Financial Economics – Policy Responses to the Global Financial Crises
The credit crunch and the collapse of Lehman led to a steep fall in global real output and an even bigger decline in the volume of world trade. There were well-founded fears that the world economy was at risk of another depression similar to the 1930s.
Macroeconomic policy in many countries responded:
- Large conventional/unconventional monetary easing involving deep cuts in policy interest rates and quantitative easing
- Massive fiscal stimulus for a while – especially in China and (to a lesser extent) in the USA
- Backstop and bailout of the private sector (financial system, households, corporations) – including (in the UK) bail-outs and nationalisation of some banks
Side-Effects of the Macro Policy Response Post 2008
Ultra-low interest rates and quantitative easing:
- Surge in demand for assets – rising house prices (again)
- Increase in demand for commodities
- Limited reductions in private sector debt
- Continued survival of zombie businesses
- Issues about how and when to exit from QE and near-zero interest rates – dependency on low interest rates?
Big rise in fiscal deficits and national debt
- How and how fast to reduce fiscal deficits and debts that may be unsustainable?
- How to deal with the moral hazard that bailouts of the financial system may have induced?
- Decisions on when/whether to reverse nationalisation
Keynesian v Austrian Perspectives on Policy Response
- Provide a strong monetary & fiscal stimulus – public sector spending needed when private sector demand is weak
- Focus in particular on labour-intensive infrastructure projects with a potentially high fiscal multiplier effect
- Bailout the private sector to prevent catastrophic job losses
- Key is to support animal spirits and prevent a collapse in demand
- Avoid bail-outs as they lead to moral hazard and the survival of zombie businesses which ultimately constrains long run growth
- Fast-forward structural economic / market reforms to promote competition and raise productivity
- Against counter-cyclical macro stimulus – especially ultra-low interest rates as this “distorts” the allocation of capital
Strategies for Avoiding Future Financial Crises
- Floating exchange rates rather than fixed ones that could collapse
- Build up foreign currency reserves to avoid liquidity runs on banks
- Better regulated banks and financial systems
- Take steps to reduce public and private sector debt to reduce solvency risks
- Structural reforms to improve competitiveness of real economy