Aurora Borealis
1 September 2014 CFA Institute Journal Review

Monetary Policy and the Twin Crises (Digest Summary)

  1. Michal Szudejko

The author discusses the monetary policies of the United States, the euro area, and the United Kingdom before, during, and after recent financial crises. He maintains, based on historical evidence, that correlations between the volatility in output, inflation, and monetary growth are strong and positive. Therefore, growth in the monetary base observed in the past few years in the three regions may turn out to be anything but beneficial to the economy.

What’s Inside?

The author begins with a summary analysis of recent financial turmoil and a discussion of the role of monetary policies in the euro area, the United Kingdom, and the United States prior to, during, and after crises. He concludes that erratic behavior of the monetary base destabilizes the real economy. Variability in money is parallel to variability in GDP. This observation justifies a conclusion that central banks cannot take on policy that pursues several goals at the same time. The author also recommends that the eurozone introduce a balancing method similar to the gold-standard mechanism. The mechanism would allow for the management of reserves among countries and prevent an unbalanced flow of capital across the currency zone.

How Is This Research Useful to Practitioners?

The author’s focus regarding the recent financial crises is on the relationship between monetary policy and the real economy in the period surrounding the downturn.

He presents a short outline of the crises in both the United States and Europe, with particular stress on the role of monetary authorities before, during, and after the crisis situations. Although the crises were related across the globe, they each had different local drivers. In the United States, these drivers were the housing market bubble and increased uncertainty. In the eurozone, it was incompleteness of the project of establishing a single currency. The principal problem was investors’ belief that the implementation of a single currency evened out risk levels among countries, which drove them to excessive allocation of portfolios in the instruments issued by countries that were soon to be troubled. The unprecedented inflow of funds resulting from mispriced sovereign risk allowed governments to postpone necessary budget reforms. The author maintains that there was no balancing mechanism built into the single-currency mechanism that would prevent such dispersion, transfer funds from countries with current account deficits to those with surpluses, and level out economic growth rates.

Another problem concerns the monetary policies in the post-crisis period. These policies led to historically high monetary base levels in spite of warnings of potential inflationary pressures and further disruptions to the financial markets. There is currently no compensating effect for the monetary base and its flow into the real economy, which can partly be attributed to the fact that commercial banks did not transfer these additional funds to the market. Instead, they kept additional liquidity on reserve, which may be because of interest paid by central banks but also because of the high levels of uncertainty.

The author provides further insight into the background of the recent financial crises. The most important contribution rests on his analysis from the perspective of monetary policymaking. Hence, the research is most interesting to central bankers and academics who focus on monetary policy.

How Did the Author Conduct This Research?

The author’s conclusions are backed by his analysis of historical data. In particular, he looks for patterns in the relationship between output, price level, and monetary volatilities. To measure monetary policy, the author uses ex post real policy rates and two monetary aggregates (i.e., the monetary base and a broader definition of money). Long-term data patterns for the United States, the United Kingdom, and continental Europe (exemplified by the Netherlands) show a positive relationship between output and inflation volatility. In particular, the author sees no potential for reverse causation in this relationship. Thus, the variability in money has only a parallel, not a magnifying, effect on volatility in the GDP levels.

Empirical evidence shows that both before and after the crisis, there was no problem with lack of liquidity. Instead, it was the uncertainty that provided significant imbalance in the way this liquidity was distributed. Another issue that became one of the negative factors was the short-termism of monetary policy in the wake of the crisis. Moreover, monetary policy did not help to make rational assessments of risk levels in the United States or Europe. In the case of the United States, this issue was related to a particular asset. In Europe, the single currency blurred the risk levels of different countries.

Abstractor’s Viewpoint

The author provides an interesting viewpoint on the financial crisis. His research is not typical scientific analysis but rather a discussion that presents several issues that could be transformed into quantitative research. The author makes several observations based on historical data and puts the conclusions in the time frame of recent financial turmoil. The most important question brought forward is, Why did monetary policymakers not produce similar analyses? I assess the research’s value as very high, from both a practical and a theoretical perspective.

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