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10-Year retrospective: Lesson 1

The first in a series on lessons of the global financial crisis

The financial crisis showed up the defects of monetary models. These in turn reflected a flawed idea of money. That is why central banks failed to anticipate the crisis and could not deal with it effectively when it arrived. That is the message of The Money Trap.

The lead-up to the crisis was marked by the near-universal adoption of inflation targeting. This became sacrosanct as the framework for monetary policy ( implicit in the case of the Federal Reserve). It became the nearest we had to a global monetary standard.  The first lessons of the crisis is that this model was deeply deceptive.

Governments and the public fell for the money trap. Here’s six reasons why:

Firstly, rapid globalisation, from the mid-1990s on. This was marked by the introduction of flexible supply chains and technological innovation. These  placed downward pressure on  consumer prices. Against this background, a monetary policy committed to delivering sustained inflation had to battle against the natural tendency towards lower consumer prices.  Money was created in an efffort to spur price inflation. Instead, it found an outlet in asset prices.

This set the scene for a sequence of booms and busts, as in 1997-2001, 2003-07 and the vast asset price bubbles of 2010-on.

Secondly, the narrow focus on consumer price mandates. This led central banks to pay little attention to evidence that low rates might be undermining financial stability.  The minutes of the Fed’s Federal Open Market Committee reveal little evidence of concern with growing turmoil in financial markets.

As the experienced observer, Anthony Elson, concludes: “a regime of inflation targeting was inadequate in that it essentially ignored the potential problem of systemic financial risk” (The Global Financial Crisis in Retrospect:Evolution, Resolution, and Lessons for Prevention)

And more damningly:

“Rarely, if ever, were representatives from the bank regulatory side of the Fed’s operations asked to speak or comment on potential financial risks in the economy.”

Thirdly, unrealistic assumptions. A great deal of information about, and accurate assessment of, variables such as “the output gap”  and the neutral level of interest rates is needed for an inflation targeting policy to be implemented. Such information was not available.

Fourthly, the role of the US dollar. At a time when the monetary domain of the US dollar still dominated global finance, other countries and central banks had to adapt to Fed policy. If its policies depreciated the dollar, others had to watch their exchange rates rise or follow more expansionary policies themselves. In a globalised finance system, with freee capital movements, that was a recipe for destabilising cross-border capital flows and exchange rate volatility.

Fifthly, neglect of money. The monetary models that led to the financil crisis largely ignored money, credit and banking.

Sixthly, central banks held interest rates down and kept them there. This “too low for too long” bias produced bad investment decisions, kept “zombie” companies (who would otherwise go bankrupt) in existence, raised uncertainty and stimulated a search for yield in high-risk investments.

The result? Society remained firmly stuck in the money trap.

That is why policy regimes since the financial crisis not only failed in the basic task of providing reliable money but have again tricked people into making imprudent investment and savings decisions. People are angry. But do not know the real cause or where to direct their rage.

In Britain, the results include Brexit

We shall be living with the consequences for many years to come.

Many developed economes have suffered a long-term growth slowdown as a result of the crisis.

Britain is particularly badly affected. As former Chancellor Alistair Darling has now recognised, these results include the vote for Brexit.

The crisis showed the assumptions that had governed monetary policy-making pre crisis were flawed.

We have not learnt the lessons. It is easy to pin all the blame the central bankers. They must take their share of responsibility. However, society as a whole has failed to rise to the challenge. The challenge is to understand the nature of The Money Trap.

In my book and on this blog I have tried to explain what has really gone wrong – as in this note .