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Cambridge Journal of Economics 2009, 33, 581–608 doi:10.

1093/cje/bep026

The limits of central bank policy: economic crisis and the challenge of effective solutions
Jamie Morgan*
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The paper examines the development of central bank policy prior to and during the recent financial crisis. The argument is made that it contained multiple failures that not only generated constraints on adequately identifying and addressing the crisis but also contributed to that crisis. Those failures derived from a combination of theory and institutional practice. Specifically the use of forms of inflationary targeting based on broad adherence to the Taylor rule framework and the use of versions of a Conventional Theoretical Macro Model (CTMM) were both problematic. This was particularly so in the way policy was focused through issues of the primacy of price stability. The institutional arrangements of the central banks were also problematic. The division of labour between the central banks and other regulatory bodies and the limited information available within a liberalised finance system hampered efforts to fully appreciate the gravity of the situation. Partly due to the constraints imposed by the thinking and strategies that had been developed the central banks never got to grips with the fundamental problems of the crisis. Interest rate policy and liquidity provision were undertaken in ways that steadily radicalised the approaches of the banks but always in a way that was event led and always in ways that could not resolve those fundamental problems. The nature of the crisis highlights the importance of transforming the approach and institutional framework of the central banks. Relatedly, it highlights the need for a more Keynesian and heterodox approach to economics within decision making bodies at central banks. Key words: Central bank policy, Taylor rule framework, Fed, Bank of England, Keynes, Interest rates, Liquidity JEL classifications: G0, B4, P1

1. Introduction
As many of the papers collected here argue, and as many academics and policy makers around the world now acknowledge, the current economic crisis is both quantitatively and qualitatively different than any in recent memory. Though beginning as a financial crisis restricted to particular states and regions it has become a pan-systemic and essentially global economic crisis (Thompson, 2009). The nature of that crisis has revealed basic vulnerabilities within states and around the world. Those vulnerabilities were based on
Manuscript received 31 March 2009; final version received 10 May 2009. Address for correspondence: The Centre of Excellence in Global Governance Research, PO BOX 4 (Yliopistonkatu 3) 00014, University of Helsinki, Finland; email: zen34405@zen.co.uk * University of Helsinki.
Ó The Author 2009. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved.

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a combination of debt and leverage, intra-financial multiplication and securitisation, pathological structural developments in individual economies, and unsustainable asymmetries in global capital accumulation, creating imbalances in trade, investment and consumption dynamics (Morgan, 2008, 2009; Wade, 2008). Initially, the crisis was ‘slowburning’, involving progressive reappraisals of the financial outlook by major institutions and punctuated by a series of critical events. Each event was followed by a period of calm and an attempt by states, markets and many in the media to promulgate the view that recovery was imminent and that ‘real economy’ effects would be shallow and short-lived. This remained the case from the freezing of credit markets and the decoupling of Libor and market interest rates from central bank short term interest rates in August 2007, through the crash of equity markets in January 2008, and the collapse of Bear Stearns in March 2008, all the way through to the stagflation debates of that summer. The rhetorical shift was, however, progressively towards the negative: financial deleveraging / correction / slowdown / downturn. Yet it was only after the bailout of AIG and the collapse of Lehman in September 2008 that it no longer became tenable to pursue a rhetorical line of limitation. There are at least two reasons why a rhetorical line of limitation was pursued. One is that key actors in the system were aware of the potential negative behavioural effects of stating either how bad things were or what worse case scenarios might entail. In a liberalised and increasingly interconnected and interdependent system words and actions have great ‘confidence’ effects. These are no less significant than the individual ‘substantive’ aspects of the system to which they refer. The two are, in many respects, linked. A second reason for a rhetorical line of limitation was simply that the scale and extent of the emerging crisis was under-estimated. That it was under-estimated is in turn indicative of the predominance of the ideas that gave birth to the dysfunctional system from which the crisis then manifested. These two reasons—awareness and under-estimation—might appear to be contradictory. They are, however, more appropriately thought of as in tension. Key actors were sufficiently aware to know that problems were emerging but they were also committed to policy positions and institutional arrangements that constrained the way problems were perceived and how they could be managed. In this paper I focus on one example of this constraint: the role of central banks. More specifically, given their nodal roles in the initial financial crisis, I focus on the Bank of England and the Federal Reserve Bank (Fed), but also with some comment on the European Central Bank (ECB). My main point is that although it would be an over-statement to suggest that theoretical models absolutely dominate and determine central bank perspective and policy one can still plausibly argue that they provide a significant resource for how data is viewed and how thinking on issues regarding economic management are framed. Since the 1990s the Bank of England and Fed in particular have made use of a Taylor rule framework approach that is, in turn, rooted in a Conventional Theoretical Macro Model (CTMM). The Taylor rule focuses on the manipulation of short term interest rates to maintain stable inflation and economic growth. The Taylor rule framework and the CTMM are problematic in a number of specific and general ways, which I set out in Sections 2 and 3. Specifically, the combined approach pays little or no attention to broad money, is based in rational expectations and has, in its Bank of England guise, used an extrapolation procedure that has a strong presumption of long term stability. More generally, and from a Keynesian point of view, the modelling procedure creates problems of certainty that fail to account for qualitative changes in a system. In terms of the crisis the problems meant that within a monetarist perspective of inflationary targeting there was no pressure deriving from the approach for the central banks to act to forestall potential problems inhering in the broader tendencies and capacities of the economy. Rather the opposite held true, the apparent success of inflationary targeting in

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less directly. As such 1 For a useful source of information on central bank structures see the Bank for International Settlements (BIS) homepage at www. Maintaining financial stability is the other main remit of central banks. 2000).The limits of central bank policy 583 creating relative price stability as part of the ‘great moderation’ provided central banks with a degree of confidence that economic management was effective. On the Bank of England see Bean (2001). One could argue that in the context of the underlying deflationary effects of global outsourcing to least-cost sites such as China. as I set out in Section 5. What the crisis reveals is that the division of labour regarding financial oversight and the simple fact of the opacity and complexity of liberalised finance worked against any individual institution having a broad view of the pan-systemic potential for crisis. in securitisation and intra-financial multiplication. weakened domestic trade unions’ ability to secure higher pay claims.oxfordjournals.2 The Fed. Bank of England and. My final point is that the very fact that such a crisis has been possible indicates the need for a fundamental change in the ethos of the financial system.1 However. the existence of price stability and the economic management ethos of the central banks helped to feed financial instability by contributing to a debt-related economic growth culture that helped feed further pathological developments. the theoretical models used. have pursued a form of policy informed by a common brand of applied monetarism that emerged in the 1990s. member of the ECB governing council: ‘I think that there is an excessive and useless gap between academic discussions and central banking practice concerning monetary policy strategy. Each is mandated specifically to control inflation as part of its primary function. differences between all central banks. and the broader role of the economist within the central banks. Problems were either not recognised as profound or were not acted upon effectively until it was too late. In any case their primary policy tools: short term interest rates and liquidity management.org/ by guest on December 13. 2013 2. for various historical reasons. . A key issue is that if price instability is not providing a signal of financial instability then the central bank must look to other sources of information and impetus to identify any incipient instability. are simply not set up to deal with a pan-systemic and structural crisis. I briefly address these points in the conclusion. The Taylor rule framework.org. central banks found themselves consistently unable to get to grips with the emerging crisis. 2 According to Eugenio Solans. there are also commonalities.bis. When reading academic literature. Although the central banks have steadily radicalised their approaches to the crisis they have done so in a way that has been event-led. Thereafter. Furthermore. the central banks used discretion to maintain interest rates below what a strict adherence to a Taylor rule would otherwise require. For background on the Fed see Hetzel (2008). whereas—in practice—the ways in which central banks take monetary policy decisions are not so different’ (Solans. and in the context of the use of inflation measures that strip out bubble markets like housing. one draws the conclusion that many different and even opposite approaches exist. the ECB. for example. Clearly central banks were constrained in their view of the potentials for problems to become genuine financial crisis. Here the institutional arrangements in which central banks are placed come into question and I explore this in Section 4. Each sets a short term interest rate whose purpose is to feed through and influence short term market interest rates and. the very confidence instilled by the great moderation provided the grounds for deviations from the Taylor rule so long as relative price stability was maintained. including the institutional arrangement of central banks. long term commercial rates. CTMM and monetarism There are. The degree of ‘discretion’ and the potential for dissent and discussion inherent in a committee-based decision making process at the central banks did not ameliorate this. to a lesser degree. Part of that change must also be a change in the approach to banking. As such. Downloaded from http://cje.

It is also conveniently ‘empirical’ in the sense of application. supported by both Ben Bernanke and new governor Frederic Mishkin. p. The approach is quasi-historical.’s (2001) critique. It was also taken up by the Bank of England monetary policy committee (MPC) in 1997 and became a constituent in interest rate decisions made by the ECB governing council (Surrico. . set out as equation 3 in Angeriz and Arestis’s (2007. The deviation of GDP from trend is represented by y. 2003). the Fed has moved towards making this target a more explicit condition. The interest rate. Taylor. Under Alan Greenspan. everything else is viewed through the primary importance of price stability. and p is the rate of inflation over the last four quarters. Note also that targeting has a longer history at the Bank of England than adoption of a Taylor rule framework. the main point is that some form of targeting has been linked to the basic tenet that low and stable inflation is a key constituent in economic growth and that the manipulation of short term interest rates affects both market rates and broader inflationary expectations.g. Whether implicit or explicit. The Bank of England has a specific target inflation rate imposed by the Chancellor and currently set at 2% based on the consumer price index (CPI). When not in a time of crisis. rather than a specific institutional arrangement. It produces a simple formula for setting interest rates. However.2 1 For academic reference to the ‘consensus among practitioners’ see the American Economic Review conference papers and proceedings 2001. r. however. It was. for example. as such.oxfordjournals. which. (2007) at the Federal Reserve Bank of Kansas express it as: . Of particular note are Woodford’s defense (2001). Downloaded from http://cje. and Alvarez et al. The Fed is slightly different again. had been steadily moving away from a reliance on such complicated aggregates. It was initially introduced in 1992 following withdrawal from the exchange rate mechanism (ERM).584 J. 2007). The ECB has operated with greater latitude in terms of its ‘target’ because it has had to work across multiple economies that have not ‘converged’ on the basis of monetary union in the ways initially predicted (Surrico. also at 2%. appealing to central banks like the Fed. r 5 p 1 1 2y 1 1 2ðp 2 2Þ 1 2 The framework provides a simple relation between the short term interest rate and the goals of monetary policy. 866) synthesis of the Bank of England model. 2 It is. 2%). Asso et al. it operated according to a ‘preferred’ inflation rate creating an implicit target (Mishkin. The allowed parameter of deviation is 1%. As of 2009. since Taylor ‘tested’ the framework by assessing its fit to actual Fed interest rate policy in the late 1980s. A target inflation rate is one at which GDP is on trend (in this case. is set to moderate inflation and push gross domestic product (GDP) to its trend level. For the broader context regarding the dividing lines of Monetarism see Taylor (1993. From 1995. The ECB has more generally articulated an aim of price stability. controlling inflation and the role of interest rates in doing so. Knowing the current inflation rate and output gap then allows one to set a corresponding interest rate to moderate inflation and minimise business cycle fluctuations by balancing the equation (again 2% at equilibrium). 2013 . since the late 1980s. The essential features.1 The framework can be expressed in various ways. 2003). Note that Angeriz and Arestis set out the model using six equations whilst Smith (2007) reduces it to three. The effect of current interest rates on inflation is assumed to be time-lagged over several quarters.org/ by guest on December 13. The theoretical basis of the role of interest rates has been provided since the mid1990s by the Taylor rule framework (e. discussed hereafter. as well as a justification for focusing primarily on short term interest rates as opposed to complicated measures of monetary aggregates. 1998). the Board of Governors of the Fed and the Fed Open Market Committee (FOMC) who set interest rates began to discuss and apply the Taylor rule framework in various modified forms. however. Morgan each has some form of inflation target. its context and significance were substantively changed by the independence of the Bank as of 1997 and the creation of the MPC. remain the same. 2007) and Leeson (2000).

at least when compared with the preceding period of the 1 Downloaded from http://cje. provided an overall context for this. A Taylor-based approach. All central banks consider a wide variety of inflation measures but will place greater emphasis on one or the other in making decisions. the market collapse and the events of 9/11 were used to justify even lower interest rates.oxfordjournals.1 If it were then it would tend to be inflationary in its effects. the potential for a great deal of discretion that might see interest rates become expansionary. For example. energy. The Bank of England is required to use the CPI. In particular. interest rate policy is usually held to be ‘neutral’ in the sense that it should not in itself be used as an additional source of economic growth. 2013 An orthodox monetarist position would argue that interest rates cannot be a source of growth in the long run. Further latitude is also provided by the ‘Taylor Principle’. based on issues of exogenous shocks and on anticipated underlying deflationary forces as China entered the World Trade Organisation. if relative price stability is maintained then it becomes possible for interest rates to deviate from a rigid application of a Taylor rule framework precisely because of relative price stability. . then. Relative price stability. food and clothing). particularly as measured using methods that strip out ‘volatile’ aspects of the economy (housing. The latter two feed into the Taylor equation. Versions of the CTMM are used by the Bank of England.org/ by guest on December 13. The Taylor rule framework constituent of the CTMM had a particular appeal in that it was a rule based approach that could easily be reconciled with a central bank’s relevant decision making body’s use of discretion in setting interest rates. Thereafter. There is. The assumption remains that the Taylor rule holds good but that broader factors within the economy are affecting prices in ways that allow interest rates to be higher or lower than might otherwise be expected. From the mid-1990s to the current crisis central bank interest rates in the UK and US were historically low. The focus on price stability related to the rule also creates scope for discretion. The CTMM is a three equation model. it fitted with a new consensus that spread from the Fed that combined a more flexible rule-based approach with discretion and did so based on a new interest rate setting strategy (Blinder and Reis. The model is also used in turn by many capital market actors in order to assess central bank behaviour. Greenspan repeatedly justified the rate based on underlying productivity effects. The second equation is a Philips curve used to determine inflation. The first equation is used to determine the output gap (an IS curve). The Taylor Principle states that the nominal interest rate should increase by more than a ratio of 1:1 with inflation in order that the real interest rate is increased. had the appeal of technical elegance. If targeting is institutionalised and explicit then the existence of parameters creates a licence for degrees of variation from strict adherence to the rule.The limits of central bank policy 585 The Taylor rule is itself one constituent in the CTMM. Even here there is still a great deal of scope for debate regarding current economic conditions and the future effects of those conditions. arguably US interest rates were expansionary during the run up to the end of the dotcom boom of March 2000. 2007). it provided a useful theoretical resource in resolving the perennial conflict in central bank practice between rigid rules-based approaches and intuitive discretionary approaches. In principle. 2005). As such. For tractability purposes the CTMM assumes a closed economy. the Fed and a wide variety of central banks as a primary modelling tool (Smith. a focus on a simple primary policy tool and a degree of flexibility in its application. However. therefore. If targeting is looser the same applies in an informal way. broadly rational expectations (a discounted future) and excludes broad money or credit. The issue here becomes which measures of inflation and GDP are used and what degrees of expected feed-through from underlying forces are allowed for that are perhaps not visible in current data.

wages. Communication is understood to work at different levels.5%. More importantly their movement lacked a volatility that could itself be problematic for economic stability. A policy of gradualism limited the destabilising effects of sudden large changes. The overall intention was that economic actors would ‘factor’ in the trend and accommodate to it. policy and fact. Despite the. A policy of incrementalism created a trend or tendency that it was assumed would form an expectation management system that various economic actors could internalise as a behavioural pathway. Both articulate a kind of stability.oxfordjournals. Smith. as well as the letters the Governor must write to the Chancellor if and when the parameters of the inflation target are breached. affecting employment. the creation of a ‘direction bias’ and the communication of ‘balance of risk’. incremental and signalled. the period from the mid-1990s to the credit crunch of August 2007 was one of low inflation. strongly influenced in its design by CTMM (Harrison et al. typically 0. 2005. From June 1989 to August 2006 there were 74 interest rate changes by the FOMC of which 57 were 0. is a matter of degree. The difference.). however. speeches to specific functions by the Governor and deputy governors. Morgan 1980s. Until the end of 2003 the general trend had been downwards.1 Its communicative aspect has been one variously articulated as partial ‘transparency’. allows for adjustment to be gradual and manageable. Rates varied from 7. Here the very existence of a relatively simple rule-based approach that the central bank could be seen to be broadly adhering to provided a useful underpinning to the strategy. For central banks there seemed to be a broad fit between theory.5% and. These provide ‘hard’ empirical evidence based on data sets and forecasting. pace Shiller (2005) and Greenspan. analysts and the media. The underlying tenet is that central banks can play a nodal role in shaping behaviour through communication that in turn can feed through to achieve the goals incorporated in the theoretical model. For example. The pathway followed a narrative of how and why central bank policy was evolving. The media simplify and humanise the material to suit their particular medium and audience.. hawks and doves etc.com crash March 2000 to October 2002. 32 of which were 0.5%. 1997). From the beginning of 1998 to the end of 2007 there were 33 changes in the base rate by the MPC. the (delayed) published excerpts from monthly MPC meetings (indicating voting splits. The contents provide material for market actors. prior to the crisis. ‘irrational exuberance’ culminating in the dot. These are based primarily on the Bank of England Quarterly Model (BEQM). Changes were small. Downloaded from http://cje.25% and 16 were 0. 2007). broadly in accordance with (but not slavishly beholden to) the model. The overall approach to interest rates is one described by Bernanke as ‘constrained discretion’ (Bernanke and Mishkin. Fed economic forecasts would be published each quarter rather than biannually and would be for three rather than two years and published excerpts from FOMC meetings would include greater information on any dissenting positions. the 1997 institutional changes were also intended to add ‘credibility’ to central bank behaviour by ‘depoliticising’ interest rate decisions. 2013 . has articulated a more rules-based approach (stricter adherence to the models described as a more empirical-scientific approach). averaged around 5%. Other avenues of communication include representations to the Treasury Select Committee. at least formally.25% and one of which was 0. In the case of the Bank of England. consumption and capital markets.org/ by guest on December 13.5% to 3.25% or 0.5%.586 J. The theoretical model claims to moderate the business cycle. at the Bank of England one has the quarterly reports: the inflation report and the financial risk report. general economic growth and relatively stable high 1 The balance within the strategy between formal rules and discretion has been variable: Greenspan tended more towards discretion and Bernanke. The clearest statement of the narrowness of the difference was provided on 14 November 2007 when the Fed announced a new communication strategy with a greater emphasis on showing the role of a rules based and data approach but one that also highlights the need for greater transparency. whereas the strategy of interest rate changes and their communication.

one might argue that the data or empirical information fed into the model to derive inflation and GDP levels (output gaps etc. both of which are inherent to policy interventions in relation to output gaps and inflation. 1936: chs 11 & 12). Ultimately those problems were part of the reason why the ‘moderation’ was misunderstood. Policy can be ‘effective’ in this sense. It simply does not require it to be part of the decision making process in setting interest rates once the model has been run. Tacitly averaging out and terming that ‘stability’. One might respond that they are capturing Lucasian stylised facts. Shifts in behaviour based on widespread changes in attitude or belief may be a cause of Downloaded from http://cje. The multiple points of failure of applied monetarism as central bank policy Central bank policy during the period of the great moderation was deeply problematic in a number of ways. seeking to realise that equilibrium reveals a basic problem. of course. and Treasury officials who worked in conjunction with them. It takes the relative instability of a period and shows how the equation would have moderated it or it takes the relative stability of a period and iterates it without demanding a broader picture of what it is that is creating the relative stability. Seismic shifts in patterns of behaviour are not common but nor are they uncommon. This raises a further Keynesian point regarding liquidity preference and the marginal efficiency of capital. Central bankers. Put another way. If we consider this as a problem of theory the model has deep methodological problems that then create practical problems of policy.) capture causes. fictitious—an imagined goal. Here.org/ by guest on December 13. But it is fiction with a function. The equilibriums constructed from trend rates ultimately assume normal distributions that underpin the notion of statistical convergence around measures of GDP and inflation. 3. took to referring to this period as the ‘great moderation’ or. in Mervyn King’s phrasing. again. and are being assumed to be. Taylor’s approach is rooted in modified rational expectations as is the CTMM more broadly. It does not formally exclude that broader picture of causes. reality has a series of ‘fundamentals’ that provide an enduring rational calculative basis for actors within the system allowing it to ‘return’ to equilibrium. It is an ‘as if’ that becomes the ‘real’ that should be.oxfordjournals. When this is conjoined with forecasting based on collected data this shifting idealised point becomes not just the goal but also the real point of the system at any one time. Interest rates are ultimately set against a psychological unknown whose only anchor is that actors are. And.The limits of central bank policy 587 employment. Nor does it mean that manipulating interest rates cannot be correlated in a statistically significant way with inflation and growth over a given period (which is what the great moderation was). in one sense. which is then understood as a moderation of variation in some deep underlying cycle of relations between the variables in an equation. Even if this were valid. The stability implied by the targets is. The very notion of equilibrium is dubious in the way it is understood through the assumptions of CTMM. A useful way to begin is with the primary focus of applied monetarism in accordance with the Taylor rule framework: short term interest rates as a means to create low and stable inflation on the understanding that these are main constituents in economic growth. conjured from the equation. From a Keynesian point of view one would argue that one cannot simply assume that equilibrium will be restored through rational response. interpretation and understanding of those causes remains vital because it is in those causes that the very basis of any specific conjuncture of stability or pattern that has occurred resides. de-emphasises that the variation is itself real and not reducible to the variables in the equation but to their multiple causes. 2013 . continuing to act on the basis of what they have already done because they deem this a reasonable way to proceed (Keynes. the NICE economy (non-inflationary consistently expansionary).

The trouble with the Taylor rule framework is that it pushes all of these considerations to the side. As Minsky also pointed out the capacity for this to occur is not some randomised exogenous shock to an otherwise stable system. However. so one might assume that an effective interest rate policy was in any case always one managing and constructing the future. qualitative change as a cause of crisis is ultimately excluded. a common characteristic in all kinds of gradually accumulating ‘bubbles’. Of course. . as Minsky (1982. those elements being most emphasised which lend themselves most easily to analytical methods. the complex of causal relations may themselves be unstable or fragile in their current relative stability. (Marshall. An important aspect of this is that in so far as a distribution or pattern holds good for a time it is based on rationales not a single rationality. Equally concerning is its lack of specific attention to credit-money (such as M4). Modelling involves margins of error. Rather the opposite holds true. they must either be omitted altogether. or clipped and pruned till they resemble the conventional birds and animals of decorative art. This is precisely what the Taylor rule claims to offer.588 J. Paradoxically any approach to the empirical aspects of theoretical modelling must also be counter-factual in thinking about the future implications of what has gone before. For many important considerations. stress testing etc. a basic error to identify the causes of stability as correlative with stability per se. if short term interest rates are the primary tool of monetarist policy and interest rates are set relating to inflationary targets. or even any considerable part of it. In terms of the realism of the model one might also note that the BEQM is a two part model. especially those connected with manifold influences of the element of time. most notably. but rather that they are distorted in what they signify. see. But the basis of the modelling still remains that the underlying relations hold good. 2013 That the CTMM is based on a closed economy is in this sense deeply problematic for its broad realism. Kindleberger and Aliber (2005) and others have argued. Orphanides and Williams (2005).1 The modellers would argue that they are linking the future to the past (a patterned dependency). for example. As such. This insight is not one restricted to classical Keynesians and. the models are also forecasting and the (dis)inflationary effects of interest rates are held also to be time-lagged. And hence arises a tendency towards assigning wrong proportions to economic forces. Conversely. 1986). Shackle (1990). it is otherwise with any attempt to grasp the whole of a complex problem of real life. As Smith notes (2007: 14): 1 It is not as simple as to suggest that imperfect knowledge and uncertainty are ignored by modellers. do not lend themselves easily to mathematical expression. However. there is a painful tautology built into the forecasting. It implies the confusion between probability and uncertainty but it is also a broader problem of complexity as Marshall acknowledged a century ago: But while a mathematical illustration of the mode of action of a definite set of causes may be complete in itself.org/ by guest on December 13. so long as target parameters remain unbreached there is no pressure on the central banks to forestall problems through direct intervention via interest rates. in a series of equations. and strictly accurate within its clearly defined limits. it is intrinsic to the dynamics of a system. other substantive aspects of the system may change in ways that affect behaviour. therefore. It is. and thus simulations are run in which there are deviations.oxfordjournals. 1890/1930: 850) Downloaded from http://cje. This is important because there is no pressure deriving from the model for the central bank to act to forestall potential problems inherent in the broader tendencies and capacities of the economy. The forecasting assumes that the Taylor rule holds good and that given interest rate changes can maintain GDP on or around trend and achieve target inflation rates. the complexity of the models disguises the fact that the future is held to be like the past. Morgan other radical changes in a system. In either case. This was clearly the case in the run up to the dotcom collapse and is clearly.

The 12 members of the FOMC include the seven Governors. in which the steady state is estimated in stage one and the dynamics in stage two. one might further argue. 2013 4. which are rarely evenly split and tend towards unanimity. He was. Though Blanchflower has published little on inflation and monetary policy his views can be found in a speech to the Royal Society in Edinburgh. Qualitative changes in the system have rendered the models essentially redundant.oxfordjournals. then. The published edited minutes of meetings indicate that discussions are wide-ranging. Modelling of this kind is one reason why central bank and global institution forecasts have consistently run behind the severity of real world events over the last couple of years. 29 April (Blanchflower. Governors tend to be longstanding research active members of the Fed. etc. The design of the models has failed to adequately represent change. prominent academic economists and individuals with extensive experience in the upper echelons of commercial banking. covering all aspects of economy before decisions are made. Institutional failure. The external members tend to be prominent academic economists. His works on the non-financial causes of the Great One should also note that the central banks also refer to opinion polls. As such it is likely that his point of view carries little authority in discussion. The committees comprise a balance of experts of different kinds. This means that the whole model snaps back very quickly onto its imposed core. Forecasts have never been as inaccurate in the modern period as they have been since 2007. The very fact of the crisis tends to indicate that the committees were also found wanting. created an impediment to fully grasping that such change was occurring and what it might mean. It has a strong technical aspect and this has surely been found wanting.org/ by guest on December 13. Members tend to share a background of training and/or research in orthodox economics: precisely the kind from which the Taylor rule framework and the CTMM have derived. the executive director and chief economist of the Bank and four external members appointed by the Chancellor. price stability and financial stability It would be too simple to state that central bank policy is made mechanistically. however. The notion of a distinction between doves and hawks is also more relative than real.The limits of central bank policy 589 The BEQM is built in two distinct parts: a theoretical ‘core’ model with imposed calibrated coefficients and a set of non-core equations that include additional variables and dynamics not formally modelled in the model core. Within the MPC Professor David Blanchflower is currently the nearest to a genuinely independent figure. Members do not have a published or practical track record for unorthodox thinking on economic systems. the decision-making bodies comprise individuals with a range of expertise and positions that might be described as insiders and outsiders. 2 1 . This is analogous at the level of the whole model to the classic co-integration approach. a labour economist not a finance economist or an expert in economic systems at the broadest level. 2008). Downloaded from http://cje. Published minutes indicate that there can be disagreement but that strong dissent is diminishingly rare. four of the 11 remaining reserve bank presidents. The stabiliser terms in the BEQM are defined as the difference between the lagged dependent variable and the prediction from the ‘core model’. for example. It is a main reason why those forecasts have been progressively ‘updated’. The existence of the models. however. The insider–outsider distinction is more relative than real. He is. The nine members of the MPC include the Governor and two deputy governors. Ben Bernanke has such a background. This is also reflected in voting patterns. prominently ‘slapped down’ by Mervyn King at a Treasury Select Committee hearing in the summer of 2008. At the same time policy decisions are made by committee. the president of the New York Fed and. Ostensibly. confidence indexes.2 A background in economic systems and economic crisis is rare.1 Several cautionary points are relevant. on a rotating basis.

these key decision making committees focus on interest rates. and chains of command and hierarchy regarding financial stability. He is a former editor of the American Economic Review and. Moreover. One might also note that by the time he became chairman of the Fed in 2006 the underlying causes of the crisis were already in place. Have instabilities arisen. As such. It is further mandated to ensure that the UK financial system is beneficial to the rest of the economy. in many respects. Indeed. Arguably. unfolding events and their own institutional arrangements. The Treasury was given responsibility for setting target inflation levels. the problems that emerged from a primary focus on price stability in a context of underlying deflationary forces. a Keynesian or a dissenting figure like Minsky. with its ambiguities. the problem of institutional division of labour and a related limitation on information within a liberalised finance system. the ability of the key dialogical and ‘democratic’ decision making bodies (as opposed to the chairman of the Fed and governor and deputy governors of the Bank of England who are members) within the central banks to raise and address broader issues are highly constrained. the liberalisation of finance markets had increased the complexity. who makes the ultimate decisions. the institutional arrangements of the Fed produced two additional problems. Morgan Depression and on the financial accelerator mark him out as a genuine expert on crisis and qualitative change. 2013 . however. should one institution pressure another to take firmer action? In the US similar issues of a division of labour arose between the Fed. Since its independence in 1997. the Treasury and the Securities and Exchange Commission (SEC).590 J. the Bank of England has been mandated to maintain financial stability through operations to affect liquidity and is also empowered to act as lender of last resort. as well as issues over actual responsibility. In both the UK and USA many financial institutions operated Downloaded from http://cje. First. The notion of becoming a prisoner of discourse. This was the now maligned ‘tripartite system’.org/ by guest on December 13. This division of labour problem. formalised in the Bank of England Act 1998. an orthodox economic modeller. was exacerbated by a further information problem. The other main function of central banks in addition to controlling inflation is the maintenance of financial stability. A key question is how does one account for the failure of the central banks to effectively address financial stability prior to the actual manifestation of the crisis? One can consider this in terms of two contextualising issues. the newly created Financial Services Authority (FSA) was given responsibility for oversight of individual financial organisations’ business models. First. then. based on those issues that were already manifesting—such as the housing market bubble— Bernanke’s options were highly limited in terms of the constrained discretion policy that had been developed. who is informed. In ordinary circumstances the broader issues that central banks also address are relevant only in so far as they relate to interest rates.oxfordjournals. Any major deviation in rhetorical line from the Fed or any sudden shift in interest rate setting policy would likely be destabilising in themselves. He is not. as I note in the following sections. as the central banks radicalised in response to the crisis from 2007 this additional destabilising proved to be the case. managing the national debt and broadly overseeing the operations of the other two institutions. However. opacity and rapidity of financial systems change—and most of that was beyond the immediate oversight of the Fed. This tripartism created an apparently clear division of labour but an actual problem of blurring due to issues of adequate information flows between the institutions. though the Bank had responsibility for the system as a whole. events and institutional arrangements is also important when considering those ‘broader issues’. Second. what is to be done. is it likely instabilities will arise. both the FOMC and MPC had become prisoners of discourse. as well as a host of other oversight committees to which state and federal finance organisations reported. Second. In any case.

the lack of effective communication between different regulatory institutions and. 2007) this was a glaring regulatory flaw. 2006. 2013 . however. Palley. These included the treasury arms of financial conglomerates and investment banks. These included hedge funds. as did the development of cross-border and shadow banking and the increasing use of off-balance sheet strategies. Investment banks and treasury arms of commercial banks were increasingly engaging in proprietary trading. and the ‘light-touch’ oversight approach of the FSA contributed to this under-scrutinisation. although potentially problematic. for example. which refers to a ‘collective failure to appreciate the extent of the leverage taken on by a wide range of institutions and the associated risks of 1 The legal structure of LLPs provide numerous advantages including the maintenance of confidentiality or secrecy (see Morgan.1 Other important organisations were under-scrutinised in their operations. 2006). These were all issues that made tenable the notion that the ongoing dynamics of the financial system were leading to collective qualitative changes. Speculative investment through other derivatives that were originally intended as insurance (credit default swaps. That the IMF and the main central banks and state Treasuries had underestimated the problem was acknowledged in the April 2008 Review. For example. In an era of ‘financialisation’ (Froud et al. the fact that regulators accepted the basic story of the underlying robustness of the finance system. reflected in the blithe approach of the FSA towards those it regulated. it was not that problems went unidentified. Downloaded from http://cje. be resolved through market corrections. Prior to 2007 the dominant position was that issues. It was. The repeal of Glass Steagall in the USA. perhaps with small nudges from the state. And yet many vulnerabilities were manifest from 2004–2006 in the UK and USA in ways that clearly showed inter-connections (Gills. House prices were rising faster than incomes. One sees it in central bank and global institutions common strand of reference prior to mid 2007 to a new age of risk spreading and financial organisation efficiencies based on ever more complex mathematical and computerised modelling.org/ by guest on December 13.) was creating a highly unstable asset class. worse-case scenarios rejected.. private equity limited liability partnerships (LLPs) and special purpose vehicles. 2008. The key areas of intra-financial multiplication in which securitisation. One sees this latter point. just as importantly. By 2008 it had become more common to refer to issues as actual systemic problems based on multiple connections. but that they were identified as problems within the system not of the system. debt and leverage grew were precisely the areas in which the main oversight bodies had the least information and the least direct influence. the April 2007 Global Financial Stability Review from the International Monetary Fund (IMF) was tentatively just ahead of the curve in stating that debt and leverage were creating vulnerabilities should a ‘highly unlikely constellation of risks’ occur. Their role as prime brokers was expanding intra-financial multiplication and fuelling further securitisation and the creation of structured credit products. 2009). Absolute levels of debt were rising and leverage levels were rising making debt servicing more interest rate sensitive.The limits of central bank policy 591 without direct supervision. Pettifor. Fully grasping its complexity of inter-connections was hampered both by the lack of an overall picture. The expansionary business models of some banks were increasingly dependent on the renewal of short term debt in wholesale markets. and likely would. Here. 2007 before major institutions began to transform their assessment of these trends.oxfordjournals. blended foreign exchange futures etc. could. One important point of context regarding the failure to adequately address financial stability was that the overall system was everybody’s problem but nobody’s specific responsibility. Critics were marginalised.

The IMF statement that a disorderly wind-down was unexpected only makes sense if one has a single unified rational expectations approach to market behaviour based on a transformation from individual self-interest to stabilising collective outcomes (returning to a dynamic equilibrium based on fundamentals). 2000. Tim Congdon. Morgan a disorderly winddown’. It requires an atomistic approach for Friedman’s famous dictum to hold. Approaches to inflation 1 The January World Economic Forum also focused on the problem. As such it fed the associated and ultimately pathological changes in economic structure that were occurring. Price stability and the ‘great moderation’ seemed to make this approach reasonable. 2007. 2 Note that concern and focus is the issue here. The very basis of a liberalised market system is one where individual economic actors are assumed to behave on the basis of individual self-interests. 2013 . since the Bank of England was aware of changes in the money supply and its sources. 2008). One reason for this was the existence of powerful underlying deflationary forces arising from a combination of globalisation and lower bargaining power amongst labour (Coutts et al. low interest rates and a clear understanding that the movement of interest rates would be gradual. the issue then is not so much the lack of a general awareness of some rising individual ‘balance of risk’ issues but the translation of that to an early understanding of the potential for genuine crisis to which policy measures could be applied. remained one in which the system was seen as robust enough to deal with any arising problems—rather than that the system itself was problematic. William White notes that price stability is not a necessary correlate of financial stability (2006). Commenting on the situation. One might note here that inflation and deflation are never just monetary phenomena. however. incremental and signalled fed the continued growth of the finance system.1 The use of ‘appreciate’ here is significant in terms of what it connotes. Central banks did not rapidly raise interest rates in order to affect market rates and sharply curtail bubble effects.592 J. In fact. Since the market crash of 2000–02. but also the Bank of England to a lesser degree. Allowing interest rates to be expansionary offset these deflationary forces. Turner. a disorderly wind-down is precisely what you would expect. The indication seems to be that the very narrative of a robust system was one rooted in an orthodox theory perspective. Hatch and Clinton. the new system for introducing rises meant that they would not rise sharply. in a Bank of International Settlements paper. The Bank of England Inflation Report does contain data on the money supply and M4 (which includes bank deposits as credit creation).. Those changes included rising consumption and rising proportions of GDP reliant on expanding financial services. retail. each had maintained short term interest rates at slightly lower than the Taylor rule might require. the main modelling resources of the central bank would not be flagging this as problematic.’ The context. Downloaded from http://cje. publishing Global Risks in which it was stated: ‘Many would argue that the overall resilience of the global finance system will only become evident under conditions of severe stress over the next year. The complexity and near-infinite feedback loops of the modern financial system have exposed it to a small risk of very large systemic shocks. former member of the Treasury Panel of Independent Forecasters puts M4 expansion between 2004 and 2007 at over 12% per annum. the use of the CPI as an inflation measure that strips out housing effects further meant that low and expansionary interest rates would not affect its targeting effectiveness. In terms of financial stability. had done something less over the decade. From the point of view of Keynes or Minsky. Too great an emphasis on it can either reduce attentiveness to instability or lead to destabilising effects. leisure and housing markets. Arguably. the Fed in particular.org/ by guest on December 13.oxfordjournals. Since the Taylor rule framework meant that the central banks placed less emphasis on complex measures of monetary aggregates and the CTMM excludes broad money. particularly in the USA and the UK. Inflation and deflation are underpinned by the structural dynamics of economies. In the case of the Bank of England.2 Even as interest rates started to rise in 2003 and 2004. Their targeting systems and focus on price stability worked against this.

They would. If growth areas are also leverage areas then they are amongst the most interest rate sensitive. In January 2008. Home owners still felt wealthy. The very existence of the vulnerability arose in the context of a primary focus on interest rate policy and then served to constrain any effective use of interest rate policy. 156). The line between creating a break on the system and tipping the economy into recession was always going to be thin. despite that interest rates were increasing. was not the case because actors did not read the signals as anticipated—their rationales responded differently. 1936. This. during 2006–8. to do so. policy makers in the UK and USA championed their finance centres as beacons of the new economy. one might argue that the central banks did not only fail to respond adequately and early to the potential for financial crisis—they contributed to it. therefore. however. Nobody pushed strongly for legislation to empower the central banks to address aspects of financial innovation or to question the appropriateness of a hazy division of labour between regulators with all of its impediments. that economies had been allowed to develop such a basic vulnerability that combined the potential for financial and real economy instability. The strategy assumes that problems could be managed: actors would respond to warnings and higher borrowing costs. because the news was often better than expected. analysts notes.).oxfordjournals. such as the FSA. For example. the central banks did not pursue a strong restraining approach to interest rates prior to the crisis. therefore. ultimately be disproportionately affected by larger interest rate movements. in conjunction with the slow gradual increase in interest rates.The limits of central bank policy 593 and deflation do not just have monetary effects—they help to shape the further dynamics of those economies. It is discussed in the Quarterly Inflationary Report as a time-lag effect where equity and housing markets slowly respond to the previous rises in interest rates and the current change in credit spreads and supply of credit. intrafinancial multiplication would reduce etc.61 billion for 2007. was less than expected and its equity fell 17% to 23 January. Banks operating an 1 The response is referred to by the Bank as ‘re-pricing risk’. as growth became increasingly reliant on areas of the economy that used or produced debt and leverage the central banks’ ability to sharply curtail financial activity was reduced. This can also be seen in the failure of the communicative aspect of strategy. Other blue chip stocks. The fundamental problem was. The expansion. leverage levels would fall. failed to shape behaviour. 2013 . There is a general tendency towards a mass psychology of markets (‘anticipating what average opinion expects the average opinion to be’ Keynes. banking stocks tended to rise just after quarterly reports despite historically poor performance and large writedowns. Overall. In the real world there are structural effects in a way that monetarist theory tends to abstract from. then. Downloaded from http://cje. discretion did not mean that central banks made the leap from the overall stability of the finance system to the individual activity of financial organisations. a 57% increase. Apple reported profits of $9. Furthermore. On the contrary. and also stated a projected sales expansion for 2008 of 29% for the next quarter. might be treated in an opposite way. Accordingly. Clearly. Furthermore. 2 A complexity of rationale is always a feature of market behaviour. if they involved bubbles the sensitivity was more than simply one of the absolute costs of debt it was also one of the potentials for sudden changes in sentiment. but also a differentiation of significant asset investments (equities in particular) when new information is provided (profits warnings. consumption continued to grow. p. quarterly accounts. in the context of the institutional problems that existed. etc.1 Housing markets would cool. They did not press them to change their business models nor pressurise other oversight bodies. Those effects themselves can progressively constrain central bank policy. In terms of the current crisis. The third quarter report for 2007 is notable in that it acknowledges the failure so far to undergo rapid re-pricing.org/ by guest on December 13. the communicative aspect. however. The potential for recession through the use of interest rate policy was significant irrespective of any further collapse into financial crisis of the kind that the central banks simply did not place any credence in.2 Small incremental interest rate rises and subdued warnings of rising balance of risk left actors seemingly feeling that rising debt servicing costs could be managed rather than reduced. by comparison. such as Apple.

have limited effect on inter-bank lending. It is in many ways curious that the central banks were not more aware of this possibility. . the additional policy tools available to the banks were all ones designed to deal with manifest problems not forestalling problems: additional liquidity provision. the psychological unknowns of an uncertain future initially responded to the past by proceeding as though the past remained a good guide to the future despite changing conditions (see Keynes. both as overnight rates and three-month rates. The rates and degrees of radicalisation have varied depending on the policy area. However. highly leveraged large levels of debt created etc.). creating a statistically selfconfirming trend of growth even as absolute debt levels were rising in vulnerable ways. continuing growth) gave a degree of confidence to institutions like the central banks. This again. was that supplies of credit within the system dried up sharply and inter-bank lending rates (Libor. lender of last resort options. low inflation. The Bank of England. was that at all points all the central banks have been unable to get ahead of the emerging problems.5%. from 9 August they began to deviate sharply. was undone by its own credibility. 152–3).1 This was a supply problem creating a liquidity problem creating a pricing problem. Euribor etc. indicates that there continued to be a lack of overall perspective. Downloaded from http://cje. the interest rate responses of the main central banks followed the existing strategy of small incremental changes. in other cases. had them in place before they became imperative. easy credit. to individual consumers/employees etc. Euribor was 4. In essence. Morgan originate-and-distribute model felt no need to be overly concerned.75%. In the end it only required some immediate trigger for the underlying accumulation of problems to manifest and for the whole context of behaviour to switch. Ironically.75% and the US inter-bank rate was 5. The central banks were also tied into their targeting focus on inflation and continued to see the economic problems that were arising through the medium of their 1 The inter-bank short term lending average rates are always slightly higher than central bank rates—fractions of percentages. the very notion of a great moderation (job security. pp. Those buying securities could be comforted by the AAA rating they carried. For example.) began to deviate sharply from central bank rates. when the financial crisis began to manifest in August 2007. Of greater significance.oxfordjournals. whatever credibility the great moderation had. Some could be seduced by the way defaults of all kinds remained low in rising markets. on 10 August. Thereafter. three-month Libor was 6. 2013 5. That radicalisation. If there had been then the banks should have pursued some of the policies earlier and. etc. Events have forced the banks to adopt measures at odds with applied monetarism and more broadly at odds with market liberalism.594 J. 5. and to capital market actors that subverted the very intention of applied monetarism to be the one doing the managing. as of 9 August. this left the central banks with nowhere to go: the vulnerabilities of the finance system had already accumulated (securities had been issued and used as collateral. In the meantime. for example. and the role the central banks had in constructing and perpetuating it.org/ by guest on December 13. 1936. This meant that reducing both the central bank rate and the additional discount rates (the higher rate at which banks borrow directly from central banks) would. was notably more reluctant than the Fed or ECB to adopt loosened liquidity policies for commercial banks. however.1 Interest rates Initially. The immediate problem. The central banks respond: the ‘radicalisation’ of orthodoxy As the crisis has developed the main central banks have ‘radicalised’ within their own orthodoxy. has not been proactive but rather event led. In the end. on their own. however.

5%.2 Second. The second trigger was the growing realisation that if defaults in issued securities rose in ways feared then the main monoline insurers might be unable to meet their obligations. there was a steadily growing pressure to continue to make cuts and to make larger cuts.5% and 6%.75%. with a more variable discount usually up to 1% higher. ranging between 2. The Bank of England base rate at the beginning of the financial crisis was 5. mainly hedge funds. This began with the Fed. By this point. reducing the rate to 4. The sudden domino collapse in world equity markets on 21 January 2008 began a more rapid unravelling of the established interest rate policy of the main central banks. 2 A margin is the per cent rate of the value of the amount lent by prime brokers/bankers that the collateral of the borrower must maintain.uk/publications and navigate from news releases. Its discount rate was 1% higher. creating the impression that the central banks were committed to addressing the scale of the problem. The ECB left its already lower rate unchanged. which means that the fund equity or collateral assets stood against the loan must retain a value of 15% or more of the value of the investment (initially $1 million).25% to 5. If the invested assets fall in value then the margin is breached (a larger proportion of the value of the invested asset is now the original loan sum) triggering a ‘margin call’—the fund must restore the margin by repaying capital to the lender. As such. however. remit and institutional division of labour.5%. These were derivative trades on European equity indexes like Dax. Both cuts were at the upper end of normal at 0. These effects were rapidly transmitted from one equity market to another through the inter-connections of the global trading system.bankofengland. It cut twice at regular FOMC meetings on 18 September and 11 December. There were two immediate triggers for this. on 24 January. The first trigger was a report that China’s banks had large exposure to US securities investments. there was a certain rationale to not responding with immediate large interest rate cuts.org/ by guest on December 13.5% higher. 3 On 21 January all major equity markets in the world fell significantly in a domino effect as they opened and closed around the globe.1 The ECB rate was 4%. For example. The standard way to do this is to sell assets. it was exacerbated by the growing climate of suspicion and fear as traders realised that the future had become increasingly ‘uncertain’ and that a great deal hinged on the health of the US economy. The Fed took a more aggressive approach to cutting interest rates in 2007. The Bank of England resisted cuts until 5 December when the rate was reduced by just 0. it was exacerbated by some of the same financial organisations. See for example. Third. in the context of the wider impact of the spread of fear and the real effect this had on behaviour and thus ‘market sentiment’. Since banking stock had become prominent on main indexes any large trading volumes and price falls in these stocks would have large effects on the index. It was subsequently revealed.25% and with a commensurate change in the discount rate. However. SocGen’s total capitalisation was then only V36 billion.25% and its discount rate was 0. The Fed funds rate was 5. It was.3 1 Interest rate changes are reported by the press offices of the main central banks. a fund invests $1 million in a portfolio of securities—the fund wants to borrow money in order to make this investment. In this case $850. that SocGen had been selling (20–23 January) into a falling market to dispose of an unauthorised V50 billion of bets by Jerome Kerviel. This impression was intended to limit further capital market downturns and ultimately address the economic crisis that followed the initial financial crisis. it was exacerbated through the need of some financial organisations to sell off all kinds of equity assets at short notice to cover margin calls emanating from the banks who acted as their prime brokers and who were triggering margin calls based on value falls in securities as collateral (itself exacerbated by leverage). By January the equity prices of commercial and investment banks’ were on a long downward trend and highly volatile. http:// www. This effect was being exacerbated in three ways. The selling almost certainly contributed to the collapse in markets.The limits of central bank policy 595 models.5%. equity values had fallen more than 17% and close to 20% in most major markets from the peaks of mid-2007.co. shorting the banks in order to try to recoup some of their losses. and the banks set a margin of 15%.oxfordjournals. The range of the fall was between 3% and 7. First. always event-led and thus never got ahead of the emerging problems. Another catastrophic fall in equity values around the globe occurred on 22 January.000 is lent on a $1 million investment with a 15% margin. Downloaded from http://cje. 2013 .

a reticence to trade and finance trade with them is fatal. particularly when market conditions are already difficult for all investment banks. Asset values started to fall.efinancialnews. employment. In October. That same day Bear Stearn’s CEO issued a statement denying the bank was illiquid. Since investment banks are effectively transmission points.5% on 16 December and the latter cutting to 2% on 4 December (and then down to 1. On 6 November the Bank of England cut the base rate to 3% and the ECB cut to 3. CCC failed to meet these calls resulting in default notices from the lenders (owed a total of $20.5 billion on the back of the rumours about exposure. Downloaded from http://cje. On Friday 14 March Bear announced it had a solvency problem and was seeking credit support and a possible buyer. The Fed and the Bank of England then started moving towards effective zero rates in December. at an unscheduled meeting. In the fourth quarter of 2007 it announced its first overall loss at $854 million and by March 2008 its total writedowns were over $2 billion. etc. Its initial $600 million equity was leveraged 32 times to create a fund size with assets of $21 billion. Thereafter.com which provides a daily press release and market update service that makes extensive use of sources like Thomson financial. In 2007 it had reported $46 billion in collateralised debt obligations (CDOs) and mortgage backed security holdings.1 billion and fell that day to $11. It becomes institutionally illiquid and quickly experiences a cashflow problem that threatens its solvency. many issued by Fannie Mae and Freddie Mac. The best source to track emerging market stories of this kind is www. 2013 .75% to 2. At the scheduled FOMC meeting of 28–29 January. The ECB began to follow the same track also cutting. further rate cuts remained on hold despite steadily worsening data on all aspects of economy (output.25% to 2% on 29 March. 1% on 5 February and 0.25% and then another 0.5 billion).6 billion to CCC.75% overnight cut to 3. the former cutting to 0. CCC shares were suspended on 7 March. It took the events of late September and the final acknowledgement that there was in fact a broader economic crisis to reverse the hesitancy of the summer. 1 The collapse of Bear was triggered by the collapse of two large hedge fund groups. The fall in the value of assets caused escalating margin calls—accruing to $400 million during the week. Peleton and Carlyle Capital Corp (CCC). Other investment banks had larger scale exposures and writedowns but Bear had a greater reliance on income from securities (74% of tangible equity) and a greater proportion of exposure to such securities (424% of tangible equity compared with an average of 309%). on 5 March.5% to forestall further effects on the next day’s trading.5% and the ECB to 3. the Fed cut its rate to 1. $5 billion in assets had been liquidated.25% on 3 July). Each was a classic example of a margin call spiral exacerbated by leverage (termed ‘haircut contagion’). the Bank of England. The fund was listed in Amsterdam.5% on 8 January. to 1. the Fed cut by 0. By 10 March. by 10 March this had slowly declined to $18. An investment bank that cannot find other backers for its underwriting and cannot find buyers for the securities it issues on behalf of clients cannot function.). Morgan The collapse of the 21 January drew the Fed to respond with an emergency 0. In March Bear started to experience precisely the same kinds of reactions and spirals that the funds it lent to had. By 13 March CCC had still failed to meet its margin calls and another $97 million had accrued on the remaining $16 billion of assets not yet seized.25%.596 J. the rate was cut a further 0.5% on 5 March). as world oil and food prices soared through the summer. Each represented an actual loss to particular investment banks but also a market signal that investment banks face continued and escalating ‘exposure’ problems. The banks seized the remaining assets.5%. This in turn created further liquidity problems for investment banks as funding was withdrawn and market capitalisation reduced. set up in 2006 solicited funds on the basis of a claim of 15% annual returns. its own liquidity cushion started to seep away as counterparties reduced funding and its market capitalisation started to reduce further.5% to 3%. On 13 March the 14 main lenders refused additional funding and/or new terms and conditions and CCC effectively became insolvent. CCC. On 3 March the CCC mortgage bond fund reported liquidity problems. from a total of $176 billion in securities assets. At the beginning of March Bear Stearns had a capital pool of cash and liquid assets of $21 billion. creating and moving on forms of investment (for clients and for themselves through proprietary trading). consumption.75% (having actually increased rates to 4. On 18 March. to 4. Rather like Northern Rock it had a particularly vulnerable business model in its industry sector. in the wake of the collapse of Bear Stearns. terms and conditions become more adverse.oxfordjournals.25%. Thereafter counter-party withdrawals and credit refusals began to escalate and as of 13 March its available liquidity had fallen to $2 billion. at the beginning of March. Bear had lent $1.org/ by guest on December 13.1 It was April before the Bank of England responded with a cut to 5% and the ECB rate again remained at 4%. However. mainly invested in mortgage backed securities. brokers and traders became reluctant to trade with an organisation that they feared might collapse. the Bank of England and ECB rates remained unchanged.

This was not just because the initial manifest problem was supply of credit in the system rather than cost per se.1 However.The limits of central bank policy 5. voted for a cut. rather than preventing its erosion in the first place. These remained a drag on more radical thinking. The net effect is to produce a kind of cognitive dissonance that results in either policy paralysis—a wait and see approach—or a coin toss choice concerning which of the two one wants to tackle most (slowed growth or rising 1 The debate over inflationary forces began even earlier.4%. discretion in interest rates clearly played an increasing role compared with approximate adherence to the Taylor rule framework. Direct borrowing from the central bank could also be encouraged by reducing and even waiving the discount rate. 317): It is the return of confidence. increased from 2. What radicalisation there was occurred behind events. both of which the central banks then did at various times.oxfordjournals. whereas core inflation (excluding food and energy costs) was more stable at 1. This is the aspect of the slump which bankers and business men have been right in emphasising. always in the wake of some major event whose immediate effects had to be forestalled. to speak in ordinary language. might be thought of as a communicative act designed to foster confidence. at least prior to the shift to near zero rates. 2013 The point. Yet as acts of discretion they were. Within the MPC’s discursive context the rise in inflation reported in the quarterly Inflation Report on 13 May seemed to vindicate this caution. Cuts became larger. Such a position simply meant that a central bank would have to balance reducing short term interest rates intended to affect inter-bank rates with also offering greater supplies of short term funds to banks to create liquidity. For example. is that the central banks were already working in the context of trying to return confidence. Downloaded from http://cje. The very existence of the combination produces a perverse context for a theoretical position that assumes interest rate variations can maintain inflation and GDP on trend. The Bank of England and ECB in particular became mired in a focus on the short term inflationary potential created by rising oil and food prices in 2008 rather than the underlying problem that a recession would contract growth and almost certainly depress prices based on the characteristics of the emerging crisis. Blanchflower was also later the lone voice in the MPC concerned about deflation. in 2007–8. which were based on a modelling system and institutional division of labour that could not cope with a pan-systemic and qualitative problem. To a degree this seems to accord with a Keynesian insight (1936. The indicator used for interest rate targeting. Given the context of the interest rate strategy the central banks had developed prior to the crisis this aspect of radicalisation. the CPI. however.org/ by guest on December 13. p. A combination of slowing growth and rising prices is one that interest rates simply cannot tackle.2%. the problem was also that the primary policy tool remained constrained by the focus on targeting and management. . the retail price index (including housing costs) increased to 4. Only one member. and which the economists who have put their faith in a ‘purely monetary’ remedy have underestimated.2 Problems of interest policy as theory and practice 597 The key problem with interest rates as the primary policy tool of central banks has been that it was not a tool designed to deal with the kind of crisis that emerged. more frequent and could be unscheduled. which is so insusceptible to control in an economy of individualistic capitalism. the published minutes of the MPC meeting of January 2008 reveal that a cut was vetoed because of concerns over inflationary pressures. David Blanchflower. The commitment to do so still remained one beholden to the central banks’ focus on price stability and short term targeting broadly in accordance with its rule focus and institutional remit. Rather. The stagflation fears of the summer of 2008 highlight the problems this created in terms of the Taylor rule and a monetarist focus on interest rates as the primary policy tool for economic management.5% to 3% (just at the top end of the Treasury-set parameter).

if the UK could learn anything from Japan’s experience. 4 One might also note that Ben Bernanke specifically flagged his concerns over deflation when he took up his post at the Fed. ideally from August 2007 but at least from January 2008. vice chairman of the Board of Governors of the Fed. That breadth would have had to include more heterodox economic analysis and genuine expertise in the ramifications of the inherent instabilities of economic systems.4 Instead they opted for an expansion of the terms and conditions of liquidity creation. it is not unrealistic to expect the central banks to have been capable of this approach. with a greater interest in broad money supply such as credit. It also illustrates the potential problems of waiting too long to start to cut interest rates because of fears over inflation (Turner. 2013 5. Morgan inflation—a monetarist will always fear inflation more). 1 . rather than early to mid-2009. bank fragility and equity market collapse. 2008). There was a basic refusal to see it as a genuine emerging economic crisis of larger proportions and longer term significance. Liquidity is typically provided through the offer of The paralysis over interest rate direction was seen as an impediment to the effective management of expectations as early as January 2008. in February 2008. The reporter notes that Darling refused to answer but looked disdainful. Downloaded from http://cje. Chancellor Darling was specifically asked at a G7 Finance Ministers meeting in Tokyo. would have required them to step outside the whole theory and practice in which they had operated. One can also consider this in a broader context. In practical terms the bodies could have looked more closely at the Japanese economic experience.org/ by guest on December 13. If there had been such a vision then forestalling a pan-systemic set of negative feedback loops would have been high on the agenda. starting from the leverage in the banks and a housing market bubble. 2 Fisher argues that as a debt-related-asset sell-off is triggered the broad money supply contracts because repaid loans are not recycled (either the banks become cautious or the appetite for borrowing falls off) creating the conditions for falling prices that in turn creates new distressed sellers creating further falls in prices and so on. would recognise as debt-deflation and Keynes would recognise as liquidity trap. the limited impact of fiscal stimulus through public works in Japan was not a failure of Keynesian principles per se but rather a failure of Japan to first solve the liquidity trap problem in order to place a stabilising floor under fiscal expenditure.2 Clearly. Interestingly.oxfordjournals. Even as events unfolded in 2008 in a ‘slow-burning’ crisis there was a basic refusal to accept that the financial crisis would be more than merely a drag on the real economy. Donald Kohn. Japan provides the template for the current crisis.3 For the Bank of England. speaking at the American Economic Association conference in January 2008 commented that cutting interest rates during a period of inflationary pressure (oil price had just hit $100 per barrel) was creating mutually irreconcilable narratives. At the same time. the central banks lost valuable time in getting ahead of events by doing nothing on interest rates during the summer of 2008. This policy would have been to prevent conditions that an earlier brand of monetarist such as Fisher. which may explain why the Fed was ahead of the Bank of England and ECB in its policy measures—though it does not explain why the Fed remained event-led. In order for them to do so short term inflation targeting and price stability would have had to be lower on the agenda. Fed and ECB to have followed this tack in 2007 or 2008.598 J. There would also have had to have been a broader cross-section of economic opinion within the decision making bodies. 3 As Turner rightly points out.3 The expanding remit of liquidity creation The immediate response of the Fed and ECB to the slowing of credit markets on 9 August 2007 was to provide increased liquidity. One aspect of this would have been to cut interest rates aggressively towards 0% (in the context of other measures). all the points made in Sections 2–4 provide reasons why this did not occur. In this context higher public spending simply crowded out private investment at the same time as contributing to growing savings levels as the population feared job insecurity.1 Arguably.

75%. . For example: Interest rates are not a policy instrument for protecting unwise lenders from the consequences of their past decisions.25 billion and V42. This was followed on 6 September by two more unusually large interventions of $31. He placed this also in terms of his initial reluctance to use interest rates in a more discretionary way. as did the fact that the institution accessing the . Mervyn King had. Even anonymity did not prevent problems emerging.4 billion as overnight funds was announced on 4 September to be available for each of the following three weeks. It is not an international financial crisis. from early September the Bank of England was forced to act. For this reason. let alone in the United Kindgom. The daily settlement margin of error of the commercial banks’ accounts with the Bank of England was also widened from 1% to 3. and large nature of the provision created generalised uncertainty. 2013 However.The limits of central bank policy 599 additional short term funds at fixed rates (discount or otherwise) or through term auctions (where the rate is set by the bidding). So far what we have seen is not a threat to the financial system. the Fed provided $24 billion and the ECB V98. So it’s impossible at this stage to judge how large and how persistent this tightening of credit conditions is likely to be. On 10 August. just as there was also some reluctance to access Fed funds available at the higher discount rate. (Duncan. Prior to the crisis total sums were typically single figure billions. To the extent that these spreads are starting to widen. The Bank of England initially did nothing.org/ by guest on December 13. [But] I do not think there is much sign of major damage to loan performance in other markets. Prior to the crisis the Fed typically offered funds for liquidity on a daily basis. but rather individual bank’s poor practices.4 billion in funds. We don’t know whether these tremors in financial markets signal a more disruptive movement to come. which would simply be reinforced by any attempt to ease the problems indicated by increased Libor. Still. Again.141 eligible institutions). An additional liquidity auction sum of £4. either in the United States or Germany. since early August. 2007. The unscheduled. on 25 September there were no takers for the Bank of England £10 billion auction but an ECB auction of V50 billion was over-subscribed with 159 applicants (from the 2. We are certainly not going to protect people from unwise decisions that they have made before . arguing that the problem was not confidence in the central bank or the finance system as a whole. . The funds were available to commercial banks registered as eligible in the relevant jurisdiction. Initially there was a reluctance to use the facility. The Bank of England did nothing and many cross-border banks simply applied for short term funds through the ECB. all the central banks engaged in larger scale and/or more frequent liquidity interventions. 2007) Downloaded from http://cje.9 billion in overnight funds to an unnamed bank at a punitive discount rate of 5%. the Fed encouraged the more prominent US banks to access discount rate funds to remove the market stigma. As the crisis unfolded.oxfordjournals. On 27 September the ECB provided V3. or constitute a gradual release of pressure on spreads that have built up over some time. whilst the ECB has engaged in periodic ‘fine-tuning’ intervention. For example. The Bank of England initial offerings remained undersubscribed despite a persistently high Libor that indicated a shortage of short term funds. This in turn could affect their market capitalisation in a time of equity market fear. respectively. three-month Libor continued to rise and on 19 September the Bank also moved to offer £10 billion of additional three-month funds in each of the next four weeks and agreed to accept mortgage securities as collateral. articulated a strong moral hazard position. In both cases it was not just because of the rate but also because accessing the funds was not wholly anonymous and might provide a market signal that the banks applying for the funds were facing significant problems. I think that it is a welcome development as a more realistic appraisal of risks is being seen. singular.2 billion. this was event led.

It was. overtaken by events—emergency action became normalised. Liquidity provision was. increasingly met each event with large-scale liquidity injections. These funding shortfalls were created by a combination of broken transformation models (renewing short term borrowing to maintain long term investments). This left them with a short term funding problem in two ways. Inter-bank lending rates increased sharply. For example. This was steadily manifesting solvency problems from liquidity problems. At a G10 meeting in mid-November 2007 it had been agreed that greater Downloaded from http://cje. Reductions in the liquidity of assets and in the willingness of organisations to lend among themselves (collateralised by such assets) were creating a spiral of losses of value. had reduced or frozen. one equally hampered by the problem of returning confidence to a system that was now unwinding in a ‘disorderly’ way. The Fed. The more immediate problem was that the scale of liquidity provision was always less than the overall scale of the problem being addressed. It also left the banks with funding shortfalls related to their ongoing exposures to other financial organisations that in turn were in dire need of capital for liquidity. This was exacerbated by the way the central banks took an event-led approach on liquidity as they did with interest rates. As the cycle of liquidity offerings expanded. This came on the back of the first phase of huge writedowns in securities and private equity investments reported by the US banks in their third quarter accounts.25 billion of unscheduled funds was provided by the Fed on 15 November in the wake of Bank of America’s third quarter accounts. However.600 J. This escalation was actually occurring faster than any increase in defaults in the underlying security assets that first triggered the problem. the next large unscheduled change in liquidity provision was the $41 billion provided by the Fed on 1 November 2007 following its cut to the Fed Funds Rate and undertaken in the context of the analyst Meredith Whitney’s note that Citigroup was undercapitalised by $30 billion in terms of its Tier 1 Capital ratio as a measure of financial stability.oxfordjournals. A further $47. falling values of assets (all kinds of securities that were now also illiquid) and margin calls (that are not met).org/ by guest on December 13. Intra-financial multiplication and increasing reliance on wholesale markets had created trillions of dollars of exposures. however. the scale of provision may have increased but it did so in fits and starts. as with interest rate policy. therefore. Moreover. always highly constrained as a way to restore inter-bank lending and also wholesale markets more broadly. to a degree. It could not restore value to the assets that the banks held or guaranteed or were linked to through their use as collateral by borrowing organisations. was in many ways little more than a confidence statement. which in turn created new needs for new liquidity via the injection of funds from the central banks. 2013 . Morgan funds could be from one of many geographical locations. This remained so despite the move to coordinated liquidity provision between the main central banks. It left the banks with an ongoing problem of recurring funding shortfalls to balance short term transaction asymmetries between themselves. Whitney’s note caused a fall in Citi’s share price of 7% and an overall fall in value of the Dow totalling $369 billion. Liquidity provision. these injections remained small in proportion to the scale of the exposures and could not address the basic problem that what was at stake was the capitalisation of the banks because of their exposures. the general problem of stigma became less of a concern for the applying banks. These included investment banks. The overall problem of scale was an escalating one. hedge funds and leveraged structured investment vehicles. As in the case of interest rates the provision of liquidity by the central banks did not seem fundamentally set up to deal with the problem. as with the other central banks. The key problem for the banks and other financial institutions was that wholesale markets. and commercial paper markets in particular.

2 Combined with a new $100 billion open market operation of 28 day swaps for repurchase of offered securities (Treasury. 3 The unscheduled Fed intervention raised average bank market equity by 7. however. commercial lending did not ease.gov/monetarypolicy/taf. two Bank of England auctions each of £11. was at less than the discount rate of 4. The outcome also illustrates the underlying problem. was politically fraught.3 Bear.4 Problems of liquidity policy Liquidity policy in tandem with interest rate policy was never able to manage the emerging crisis.The limits of central bank policy 601 coordination was needed. The Fed auction was through the newly created Term Auction Facility (TAF): a fixed sum offering of longer term funds (28 day. on 12 December. 2007. This manifested in a joint announcement.25 billion in three-month funds and two ECB auctions to talling V20 billion (plus other auctions by other central banks).federalreserve. . Its scale of single offerings varied but tended to slowly increase.org/ by guest on December 13. Again. 35 day funds etc. 2013 5.). It increased to $30 billion in January 2008 and $50 billion in early March. The specific problem in terms of liquidity policy was that it only became necessary because of vulnerabilities inherent in the way the financial system had developed. The provision of a credit line to JP Morgan by the Fed. though beginning as a short term measure. as with coordinated provision by the other main central banks.htm for the basis of the TAF and http://www.) in a swap for collateral where the rate is set by the bidding process (the minimum is the expected federal funds rate and the maximum is behaviourally moderated to less than the discount rate).oxfordjournals.htm for summary statistics.75% and received applications to the sum of $61 billion (i.e. became a persistent feature of the finance system.2 March was another pivotal month. Inter-bank rates remained significantly above base rates. The Fed added another $200 billion of unscheduled funds to the $200 billion already committed through the TAF and other avenues for the month.5% but Bear’s by just 1%. Most of the funds were not subject to discount rates. on 14 March the Fed sought to manage the problem by facilitating a takeover by JP Morgan and also creating a Primary Dealer Credit Facility under provision 10b5 of the Federal Reserve Act.1 The Fed auction of 19 December. of new funds for auction: two Fed auctions totalling $20 billion each of one-month funds. etc. was more than three times oversubscribed).federalreserve. the market capitalisation of banks continued to slide (resulting at this point in a rush to access sovereign wealth fund capital) and other financial organisations continued to become insolvent. The 1 See http://www. This process. generalised the core aspect of what had occurred at Northern Rock. It signalled a shift from simply providing short term liquidity in swaps and loans of up to three months to accepting the longer term risk inherent in the accumulation of speculative investment assets that was at the heart of the problems being experienced by the banks. federally backed mortgage securities via Freddie Mac. This extended TAF-type funding to non-deposit institutions. Downloaded from http://cje. As rumour began to spread that Bear Stearns faced insolvency the central banks responded with another round of coordinated large scale injections. as an investment bank rather than a depository institution could not access TAF funds and. The TAF. guaranteeing $30 billion of Bear securities (with JP Morgan agreeing to accept the first $1 billion of any losses). It reinitiated a process of directly socialising any costs of the ongoing crisis. The oversubscription indicated the degree of demand in the market. the response was event led and was unable to prevent the continuation of underlying problems—Lehman Brothers was almost immediately singled out as the next most vulnerable of the investment banks—though that story did not reach its conclusion until September.gov/newsevents/press/monetary/20071212a. as it slid into insolvency.

Again. however. More specifically.org/ by guest on December 13. 2013 .602 J. it would have required an operational institutional structure that did not inhibit information flows regarding possible instabilities and did not create impediments to imposing policies designed to generate stabilities. This is one of regulative ethos. However. The US Treasury and Fed could not even coordinate a small group of larger US banks in October 2007 to create the ‘Master Liquidity Enhancement Conduit’ as a $100 billion special purpose vehicle to buy up and isolate already problematic sub-prime-related securities. The problems experienced in passing the subsequent US Treasury open-ended usage $700 billion banking bailout plan simply underscore the nature of the difficulty. It would be a pre-emptive multi-trillion dollar exercise—notional though most of it would have been in terms of actual defaults if the system could have been genuinely stabilised. Third. the very notion of a political consensus and mandate for radical policy intervention was problematic. Morgan problems had to exist in order for the central banks to shift from ordinary low level and limited liquidity management operations to larger scale interventions. As the crisis has illustrated. More importantly. this was not likely. In terms of the scale of the problem the interventions were never going to be large enough. an overall context in which financial stability was decoupled from a focus on price stability. First. and where the institutions continued to state that the overall real economy effects would be muted was unlikely to say the least. in the context of liquidity provision during the crisis. The existence of the system based on particular tendencies to overcome regulation and work round interventions is the more fundamental problem. These three. Should the system be based on the ethos of what is not prevented is allowed. The potential for important changes here now exists. consensus and mandate have remained divisive issues even as the problems have manifested. would have had any possibility of stabilising interbank lending and freeing credit markets as a long term outcome that would have avoided the perpetual manifestation of new problems in the finance system through illiquidity. despite the fact that the banks were better placed than anyone else to know the ramifications of a failure to do so. Only long term liquidity offerings on a huge scale could break the cycle. or should it be based on the ethos of what has not been allowed is prevented? The point may seem abstract but it can easily be rooted in law through contract enforcement within national boundaries. Second. Such intervention prior to the manifestation of the problems on a large scale would require not only establishing the likelihood of those problems but also persuasively setting out why they should be collectively tackled. given the points in Sections 2–4. This would be more than the lender of last resort and final intervention policies that central banks use to draw a ‘too big to fail’ line under the main banks when problems reach their culmination. the first point would in turn (as in the case of interest rate policy) have required that decision making bodies contain a greater range of heterodox thinkers with an expertise in economic systems as systems with inherent instabilities. and the underlying value of the assets they and other financial institutions held.oxfordjournals. only guaranteeing the capitalisation of the banks. In the end they imply the need for vigilance in chasing a runaway liberalised system. It would have required several differences. Creating a broader popular mandate when the basis of the narrative of the recent period was one of private risk and great gains. To be genuinely effective early on all kinds of areas might have needed to be covered in one way or another in order to facilitate the flow of credit and close down problems of downward Downloaded from http://cje. where orienting on financial stability took precedence over and framed any commitment to price stability. as avenues through which liquidity based problems might be resolved still presuppose the system that creates the problems.

But it cannot fix them if it leaves in place the underlying tendency to expand finance in vulnerable ways. . However. 1962. the terms of the offer illustrate a tension inherent in the political process of socialising costs. These areas (issued securities.5 Illustrating the contradictions of the shift to socialised costs After the events of March 2008 in the USA. Specifically. The Bank of England’s approach was to 1 http://www. under Treasury direction and also subject to King’s own preference for moral hazard argument.co.The limits of central bank policy 603 spirals from fears over collateral sources. 157) It is the basis on which Robinson affirms that economics is a socio-political realm that demands genuine discussion of what kind of economy is socially beneficial: Keynes brought back the moral problem that laissez-faire theory had abolished . to ease the problem created by illiquidity and value losses in the banks that had now become a main issue for the individual banks’ lending function and for the stability of the finance system as a whole. that the very idea of wealth as money rather than as a useful thing distorts the fundamental measures and perspectives of economics. 2013 This is a point also made by those influenced by Aristotle.uk/publications/news/2008/029. pp. The Treasury gilts. At the same time the Bank of England was under pressure to do something substantive. as well as (as MacIntyre. argues) its practices in society. and in the context of the growing number of rights issues being prepared for new capital raisings by the British banks (particularly Royal Bank of Scotland).htm . Liquidity management presupposes the problems it is ultimately required to try to fix. . 39). multiplication and private sources of profit: quintessentially areas of market liberalism much of it belonging in no single country. The swap was for one year. providing a longer term source of funds to the banks than typical central bank liquidity operations. One might also note that the growing demands by market actors during 2007–9 indicate the tension in a neoliberal ideology: limited intervention is in everyone’s interest but when we fail we demand aid/support etc. but rather more exploitatively oligopolistic (limited numbers of key actors extracting disproportionate gains). It indicates that market liberalism is not free market. 5. p. the Bank of England introduced the Special Liquidity Scheme (SLS). The central bank. When such vulnerability develops it can merely continue to fail until such time as costs are socialised. as more liquid assets. wanted to limit the costs to the taxpayer of any losses deriving from the banks assets. Liquidity management cannot fix this basic problem because the problem is structural. such as Maki (2001. could then provide better collateral for the banks. By making it impossible to believe any longer in an automatic reconciliation of conflicting interests into a harmonious whole. nodal financial organisations from which margin calls might emanate and escalate etc.) were all areas based on financialisation. Economics once more became political economy. 1936.org/ by guest on December 13. extendable to three. 2000. 72–3) Downloaded from http://cje. That is what a pan-systemic crisis signals.oxfordjournals. The ideology to end ideologies broke down. the General Theory brought out into the open the problem of choice and judgement that the neo-classicals had managed to smother.1 The SLS offered Treasury gilts over the following six months specially issued by the Treasury’s Debt Management Office in swaps for commercial bank’s currently illiquid but AAA-rated mortgage securities and credit card or unsecuritised mortgage assets.bankofengland. (Robinson. p. This is another basic Keynesian point that ‘There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable’ (Keynes.

expose the taxpayer to the possibility of losses in high rated mortgage securities. The participating banks would also be charged a fee minimum of 0. It was not sufficient to prevent the accumulating effects of the economic crisis in 2009 resulting in a huge rise in public spending in the UK. The scheme itself was openended in terms of the sums of securities involved but it was initially estimated that demand would be around £50 billion. It was not sufficient to prevent the need for the Treasury to develop the Asset Protection Scheme in 2009. There would be. 2013 http://www.1 This was still not sufficient to prevent the partial nationalisation of Royal Bank of Scotland and HBOS/ Lloyds. therefore. One can make the same points regarding 1 Downloaded from http://cje.oxfordjournals. they had become insolvent and/or been nationalised. It did. Over the duration of the SLS the finance system continued to decline.2 trillion at the time and the ongoing wholesale funding of the banks stood at £550 billion). As such. According to Mervyn King the aim was to ‘improve the liquidity position of the banking system and raise confidence in financial markets while ensuring that the risk of losses on the loans they have made remains with the banks’. It introduced a Discount Window Facility in October 2008. if under three years to maturity then the assets would be taken at a 12% discount.2% of the transaction.co. If the securities ratings fell after they had been accepted they were to be replaced. By its close on 30 January 2009 the SLS had been used by 32 banks and building societies creating a total of £185 billion in new Treasury securities against swaps of £287 billion in bank securities. The securities accepted would be taken at a percentage discount rising with the duration to maturity of the security. In policy terms it could be described as a failure to prevent the future socialising of costs. The Bank of England continued to introduce more piecemeal and limited policy solutions. It was not sufficient to prevent the need to add quantitative easing as the final logic of ineffectually cutting interest rates.604 J. Since the poorer. but it had also been set up in terms of a contradiction. Only AAA securities issued before 2008 would be accepted. This being so it represented a politically and economically acceptable (rather than genuinely rational) policy move that did nothing to prevent the eventual need to partially nationalise some UK banks. assets remained on the books of the banks the core of the problem of confidence in the banks would remain. Morgan weight the scheme on the side of protecting the taxpayer against losses.org/ by guest on December 13.e. But this would only occur if the banks (and building societies) were unable to accept back their better assets i. Since the core issue was one of ‘problem assets’ rather than all assets then accepting only the highest quality assets and in relatively small amounts was essentially meaningless in terms of longer term effects. which accepted a broader range of securities as collateral. which introduced a whole new raft of public exposure to potential losses generated in the private sector. however. This was so even though the scale of the scheme was larger than initially anticipated. If 3–5 years then the discount would be 14% and so forth. In January 2009 it extended the period of lending from 30 days to one year.pdf .uk/markets/marketnotice090319dwf. as it did in other countries around the world (precisely as public revenues fell). The discount was to offset any possible defaults in the underlying income streams of the securities. For example. improve liquidity or put a floor under the problems of the banks. a continuation of writedowns as defaults and valuations fell and a continuation of suspicion of bank equity (and the adequacy of tier 1 capital measures and so forth). Not only was the scheme relatively small (the total stock of mortgage securities in the UK was £1. These ranged from AAA securities to ‘illiquid’ debt securities.bankofengland. the SLS would do nothing to trigger new lending. less liquid.

in most cases. This requires a degree of iconoclasm and non-conformity that must be mirrored in both theory and 1 There are. There has always been a counter-discourse objecting to this. But in the absence of that infallible criterion. [but] it is precisely the empirical validity of the assumptions on which the usefulness of the entire exercise depends. central bank policy was not enough to either stabilise the finance system or to contribute effectively to managing the broader economic problems that ultimately became the current economic crisis. 1871/ 1970. doing so would raise profound problems for the tractability of modelling as a forecasting and management tool. including within central bank policy.1 For a critic it raises the issue that the very notion of ‘reliability’ creates a false confidence: one that might only manifest when qualitative change undermines a period of relative stability. It indicates that the theoretical basis of central bank modelling should be reassessed. A despotic calm is usually the triumph of error. In short. for example. pp. p. However. eliminating rational expectations and removing the stability bias in the BEQM. Jevons. By way of conclusion: ethos and practice The failure of central bank policy has been a theoretical and a practical failure. 6. states: In matters of philosophy and science authority has ever been the great opponent of truth. 1873/2007. For a modeller it would raise the issue of how to reconcile any reconstruction of modelling with ‘reliability’. 1–2) But perhaps verification is the wrong term since the main relevant role of the economist is as seer: taking what has and is happening and seeing where it might lead. understood as producing determinant outcomes (‘answers’). .oxfordjournals. is a very difficult and seldom very neat assessment and verification of these assumptions in terms of observed facts. . we have all an equal right to grope about in our search of it. 2013 Leontieff was amongst the first to recognise this in the modern development of economics: Uncritical enthusiasm for mathematical formulation tends to conceal the ephemeral substantive content of the argument behind the formidable front of algebraic signs . (Leontieff. . has tended to suppress. 8). In doing so that policy has exposed that ‘in exact proportion to the power of this system is its delicacy I should hardly say too much if I said its danger’ (Bagehot. As such. 2006). pp. . This latter point might seem to imply simply adjusting the modelling process: allowing for broad money.. This in turn raises the broader point of the role of the economist and the very nature of economy. 1971. compromises in the form of post-Keynesian approaches to banking analysis (Alves et al. The economist as critic and economics as a broad based set of approaches is something that the theory and practice of economics. It indicates the need for a rethink of the institutional arrangements and division of labour of the central banks. 2008) and central bank policy (Palley. In the republic of the sciences sedition and even anarchy are beneficial . and nobody and no school nor clique must be allowed to set up a standard of orthodoxy that shall bar the freedom of inquiry. As such central bank policy failed the basic test of central banking identified by its first prominent theorist Walter Bagehot. (Jevons.The limits of central bank policy 605 the Fed and the ECB.org/ by guest on December 13. It suggests that a focus on short term interest rates and targeting as a primary policy tool is potentially dangerous. the problem of theory links back into the problem of practice and of institutional arrangements. 260–1) Downloaded from http://cje. What is really needed. and we will hold it as a sacred inviolable thing. It would bring into question the very method and purpose built into modelling. however. Show us the undoubted infallible criterion of absolute truth. . even within the work of those claimed as founding fathers of modern economics.

Part of the problem. accounting and reporting in ways that reduce under-estimation of ‘risk’.. 2009). including the ability to conduct onsite examinations. Modern capitalism has no purpose except to keep the show going . It is the basis of Shiller’s (2008) approach to solving the problems of financial innovation by adding more and better innovation (reducing information asymmetries). Robinson. seems to be the basis of many of the current favoured reform approaches. As many have begun to note. 2013 . Ben Bernanke and a long list of others are all. The general way of thinking also forms the basis of new SEC regulations designed to bring hedge funds under its remit. Tim Geithner. based in a debased form of Berlin’s (1969) concept of negative liberty where the notion of Smith’s (1759/2000) moral gravitation in the form of sentiment has been excised. that regulation must change the nature of the finance system and its relation to the economy. however. . Downloaded from http://cje. It forms the basis of the US Treasury Blueprint for Regulatory Reform. however. run in various directions. Even if the crises that are looming up are overcome and a new run of prosperity lies ahead. However.oxfordjournals. Paul Volker. All three essentially add another layer of regulation to already existing national and state institutions designed to produce coherency through top stage oversight and strategic direction. Morgan practice.1 This. deeper problems will still remain. It would be wrong to simply denigrate key actors in economics and policy as technocrats in some primitive sense.. for example. In this context the question. what is the social welfare benefit of banking and finance. Its main points were: (i) give the Fed greater oversight of non-depository financial institutions. by narrowed specialised knowledge discourses because they are technical areas subject to expertise and particular interests (Moran. 2009). heterodox thinking in more democratic forums is required (Patomaki. from the current point. They are impeded by 1 This. and coordination and communication between oversight bodies in a still liberalised system where the oversight bodies have more rapid response measures to call on in intervening to sterilise and isolate problems. provides an important reminder here: It is easy enough to make models on stated assumptions.org/ by guest on December 13. . They also add some hands-on aspects to Fed powers—including greater direct scrutiny of investment banks and private placement markets for securities. simply endorses the continuing arms race between regulator and the system. New regulation could. . writing in 1970 of the coming crises of that decade. published on 31 March 2008. is that the people advising on this are drawn from the same pool that created the current problems. balances and debate. 2008). . should be one that is directly addressed in thinking about the structure of the system that then needs to be regulated. It has gone hand in hand with a more general capture of areas of political policy that should be subject to broader checks. It should be the duty of economists to do their best to enlighten the public about the economic aspects of these menacing problems.606 J. The difficulty is to find the assumptions that are relevant to reality . It provides the basis of much of the discussion by the Financial Stability Forum through the IMF to provide a more effective global early warning system (2008). It is the basis of the Centre for Economic Policy Report (CEPR) approach to standardising securities trading through central clearing houses (Brunnermeier et al. which is essentially based on improving transparency. Larry Summers. This may result in a quite different context in which a central bank would operate. It could involve greater degrees of oversight. financial innovation has also been social innovation and social transformation (Engelen et al. (iii) establish a Mortgage Origination Commission (MOC) to regulate home loans on a national basis. products of economics training and an institutional socialisation that is an impediment rather than an aid to new thinking. (ii) make the Fed primarily responsible for financial market stability. An alternative would be to rethink the very basis of banking and finance. presupposes a balance of regulation based on an underlying continuation of the ethos of the system as is—the ethos where whatever is not formally prevented is allowed. Mervyn King. One of the main outcomes of the current crisis is the acknowledgement by policy makers that new thinking is required. in various ways. 2007). This ethos. More broadly. It also requires a more pluralistic forum for debate regarding how the whole economy is structured in a way that modern macroeconomics does not capture.

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