In a traditional recession, a central bank such as the US Federal Reserve (the Fed) may overshoot its targets in overreaction to rising inflation. This can bring a healthy economy into an ordinary recession. Traditional monetary instruments such as decreasing the discount rate, reducing the reserve requirement and/or following expansionary open market operations that entail buying government securities by the central bank may be good enough to bring the economy out of this recession. But the 2007-2009 Great Recession is a major crisis and is not a traditional recession. This brings up the question of whether the traditional tools are good enough to deal with a major crisis such as the Great Recession.
The Great Recession has proven that these instruments should be supplemented by nontraditional tools which have become known as quantitative easing.[i] But using quantitative easing in a liquidity trap was not good enough to deal with the entire problems that put forth by the Great recession. Fiscal policy has also been used but this time-consuming, lagging policy could not successfully focus on specific targets, and it also brought up the budget deficit and public debt into unprecedented levels for many years to come.
Olivier Blanchard, the IMF chief economist, and others have raised these questions.[ii] In a recent paper that deals with the post crisis issues, Blanchard contends that macroeconomic policy should expand its domain to include more than its traditional grand goals of economic growth, full employment and price stability. It should include new targets such as leverage, liquidity, housing bubbles and stock market exuberance. But this in turn brings up the subject of what new regulatory tools that can effectively deal with those post crisis targets. The new tools include the required capital requirement that deals with the financial institutions’ leverage, the margin requirement that regulates buying and selling stocks and derivatives on borrowed money, the liquidity ratios that address banks’ liquidity and solvency, and the loan-to value ratio that can detect housing bubbles and underwater houses. But again, this in turn raises another question which is: what’s appropriate institutional framework that can effectively target the new issues at the macroeconomic level? The answer hinges on whether to have more separation or more coordination between the monetary and regulatory authorities as raised by Blanchard.
As we have witnessed, if an economy is overheating, leverage is high, liquidity is excessive, stock market is grossly overvalued, and housing market is bubbling, then raising interest rate alone is not likely to do multifaceted tasks. It could dampen economic activity. But if business’s balance sheets have holes in them or carry toxic assets, banks are over-stretched and the houses and stock markets are bubbling and overvalued, then in addition to interest rate such an economy needs other regulatory tools that can directly target the holes, the housing bubbles, the stock market-overvaluations and delivery the medicine to the holes, the toxic assets, the bubbles and overvaluations. Can this be done by coordination at the macroeconomic level between several separated monetary and regulatory authorities? Separate regulatory authorities may not be able to work at the macro level. On the other hand, In terms of a major crisis one authority that has supervision of the macroeconomy may or may not be able to handle the crisis as well as needed. If this option is possible, then the authority should be the monetary authority with expanded regulatory and supervisory divisions. If this reform turns out to be an overwhelming task for the expanded monetary authority to do, then an expanded board of governors headed by the chief of the central bank can be formed to include governors from the central bank, security and exchange commission, housing authorities, deposit guarantee commission and others. The Board should meet monthly or quarterly to coordinate the tasks of all the monetary and regulatory authorities and deal with the traditional and new issues that may be looming and leading to a new crisis. Such a reform will require massive changes in the existing laws and bylaws.
The recent experience has shown that the separation of authorities is the worst option to deal with a major crisis which could happen again in the near future. Massive financial and regulatory reforms are now due.
[ii] O. Blanchard, G. Dell’Ariccia, and P. Mauro (2010).“Rethinking Macroeconomic Policy,” SPN/10/03. http://www.imf.org/external/pubs/ft/spn/2010/spn1003.pdf
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