What Monetary Policy after the Crisis?

Abstract

The objective of this paper is to reflect on some of the implications that recent economic experience has for monetary and financial stability policies. We contend that the financial crisis and the upsurge in inflation 2007–08 have shown that the policy model based on the new consensus in macroeconomics, which largely held sway over the past decade or more, is broken. It is argued that inflation targeting cannot deliver low inflation. We argue that fine-tuning through interest rates should not be attempted, but rather a constant real interest rate target based on the output growth rate should be adopted. The key objective of monetary policy should be shifted to financial stability, the independence of central banks should be brought to an end, and their decision making should be coordinated with other macroeconomic policy initiatives.

Acknowledgments

The authors are grateful to two anonymous referees, and to Mark Setterfield and Steve Pressman, for comments on an earlier draft.

Notes

¹We examine the role of fiscal policy in a similar context in Arestis & Sawyer (2006b, 2010a), and we provide a more extensive discussion of macroeconomic policy in Arestis & Sawyer (2010b).

²Signals such as the sharp rise in the LIBOR and Northern Rock's difficulties that resulted in the first run in over a century on a UK bank can be dated to August 2007, though there could be said to have been some still earlier signs.

³Greenspan (2008), speaking in October 2008, stated that ‘We are in the midst of a once-in-a century credit tsunami’.

⁴In the case of the UK, the current forecasts for GDP in 2009 indicate the largest year-on-year fall in output since around 1930. It is not possible to recall a financial crisis involving bank runs and partial nationalisation of financial corporations on the current scale.

⁵For example, according to Brown (2002): ‘That is why since 1997 we have rejected short-termist free for alls—the take-what-you-can irresponsibility—and have put faith in our values of economic responsibility, building from solid foundations and looking to the long term. With Bank of England independence, tough decisions on inflation, new fiscal rules, and hard public spending controls, we today in our country have economic stability not boom and bust, the lowest inflation in Europe, and long term interest rates—essential for businesses planning to borrow and invest—lower than for thirty five years. There will be no return to the short-term lurches in policy that would put long-term stability at risk. No relaxing our fiscal disciplines as some would like.’

⁶See also Ball & Sheridan (2005); Seccareccia & Lavoie (2010).

⁷John Cornwall, in contrast, viewed those arguing for independent central banks as ‘arguing for stronger anti-inflation policies and therefore, in effect, for greater unemployment, while either ignoring the real costs of their policies or maintaining there are none’ (Cornwall & Cornwall, 1998, p. 63).

⁸Available at http://www.opsi.gov.uk/acts/acts2009/ukpga_20090001_en_1

⁹Committee on Banking and Financial Services, US House of Representatives, July 22, 1999.