Aurora Borealis
1 September 2014 CFA Institute Journal Review

Monetary Policy in a Downturn: Are Financial Crises Special? (Digest Summary)

  1. Martin A. Wildy, CFA

In examining the effectiveness of monetary policy following economic downturns, the authors evaluate how it affects subsequent economic growth. They determine that accommodative policy is less effective when the downturn is associated with a financial crisis because the monetary system is not operating normally.

What’s Inside?

The authors evaluate economic downturns and subsequent recoveries, focusing specifically on the effectiveness of monetary policy in aiding economic recoveries. Easy monetary policy during “normal” economic downturns (i.e., those not accompanied by a financial crisis) results in stronger recoveries. After downturns that include a financial crisis, accommodative monetary policy is not shown to improve subsequent economic growth. The authors conclude that deleveraging is a more important contributor to recovery than monetary policy following a financial crisis.

How Is This Research Useful to Practitioners?

The authors examine economic downturns in 24 developed countries over a period of 56 years. Downturns associated with financial crises are found to be more severe and to last longer. In downturns without a financial crisis, the average real GDP loss is 1.9% and the average length is 3.8 years. In downturns with a financial crisis, the loss is 8.2% over a period of 5.1 years.

For normal downturns, accommodative monetary policy is positively associated with higher average GDP growth during the recovery. For downturns associated with a financial crisis, a statistically significant relationship does not exist. The authors also find that fiscal policy does not significantly affect the strength of the recovery. Their findings indicate that accommodative monetary policy diminishes over time after a crisis. Therefore, prolonging accommodative policy could delay healthy balance sheet adjustments and economic recovery. The available sample size limits their ability to draw absolute conclusions in this regard.

During a normal downturn, deleveraging is not found to produce significant benefits for the recovery because debt is not excessive and the ability to borrow and invest advantageously could result in profitable capital projects. But deleveraging during a financial crisis is highly correlated with the strength of the recovery. The authors find that during financial crises, a 10% decrease in the debt-to-GDP ratio corresponds to a 0.6% increase in average output during the recovery. As a result, they suggest that policymakers focus on aiding balance sheet repair and private sector deleveraging, although no specific suggestions are provided.

This research is relevant to those interested in the historical analysis of financial crises. It would also be of interest to policymakers, economists, and those who follow the decisions of central banks.

How Did the Authors Conduct This Research?

To conduct their research, the authors use a sample of 24 developed countries and review economic cycle data for the period of 1960–2016 (forward forecasts from the OECD’s Economic Outlook are used to extend the sample period). Downturns are defined as one or more years of negative real GDP growth. Recovery is defined as the period from the trough to when real GDP recovers to its previous peak. Monetary policy stance is defined as the difference between the real policy rate and the natural interest rate (the rate at which real GDP is growing at its trend rate).

To identify a financial crisis, the authors rely on the research of others, including Reinhart and Rogoff (This Time Is Different, 2009). A financial crisis is associated with a downturn when the latter occurs during the recession or the two years proceeding. Their sample size of 78 downturns and 34 financial crises is relatively small, which is not unexpected when conducting research on economic cycles and financial crises. The appendix includes an interesting visual representation of economic growth for each country and its cycles.

In their robustness tests, the authors control for fiscal policy, exchange rate movements, economic conditions abroad, and the role of deleveraging. They find no reason to change their results based on these tests. They acknowledge that, given the complex nature of economic systems, there may be other important factors, including expectations for the future state of the economy, which are not controlled for.

Abstractor’s Viewpoint

Research that increases our awareness of financial crises warrants attention. The authors focus on monetary policy and conclude that when an economic downturn is accompanied by a financial crisis, monetary policy is not effective in stimulating future growth. If it is not effective, it is reasonable to ask what a better response might be. The authors suggest that policies to facilitate balance sheet repair may help but offer no specifics. They also hypothesize that downturns could be deeper without accommodative monetary policy, and I would like to see this relationship quantified. Additional research to determine which policies best aid balance sheet repair may also help improve future responses.

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