7's structural fiscal deficit also rose by 4.6 percentage points between 2019 and 2020, according to the International Monetary Fund. This growth momentum has not abated until 2021. China's epidemic prevention measures and the outbreak of the Russian-Ukrainian war have further increased demand, breaking the balance between supply and demand. The result is a temporary rise in inflation and interest rates, which has once again hit the already fragile banking system.
The Fed's move led to an increase in the broad money supply after the financial crisis
In short, contrary to what many people think, central banks are not behind the crisis, but only puppets in the hands of a much greater power. Admittedly, central banks did make mistakes. Perhaps the central bank's monetary policy should have "gone against the wind", that is, started early before the crisis, ended early after the crisis, and withdrew monetary support early in 2021. However, I believe that with financial liberalization already a reality and the world economy being hit hard, it would probably not help if the central bank did so. Crises are inevitable.
Of course, critics must be precise about the alternatives they offer and the implications they might have. We must refine and quantify the counterfactuals: what should the interest rate be? What extent is financial collapse, recession and rising unemployment likely to follow a financial crisis? Why do critics assume that higher interest rates lead to more business investment? Killing "zombie firms" can help increase productivity, but it can also lead to long-term reductions in production, so is that really a good thing?
After the pandemic, currencies in high-income countries surged
None of humanity's institutions are perfect, sometimes even incompetent, and central banks are incompetent. However, central banks are not crazy. If we blame all the economic problems of the past few decades on loose monetary policy, we are avoiding the problem. This idea is based on the illusion that we can find a one-and-done solution to the problems of the financial system and the real economy. Assuming the central bank hadn't stepped in, things wouldn't get any better. We cannot abolish democracy. We cannot follow the economic policies of the nineteenth century, but we must adapt them to today's society.
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