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Symposium 2015

Solution for Monetary Policy - Lessons Learned from the Crisis and the Post-Crisis Period

The Challenge

With the onset of the Financial Crisis 2008 many central banks worldwide considerably eased their monetary policies. Some central banks, like the Federal Reserve, the European Central Bank, and the Ba ...

With the onset of the Financial Crisis 2008 many central banks worldwide considerably eased their monetary policies. Some central banks, like the Federal Reserve, the European Central Bank, and the Bank of England, quickly reached the zero-lower-bound on nominal interest rates; these central banks then started conducting extraordinary measures like quantitative easing and forward guidance. There is some consensus that this massive monetary stimulus in the first, ‘acute’, phase of the crisis was largely appropriate, preventing a second Great Depression. However, since then, discussion has turned toward how long monetary policy should remain highly expansionary, because of doubts about the effectiveness of expansionary monetary policy in the aftermath of banking crises. Moreover, expansionary monetary policy over a long period of time might be associated with adverse side effects such as financial instability, asset price bubbles, slower structural adjustment, distorted investment decisions, and inflation.

The Age of Financial Repression

Almost all Western nations are implementing or have plans to implement policies aimed at reducing or at the very least stopping the increase of their national debts. The main argument for those policies is the fact that the national debt in many Western nations in dangerously near or even above the threshold of 90 percent of GDP. Unpopularity of large enough cuts in government spending and tax increases, in combination with low economic growth for a considerable period of time, has started to lead politicians in many Western nations to turn to “solutions” that we long ago decided were not very good policies. Many of those can be put together under the financial repression umbrella. We speak of financial repression when governments implement policies that aim to channel funds towards the government where those funds would flow to other assets if government policies were absent. For example, many governments have enacted laws and regulations that give a nudge to financial companies to invest more money in debt of the government of their domicile. Take, for example, the so-called Basel III regulation, on increasing financial buffers at banks. Among other things, Basel III regulation stipulates that banks do not have to set cash aside against their investments in government bonds with ratings of AA– or higher. If they invest in government bond of their domicile countries, there is no need for buffers, even if the rating is lower.

Another form of financial repression is conducted by Western central banks by making sure the real interest rates are negative. In the euro area, the ECB’s policy rate stands now at 0,05 percent, while the average inflation was since the start of the financial crisis in 2008 above 2 percent and only recently dropping but still positive. It is not only the short-term real rates that are negative. Because the Fed, the ECB and the BoE, among other central banks, have ventured or are to venture into capital markets as well, via quantitative easing or the ECB version thereof, the expanded asset purchase programs, even the long-term real interest rates are negative.

All of this falls into the category “soft financial repression” because banks in this case are only nudged, not made to invest in government debt. There is also the hard version of financial repression. Some governments, for example, demand from financial institutions in their countries to increase their holdings of government debt or in any case not to lower their holdings.

For a long time, direct or indirect monetary financing of budget deficits ranked among the most serious and damaging offences a central bank can do. Quantitative easing and ECB’s expanded asset purchase programs are just fancy new names for direct and indirect monetary financing. Long time ago, monetary scholars have determined, based on experiences, that monetary financing is a bad policy, because it inflicts more harm than good in the medium and long term. There is absolutely no reason to expect that this time will be different. The fact that central banks in the West engage in monetary financing, says a lot about the real degree of their independence from their governments. Those policies in combination with Basel III regulations and the fact that all of them are of long-term nature, mean that financial repression is only set to get even worse and in any case will define the economic landscape for at least a decade.

The only solution for mitigating financial repression is changing the Basel III regulations in such a way that the preferred treatment of government bonds will be diminished. The banks will then not be forced to invest in government debt and could play their role again in financing SMEs and other companies. Furthermore, central banks like the Fed, the ECB and BoE should be very careful with direct or indirect monetary financing of budget deficits because they take away the incentives for governments to implement the necessary structural reforms in the labor and product markets.

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