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Keywords: monetary policy, new monetary consensus, global financial crisis, central banking

JEL classification: E50, E52, E58, E66, G01

Introduction:

The 2007-2010 Global Financial Crisis has reshuffled the cards for central banks throughout

the world. In the wake of the biggest crisis since the Great Depression, we examine the

evolution of modern central banking since the inflationary chaos of the 1970s and the

controversial monetarist experiments of the 1980s leading to the New Monetary Consensus

that took shape in the 1990s and that prevailed until 2007. We then review the limitations

placed on monetary policy in the aftermath of the global meltdown in order to show that the

global financial crisis has shattered the consensus on monetary policy. Finally, we address a

few unavoidable issues for central banks in a post-crisis scenario.

1) The inflationary chaos in the 1970s and the monetarist revolution

a) The shortcomings of macroeconomic policies in the 1960s

Prior to the late 1970s, monetary policy was encapsulated in a surprisingly reductive

dialectic between unemployment and inflation, notably symbolized by the go-stop policies

and the Phillips curve. The economy was stimulated by low interest rates in the go-phase until

overheating inevitably gave rise to inflationary pressures and triggered the stop-phase

characterized by a restrictive monetary stance. Goodfriend (2005) argues that households

(price-takers) were in fact incorporating monetary stimuli by making inflationary wage-claims

in the go-phase while firms (price-setters) were simultaneously raising prices above the

equilibrium level of the previous phase thereby negating the policy change. This learning

curve had far-reaching consequences in the bond market where lenders espoused the business

cycle by requiring additional inflation premia (ibid). This resulted in increased volatility of

both output and inflation, which rendered monetary policy ineffective.

While policy-makers were accustomed to allowing inflation to drift temporarily

throughout the stop-and-go policy era in the hope that it would help bring down

unemployment, monetarist economists under the aegis of Milton Friedman (Goodfriend,

2007) gained prominence in the 1970s. They argued that a short run Phillips Curve existed but

that in the long run, its shape was vertical meaning that there was no trade-off between

unemployment and inflation. In the long run, only a single rate of unemployment (the NAIRU

or "natural" rate) was thus consistent with a stable inflation rate.

b) The inflationary chaos and the Keynesian retreat in the 1970s

In the 1960s, productivity began to slow in the U.S., inflation began to rise, and profits

began to fall (Bowles, Gordon, and Weisskopf 1990). The Philips curve was further discarded

in the 1970s when many countries simultaneously experienced high levels of inflation and

unemployment with U.S. prime interest rates soaring into the double-digits. While the precise

impact of the two oil shocks on the great stagflation of the 1970s is still a matter of scholarly

dispute (Barsky & Kilian, 2000), the two OPEC-induced oil shocks that occurred in 1973 and

1979-1980 undoubtedly symbolize to date the retreat of Keynesian ideas

Keynesian remedies to inflation proved ineffective during the 1970s and irremediably

undermined the faith in stop-and-go policies. In the light of this failure, orthodox theories

emerged stronger than ever. The debate in academia started to focus anew on the

microeconomic foundations of macroeconomics (requiring an increasingly high level of

mathematical formalism) and paved the way for the monetarist revolution of the 1980s. The

decline of Keynesian ideas led to a new stage of capitalist development – also known as

neoliberalism – wherein economic policy was premised on the belief that unregulated markets

were the most efficient form of economic organization, maximizing productivity and welfare.

c) The demise of the Bretton Woods exchange-rate system

The shortcomings of the macroeconomic policies of the 1960s were further aggravated

in 1971 by the demise of the Bretton Woods exchange-rate system that had prevailed

throughout the post-war period. By the late 1960s, it had become clear that the USA would

be unable to honor the gold convertibility of the dollar in the case of a run on US gold

emanating from export-led growth countries that had accumulated considerable dollar

reserves in the post-war period. President Nixon anticipated the crisis and suspended

convertibility in 1971. This decision put an end to the Bretton Woods system of fixed

exchange rates and gave birth to a new era of floating exchange rates wherein “the main

currencies float[ed] and crush[ed] against each other like continental plates” (Soros 1997:48).

The dollar fluctuated widely from the 1970s onwards. Increasing exchange-rate risk started to

be hedged by exponentially rising transnational corporations that neutralized those

fluctuations through well-designed and sophisticated hedging strategies (Watson and Head,

2006) both internally with matching, netting, leading and lagging techniques, and externally

on eurocurrency markets and with over-the-counter derivatives (options, futures, swaps…).

d) The monetarist years (Reagan –Thatcher)

Monetarism is a school of thought that gained popularity in the late 1960s and 1970s

by emphasizing the primary importance of the money supply in determining nominal GDP

and the price level. Federal Reserve chairman Paul Volcker arrived in August 1979 and

rapidly endorsed the monetarist credo by putting money supply growth at the heart of

monetary policy. He very sharply increased interest rates from 1979-1983 in a famous

disinflationary scenario. After U.S. prime interest rates had soared into the double-digits,

inflation was eventually brought down to 4% in 1984. Under Volcker, the federal funds rate,

which had averaged 11.2% in 1979, was raised to a peak of 20% in June 1981 while the prime

rate rose to 21.5% the same year. The victory over inflation came at a high cost. The

superimposition of monetary tightening and credit controls caused real GDP to decline at a

staggering 10 percent in the second quarter of 1980. In the aftermath of two banking

deregulation Acts in 1982, the development of “quasi-money” deposits and other financial

innovation made it difficult for central banks to measure accurately the increasingly volatile

monetary aggregates. Money supply targeting as the principal objective of US monetary

policy was therefore abandoned in 1982. Keynesian policies were reinstated in 1983 through

both fiscal stimulus and money supply growth. The British economy wholeheartedly adopted

the monetarist stance under Margaret Thatcher. Although inflation came down, it was at the

price of rising unemployment, which soared from 5.4 to 11.8 percent.

The British economy logically sank into a deep recession. Between 1979 and 1984,

manufacturing output fell 10 percent, and manufacturing investment fell 30 percent.

Eventually production recovered to a respectable 2.8 percent growth. However, the Bank of

England came under pressure to abandon monetarism in 1986.

2) The new mantras of the 90s:

transparency, price stability, credibility and inflation targeting

Following the inconclusive monetarist experiment of the 1980s, price stability and low

inflation, rather than strict money-supply control, came to be viewed among both academics

and practitioners as the most appropriate long-run objective for monetary policy.

The feasibility of monetary targeting was hampered in the 1980s by bank deregulation1

(Guttman, 2008,pp 5-6) but was also theoretically challenged by post-Keynesian endogenous

money theorists such as Moore, Kaldor or Davidson who rejected the money multiplier2

postulating a causation running from money aggregates to prices, inspired by the quantity

theory of money. These economists argued with steadfast consistency that money was indeed

credit-driven and demand-determined. As a consequence, money-supply targets were

progressively abandoned3. However, as long as the Rational Expectations School and real

business cycle theory (curiously compatible with endogenous money) reigned supreme in

academia in the 1980s, macroeconomic models were often devoid of any role for monetary

policy (Taylor, 2007). However, what emerged in the 1990s was a new regime of central

banking leading to a widespread monetary consensus whose modus operandi consisted of

fine-tuning interest-rate setting policies driven by more or less explicit inflation-targets.

We review briefly the mantras that form the bedrock of this new monetary consensus (NMC):

a) Transparency

For Dincer and Eichengreen (2007, p.1), “[t]he transparency with which central banks

go about their business is the most dramatic difference between central banking now and

central banking in earlier historical periods”. As Geraats (2002, p.1) states, “[c]entral bank

transparency could be defined as the absence of asymmetric information between monetary

policymakers and other economic agents”. Transparency may apply to policy objectives,

outlooks and strategies. The NMC promotes the widely shared view that transparency enables

effective communication with the market thereby ensuring stabilizing macroeconomic

effects4. The effective management of expectations

5 is key to understanding how economic

outcomes are potentially influenced by central banks.

1 See the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St Germain

Depository Institutions Act of 1982 2 Interestingly enough, the Federal Reserve of New York has not dismissed the existence of the money

multiplier. Instead, it explains the abandonment of money-supply targeting by the rise of financial markets:

“[p]rior to 1980, the monetary policy literature primarily focused on the role of monetary aggregates in the

supply of credit. However, with the emergence of the market-based financial system, the ratio of high-powered

money to total credit (the money multiplier) became highly unstable. As a consequence, monetary aggregates

faded from both the policy debate and the monetary policy literature (Adrian & Song shin, 2010, p.27). 3 Although their proponents have rarely referred to post-Keynesian economics, it is apparent that the NMC

departs from monetarism for they include no reference to any monetary aggregate” (Taylor 2001: 145).

Implicitly, this was an admission of the endogenous nature of money: “the interest rate instrument can affect the

amount of money, which is endogenous (Allsopp and Vines, 2000, p.7)”. However, the Bundesbank-inspired

European Central Bank still publishes, to date, a desired growth range for M3 4 A landmark survey of 94 central banks was conducted by Fry, Julius, Mahadeva, Roger and Sterne (2000) and

revealed that three quarters of central banks under scrutiny considered transparency as a vital or very important

component of monetary policy.

Geraats (2000) cogently distinguishes between five types of central bank transparency:

1. Political transparency refers to openness about policy objectives and institutional arrangements

2. Economic transparency focuses on the disclosure of information (data, models, forecasts...)

3. Procedural transparency refers to the decision-making process of the central bank.

4. Policy transparency refers to the communication of the central bank (annoucement, explanation of

policy decisions and future policy inclinations).

5. Operational transparency concerns the implementation and the follow-up of monetary policy

actions (monitoring and supervision of the transmission channel)

Transparency was not of paramount importance under the gold standard whose demise

paved the way for “the spread of modern central banking” (Dincer & Eichengreen, 2009).

Goodfriend (2007, p.60) argues that central banks had little incentive to be transparent under

the gold standard as monetary policy merely consisted of maintaining a fixed currency price

of gold. The chaotic decade that ensued was characterized by little transparency mostly due to

the somewhat embryonic policy reflection of central bankers in a world wherein currencies

were totally delinked from gold: “central banks remained secretive after the gold standard

collapsed, in part out of habit and in part because they lacked a coherent monetary policy

strategy within which they could communicate productively (Goodfriend, 2007, p.60)”.

Another argument for transparency is democratic accountability. The need for the latter was

reinforced by the growing trend toward central bank independence. However, accountability

and transparency are not synonyms6 as shown by Geraats (2002, p.25): “[t]ransparency

refers to mere information disclosure, but accountability also involves bearing responsibility

for monetary policy actions and possibly facing repercussions when policy appears deficient.”

b) Price stability

This may be termed as the single most important priority of the NMC as well as the

primary, if not exclusive, mandate of central banks (Meyer 2001). However, any coherent

policy discourse on price stability must rest on an underlying framework of price-formation.

It is usually assumed that the capitalist sytem is composed of monopolistically profit-

maximizing firms that set prices at a markup over the marginal cost that is determined both by

market-power sustainability and productivity factors. It ensues that low inflation and price

stability are achieved by means of aggregate demand management policies. Short-term

interest rates have thus become the key instrument to achieve price stability under the new

consensus. Moreover, the underlying logic of interest-rate setting decisions has come to be

embedded in a powerful theoretical apparatus known as the Taylor rule (1993).

5 Barro-Gordon (1983) had already proposed a model in which wage-setters were influenced by expected future

monetary policy. 6 The literature on central banking (Briault, Haldane and King, 1997; Eijffinger, Hoeberichts and Schaling, 2000) has

thoroughly explored the link between these two concepts.

The latter rule states that the "real" short-term interest rate (that is, the interest rate

adjusted for inflation) should be determined according to: (1) where actual inflation is relative

to the targeted level i.e the desired level (the inflation gap), (2) how far economic activity is

above or below its "full employment" level (the output gap), and (3) a short-term interest rate

consistent with a NAIRU-like unemployment rate.

Although the Fed never explicitly followed any official rule under the new consensus,

empirical analyses have shown that US monetary policy was well described by the Taylor

rule. Many economists have argued that this successfully accounted for low inflation and

price stability under Alan Greenspan‟s mandate at the Fed.

c) Credibility

Credibility “concerns people‟s beliefs about what policymakers will do in the future”

(Gomme, 2006) and might be viewed as the coping stone of the new consensus. Credibility-

building strategies of central banks thereunder have depended on many factors such as

transparency (i.e the five types thereof), independence and past history of inflation.

As previously stated, central to the new consensus are low inflation and price stability.

Credibility ensures effective monetary policy in several ways. First of all, in order to

overcome the time-inconsistency problem (Prescott & Kydland, 1977), central bankers are

inclined to “develop a reputation for credibility recognizing that the long-term benefits of

having reputation exceed the short-run costs (Gomme, 2006)”. Secondly, credibility arguably

puts an end to the high volatility of both output and inflation that was the hallmark of stop-

and-go policies in the 1960s (Taylor, 1979). This period of reduced volatility is often referred

to as the Great Moderation (Gali and Gambetti, 2009) in the literature. Thirdly, credibility

enables the successful management of inflation expectations7, which is of paramount

importance in ensuring the effectiveness of aggregate demand management policies. Fourthly,

in the absence of any exogenous macroeconomic shock, current price-setting policies will be

anchored to the inflation target.

Credibility has also been modelled with the help of econometric techniques. For

instance, Ruge-Murcia (1995) has developed a rational expectations model of inflation

wherein the dynamics are driven by government expenditure and the impact of past inflation

rates on the value of real taxes. However, in a groundbreaking survey of academics, Blinder

(2000) underlined both the complexity and the need for thorough measures: “in a word,

credibility matters in theory, and it is certainly believed to matter in practice— although

empirical evidence on this point is hard to come by because credibility is not easy to

measure” (Blinder 2000, p.1421). In fact, the econometric standpoint raises the very issue of

the polysemous meaning of credibility. The latter concept and the field of econometrics are

often intertwined insofar as “„credibility‟ has become associated with certain features of the

formal models that now fill much of the monetary economics literature” (Forder, 2004).

7 "Any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards to inflation expectations (Fed chairman Bernanke’s January 10, 2008 speech at the Women in Housing and Finance and Exchequer Club Joint Luncheon in Washington, DC)."

d) Inflation targeting

The defining features of the monetary consensus that prevailed throughout the

Greenspan era come under the umbrella term known as inflation targeting. In a widely

acclaimed article published in the Journal of Economic Perspectives, Mishkin and Bernanke

(1997) clarified the scope and outlined the salient features of this new monetary regime,

which became the focal point of monetary policy in the late 1990s. Inflation-targeting regimes

are best characterized “by the announcement of official target ranges for the inflation rate at

one or more horizons, and by explicit acknowledgment that low and stable inflation is the

overriding goal of monetary policy (ibid, p.97)”. Since the pioneering policy shift made by

New Zealand in 1989, the number of countries joining the ranks of inflation-targeting regimes

has grown significantly: “[it] has been adopted in recent years by a number of industrialized

countries, including Canada, the United Kingdom, New Zealand, Sweden, Australia, Finland,

Spain and Israel (ibid, p.98)”.

e) A simple model of the monetary consensus with three equations

The monetary policy rule shows central bank‟s reactions in context of output-gap or

inflation rate deviation from its target. For look into this rule, it may be used a model with

three equations, which represent a synthesis of New Consensus‟ approach (McCallum, 2001):

a) ΔYt = a0 + a1 × ΔYt-1 + a2 × ΔYa t+1 – a3(it – Δat+1) + s1

b) Πt = b1 × ΔYt + b2 × Πt-1 + b3 × Πat+1 + s2 (where b2 + b3 = 1)

c) it = iR* + Πat+1 + c1 × ΔYt-1 + c2(Πt-1- ΠT).

ΔY: output-gap; i: nominal interest rate;

iR*: equilibrium real rate of interest or neutral rate8;

Π : inflation rate; ΠT – inflation rate target;

Πa; anticipated inflation rate;

a0: autonomous components of aggregate demand;

s1, s2: stochastic shocks

Meyer (2001, p.3) notes that this type of model “has the advantage of more accurately capturing

the prevailing operating procedures at central banks around the world”.

8 The definitions of the "neutral" rate vary with the methods of calculating them. The neutral rate also varies with

macroeconomic conditions. About its desired level Alan Greenspan (2004) said: “You can tell whether you‟re

below or above, but until you‟re there, you‟re not quite sure you are there. And we know at this stage, at one and

a quarter percent federal funds rate,that we are below neutral. When we arrive at neutral, we will know it”.

3) The limitations placed on monetary policy after the GFC

In 2008–2009, the world experienced “by far the deepest global recession since the

Great Depression (IMF, 2009)” Regardless of the existence of varying policy objectives

assigned to central banks, it is now a truism to state that significant limitations were imposed

on monetary policy in the aftermath of the GFC.

a) The statutory missions of the Fed and the ECB

A vast literature is devoted to the institutional differences between the Fed and the ECB

(Guttman, 2008).

Section 2A of the amended Federal Reserve Act9 contains a puzzling multiplicity of

objectives for monetary policy in the United States.

The Board of Governors [...] and the Federal Open Market Committee shall maintain long-run

growth of the monetary and credit aggregates commensurate with the economy‟s long-run

potential to increase production, so as to promote effectively the goals of maximum

employment, stable prices, and moderate long-term interest rates.

The absolute primacy of price stability at the expense of other macroeconomic

objectives is not inscribed in the statutes of the Federal Reserve. However, in his July 2000

„„Monetary Report to the Congress,‟‟ Greenspan hinted at the low-inflation core strategy of

the Fed by stating that: „„[i]rrespective of the complexities of economic change, our primary

goal is to find those policies that best contribute to a noninflationary environment and hence

to growth. The Federal Reserve, I trust, will always remain vigilant in pursuit of that goal”.

Contrariwise, the mandate of the European Central Bank is clearly to maintain price

stability as laid out in Article 105 in the Treaty establishing the European Community. The

ECB has hence defined price stability as a year-on-year increase in the Harmonised Index of

Consumer Prices (HICP) for the euro area of below, but close to 2% over the medium term.

b) Unstable, unpredictable and uncoordinated exchange-rate movements

Since the outbreak of the GFC, foreign exchange markets have witnessed sharp swings

and foreign exchange volatility has reached historical levels. Exchange rate forecasting has

become increasingly challenging as shown by the bumpy road followed by the dollar against

the euro. From 2005 to 2008, changes in expected monetary policies were the driving force

behind recent exchange rate movements. However, following the collapse of LB in September

2008, forecasting became excessively difficult even though fluctuations in risk aversion may

have explained the path followed by the euro-dollar exchange rate (Brender, Gagna & Pisani,

2010). This hypothesis is potentially validated empirically by the Euro slump after the Greek

crisis but it is currently of little help to predict future exchange-rate movements accurately

Interestingly, the guiding principles of the NMC seem to have occulted all explicit

exchange-rate commitments. In fact, the Taylor rule does not include any such external

requirements. However, the adoption of Taylor rule-based policies does not suppress the

9 As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of October 27, 1978 (92 Stat.

1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat. 3028).]

often-complex interactions between monetary policy and exchange-rate dynamics.

Elaborating on Taylor‟s original formulation (1993), Clarida, Gali, and Gertler (1998) have

suggested that the foreign central bank includes the difference between the exchange rate and

the target exchange rate, defined by PPP, in the reaction function of its Taylor rule; these

authors have thus constructed an asymmetric model including the real exchange rate.

What‟s more, interest-rate differentials between the dollar and the euro were arguably

correlated to exchange-rate movements until the GFC (Brender, Gagna & Pisani, 2010) and

were thought to be a function of output and inflation gaps. Put differently, Taylor rule

fundamentals were often used as empirical determinants of exchange rates. While some

authors10

have downplayed the exchange-rate predictability for empirical models of the

1990s, a strand of literature devoted to exchange rate models with Taylor rule fundamentals

emerged prior to the GFC11

. These models have shown good forecasting ability for the

Dollar/Euro exchange rate from the inception of the Euro in 1999 to late 2007 (Molodtsova,

Nikolsko-Rzhevsky, and Papell, 2008). However, the GFC has weakened the link with

Taylor-rule fundamentals and considerably increased the uncertainty surrounding exchange

rates. Finally, in spite of any clear-cut exchange-rate targeting strategy, Bini Smaghi (2009)

argues that the euro area has had a consistent exchange-rate policy since its creation: “[t]he

euro area has an exchange rate policy and it has been implementing it over the last ten years,

with full cooperation between the authorities in charge, including over the recent months”.

He also defends the ongoing efforts toward international monetary cooperation: “[s]ince the

start of the crisis, we have therefore achieved a level of trust and cooperation within the

central banking community that some would have considered unthinkable a couple of years

ago [...] global cooperation by central banks is now mirroring the globalisation of finance”.

In spite of these attempts, the practical modalities of a new global governance framework for

international monetary coordination, already absent from the NMC, remain undefined to date.

c) The zero-bound on nominal interest rates and deflationary fears

Keynes (1936) argued that zero interest rates have the negative aspect of producing a

liquidity trap whereby a further increase in the money supply has no expansionary effects.

More recently, in an almost-visionary speech12

, Bernanke (2002) had clearly foreseen that:

“the zero bound on the nominal interest rate raises another concern--the limitation that it

places on conventional monetary policy. When the short-term interest rate hits zero, the

central bank can no longer ease policy by lowering its usual interest-rate target”. This dark

scenario precisely matches the situation encountered by central banks in the aftermath of the

GFC. Indeed, the interest rate is the single most important policy instrument to achieve the

objectives of the NMC. When it reaches zero, one thus refers to the zero-bound on nominal

interest rates. The literature on the zero-bound13

rests on the Wicksellian concept of a natural

rate of interest, which has been widely debated albeit without an unequivocal conclusion.

10

“No model consistently outperforms a random walk […]. Overall, model/specification/currency combinations

that work well in one period will not necessarily work well in another period. (Yin-Wong Cheung, Menzie D.

Chinn and Antonio Garcia Pascual, “Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?”

Journal of International Money and Finance, vol. 24, November 2005, pp. 1150–75) 11

See Engel and West, 2005,2006; Mark, 2007; Clarida and Waldman, 2007; Molodtsova and Papell, 2007;

Benigno and Benigno, 2006; Groen and Matsumoto, 2006; Engel, Mark and West, 2007 12

Federal Reserve Board, remarks by Governor Ben Bernanke before the National Economists Club,

Washington, D.C., November 21, 2002 13

See Auerbach and Obstfeld (2005), Eggertsson (2003), Eggertsson and Woodford (2003), Jung, Teranishi, and

Watanabe (2005), Krugman (1998), and Woodford (1999)

Following the bankruptcy of LB in 2008, unprecedented worldwide panic on global

financial markets prompted central banks to make aggressive interest-rate cuts to mitigate the

collapse of aggregate demand and prevent a deflationary spiral. The interest-rate cutting pace

surprised most observers although central banks quickly hit the zero nominal interest bound

that restricted their scope for manoeuvre.

By using a smooth transition model (Mankiw et al., 1987) that allows for a gradual

shift over time between two regimes, concern for the zero-bound can be introduced in a non-

linear reaction function of the central bank. Whether the zero-bound is a concern or not for

central bankers, it might be relevant to re-examine optimal pre-crisis inflation levels in order

to understand the extent to which central banks retain the possibility to cut interest rates at a

later date if the economy worsens further (e.g., Bini-Smaghi 2008).

Other solutions might also be substituted to the standard interest-rate channel. This

includes the rather controversial monetization of deficits (using the printing press in order to

finance state expenditure). Until recently, the ECB could not buy up sovereign bonds in order

to finance member states‟ deficits. This situation changed dramatically with the advent of the

2010 Greek crisis when unprecedented purchases of some €16.5bn of eurozone bonds were

decided in May by the ECB in the secondary market in order to enhance market liquidity

(Wilson & Oakley, 2010). Although the ECB is still reluctant to resort to quantitative easing,

the latter option is no longer ruled out (Mackintosh, 2010).

All in all, a perfect substitute to the interest-rate channel is yet to be designed under

the new narrowly defined monetary consensus. One might then be tempted to revise the

inflation target in the face of a constraining zero-bound on nominal rates that increases the

volatility of both output and inflation as in the old stop-and-go policies.

d) Lessons from the Euro sovereign debt crisis

In 2008, Juliane von Reppert-Bismarck (Newsweek, June 28) wittingly pointed out the

weaknesses of Southern European countries by coining the infamous PIGS acronym. In 2010,

the fiscal situation of these countries started to deteriorate after a larger-than-expected public

deficit was unmasked in Greece following a massive accounting fraud reminiscent of the

Enron scandal in 2001. A generalized crisis of confidence ensued along with the widening of

bond-yield spreads and credit default swaps premia between the PIGS and Germany, the

favored benchmark country for sovereign-bond issuers in Europe. Concerns about rising

public deficits and unsustainable debt levels followed by a series of downgrading of

European Government debt by the three prominent rating agencies rapidly spread to the rest

of the globe leading to the 2010 Euro sovereign debt crisis14

.

14

On 2 May 2010, the Eurozone countries and the International Monetary Fund agreed to a €110 billion loan for

Greece, conditional on the implementation of harsh Greek austerity measures.[11]

On 9 May 2010, Europe's

Finance Ministers approved a comprehensive rescue package worth almost a trillion dollars aimed at ensuring

financial stability across Europe by creating the European Financial Stability Facility.

One puzzling question is: in the light of the figure below, why was the Euro area,

rather than the United States, hit so severely by a sovereign debt crisis in 2010?

Figure 1 General government consolidated gross debt

The Euro crisis may well have been fuelled by the perceived fragility of the banking

systems of many European countries although, at the time of writing, the results of the

recently published stress tests are on the verge of reviving European stock markets. Another

answer is that the lack of confidence in the European monetary authorities and the people who

lead them may have accounted for the speculative attacks against the Euro in 2010. As argued

by Tabellini (2010): “[t]he credibility of an independent central bank depends on the

conviction that its operations are guided by technical considerations and consistent economic

principles, rather than by political opportunism and appearance In this regard, the ECB

decision to "sterilise" the purchase of bonds with inverse operations to drain liquidity is

surprising”. Tabellini‟s criticism of the ECB‟s decision in the wake of the Euro crisis

implicitly points to the post-Keynesian argument of endogenous money (Moore 1988): “today

the cash in circulation is determined by banks‟ demand – it is not set by the ECB. The

purchase of government bonds on the secondary market changes the composition of the

budget of the ECB, but has no effect on its size, and therefore it does not alter the amount of

money in circulation. So there is no need to sterilize anything (ibid)”. Hence, Tabellini‟s

conclusion is that technical inconsistencies might impede the institutional credibility of the

ECB and, by extension, alter inflation expectations in its Taylor rule. Again, this form of

institutional credibility (that goes beyond transparency and central bank independence) has

not been modeled properly by the tenets of the NMC.

4) A few unavoidable issues for central banks in a post-crisis scenario

The GFC compels us to rethink monetary policy in new ways but also to adopt a proactive

stance in the face of a series of unavoidable issues in a post-crisis scenario.

a) The interest-rate setting policy: going beyond the Taylor Rule

The GFC has undoubtedly shaken the world of central bankers and taken monetary

policy in unchartered territory. However, it has not yet dented the faith in inflation-targeting.

“Bernanke has argued that central banks continue to pursue price stabilising policies (without

prejudice to economic activity (Giavazzi & Giovannini, 2010))”. Has the NMC been eroded

by the GFC? Is it possible for central banks to go beyond mere price stability and address the

fundamental priority of world leaders in the wake of the GFC, namely financial stability15

?

During the Great Moderation characterized by low inflation, high growth and tamed

business cycles, a narrow mandate for central banks, coupled with independence, was just

fine. Inflation targeting proved to be the hallmark of central bankers under the NMC keeping

them from undue influences from special interests and ensuring effective monetary policy.

However, the GFC is a powerful reminder that low interest rates are potentially

conducive to financial fragility. For Keynes (1936, p.252) the interest rate was simply the

price to pay to compensate for the renunciation of liquidity. In times of crisis, liquidity is

well-sought after because “people want the moon” - that is the object of their desire (money-

liquidity) cannot be produced. One lesson of the GFC is that interest rates should reflect the

value of liquidity in the boom-phase of the cycle instead of dangerously converging towards a

deflationary zero-bound limit in the downside of the business cycle in order to mitigate the

adverse consequences of tightening credit conditions. From a Taylor-rule perspective, this

means adding an additional equation in order to account for a premium that corresponds to the

shadow price of liquidity (Giavazzi & Giovannini, 2010) in times of expansion. Such an

approach would probably mean going beyond the Taylor rule insofar as inflation targeting

would no longer be the alpha and omega of monetary policy; crisis-prevention and financial

stability (through the dampening of excessive-risk taking) would also come in the picture.

b) Asset prices and core inflation

Price stability and low inflation are central to the NMC. However, the definition

usually adopted by central banks is circumscribed to core inflation. But the price index fails to

account for housing prices, oil and commodity shocks or, more generally speaking, for asset

prices thereby discarding the all-too-frequent asset-bubble phenomena observed in our

financialized economies16

. Asset bubbles were fuelled by low interest rates and highly

leveraged financial institutions and households prior to the GFC. Moreover, price stability is

compatible with a fluctuating output gap, which entails a trade-off between the two. All in all,

the stability of core inflation does not preclude macroeconomic and financial fragility.

15 Tenets of the NMC seem to think that only regulators should be entrusted with this mission, having at their disposal more appropriate tools to conduct deleveraging policies (e.g high capital requirements) or set new rules on derivatives trading to mitigate systemic risks on the OTC market. 16

major boom-bust cycles in the prices of equity and real estate in a number of industrialized countries during

the 1980s have been analyzed by Borio, Kennedy, and Prowse (1994)

Bernanke (2000) stated that “monetary policy is not by itself a sufficient tool to contain the

potentially damaging effects of booms and busts in asset prices”. The GFC has certainly

proved him right. Should the Taylor rule be retained then? In fact the latter might still prove

very useful if one is tempted to posit “a systematic relationship between Taylor rule

deviations and the development of bubbles in housing markets” (Lim, 2010).

c) Pro-growth policies and regulatory reform

After inflation expectations were stabilized, a loose monetary stance was adopted

during the GFC in order to boost pro-growth policies and avoid a grim scenario of a faltering

economic recovery17

. Drawing on the idea that the limited scope of US regulation worked as a

stepping-stone, prior to the crisis, for off-balance-sheet entities to circumvent prudential rules

and increase leverage, Philadelphia Federal Reserve Bank President Charles Plosser (2010)

has further advocated better regulation in order to dissuade market players from taking

excessive risks18

. Regulation must also be broadened to take the shadow financial sector into

account with adequate supervisory enforcement and without being detrimental to welfare-

enhancing financial innovation. The GFC has taught us that ill-designed regulation is not

neutral in macroeconomic terms, as it strongly contributed to the amplification of the

downturn by turning the decrease in US housing prices into a full-blown global crisis in 2008.

17

“I'm hopeful that businesses will be surprised by the strength of demand over the next year and that they will

actually begin to add workers, but it is quite a cautionary prospect for the U.S. and that leads me to think that

monetary policy is likely to continue to be accommodative for an extended period of time".

18 "[w]e have to have ways of disciplining the actors in the marketplace so that they don't take excessive risks,

and in many cases the market can do that and do that quite effectively. But when we protect creditors, when we

protect people from failure, we encourage them to take risks"

d) Austerity measures versus growth: a post-crisis conundrum?

The GFC has dramatically rehabilitated countercyclical Keynesian fiscal policies

partly due to the inability of monetary policy to combat the sharp decline in aggregate demand

following the credit crunch leading to the Great Recession of 2008-2009. Although aggressive

expansionary fiscal policies seem to have successfully avoided a repeat of the Great

Depression that plagued the 1930s, negative economic outcomes on unemployment and

poverty levels have been very severe since 2008 both in developed and developing nations.

Moreover, most countries entered the GFC with insufficient “fiscal space” that is with high

levels of pre-crisis government debt. As a consequence, recession-induced faltering tax

revenues as well as gigantic spending commitments (not necessarily circumscribed to the

bailout plans of the financial sector) have wrecked public finances worldwide. Budget

austerity is now on the agenda of most countries19

. Some argue (Bremmer & Roubini, 2010)

that in times of uncertainty concerning the nascent recovery, drastic austerity measures are

hardly compatible with the fast-pace deleveraging of balance sheets and income-challenged

households, financial institutions and governments notably in the Euro area, which suffered a

massive sovereign debt crisis in 2010. The trade-off between fiscal consolidation and growth

has not been properly quantified yet. Central banks will thus have to include the opportunity

costs of quantitative easing and accompany the ongoing debt-restructuring of insolvent

Mediterranean counties. In spite of its successful export-led growth and its competitive

economy, Germany should also assess the relevance of fiscal consolidation in the light of its

insufficient domestic demand. As stated by the IMF (2010), only sustained global economic

growth will ensure the success of fiscal consolidation programmes.

e) Revisiting the Theory of Optimum Currency Areas (Mundell, 1961)

One reason why the Euro sovereign debt crisis occurred and that might have been

overlooked by the NMC prior to the GFC stems from the theory of Optimum Currency Areas

(OCA) put forward by Mundell (1961). Among the conditions necessary to define an OCA,

Mundell showed that automatic fiscal transfer mechanisms are indispensable in order to

ensure harmonious redistribution effects between the regions/countries of an OCA following

an asymmetric shock such as the Greek crisis. The euro crisis showed that a shared monetary

policy without any common tax and/or fiscal policies is necessarily vulnerable. Johnson

(1970) was the first to define fiscal integration as a sine qua none condition for an OCA to

exist and function. The legacy of Mundell‟s theory is to restate that a system of fiscal

transfers and proper political institutions effectively binding member states is vital for the

future of the Euro. Since the EMU is not a proper political union, no common federal budget

and no European state was able to stand behind the common currency during the sovereign

debt crisis. The effectiveness of future monetary policy will have to address the issue of

macroeconomic imbalances within the Euro zone. The core countries such as Austria,

Finland, Germany and the Netherlands that spend less than they earn will have to agree on a

common institutional framework in order to mitigate the consequences of rising deficits in the

periphery nations such as Greece, Ireland, Portugal and Spain that spend in excess.

19

These drastic fiscal measures also are not circumscribed to rich nations. One study finds that, in a sample of 86

low and middle income countries, about 40 per cent are engaging in reductions in public expenditure in 2010-

2011 relative to 2008-2009. The average projected spending cuts are around 2.6 per cent of GDP.

f) The problematic issue of the US Dollar

Following the crisis of 1997-2000, many Asian countries decided to adopt a proactive

export-led growth strategy in order to build high foreign reserves and reduce their

macroeconomic vulnerability to rapid capital inflows. Undervalued exchange rates and high

domestic saving rates enabled the formation of massive current account surpluses that found

their counterpart with the sky-rocketing current account deficit of the United States. Along

with unprecedented US household-debt levels that paved the way for the frenzy securitization

of mortgages by under-regulated financial institutions, these global macroeconomic

imbalances were conducive to an ever-increasing demand for Treasury bonds and led to an

over-accumulation of liquidity on financial markets. By the same token, they depressed long-

term US interest rates thereby encouraging excessive leverage and risk-taking behavior.

The role of the US Dollar in enabling this situation has been explicitly criticized by the

People's Bank of China who released this statement by Zhou Xiaochuan, the central bank's

governor, on March 23, 2009. He argued in favor of “a super-sovereign reserve currency

managed by a global institution [that] could be used to both create and control the global

liquidity. And when a country's currency is no longer used as the yardstick for global trade

and as the benchmark for other currencies, the exchange rate policy of the country would be

far more effective in adjusting economic imbalances. This will significantly reduce the risks of

a future crisis and enhance crisis management capability”.

One may wonder if the success of monetary policy in a post-crisis scenario will not be

contingent on the adoption by the international community of a new reserve currency: “[t]he

desirable goal of reforming the international monetary system, therefore, is to create an

international reserve currency that is disconnected from individual nations and is able to

remain stable in the long run, thus removing the inherent deficiencies caused by using credit-

based national currencies”. In this respect, special drawing rights (SDR) have recently

received renewed attention (Swaminathan Anklesaria Aiyar 2009) in spite of significant

objections to the extension of their role (notably in terms of the new global governance

mission and the massive currency risks that would be transferred to the IMF).

Conclusion

John Kenneth Galbraith (2008) argued that the NMC was already irrelevant before the

GFC. The almighty powers of Alan Greenspan were not always consensus-building during his

mandate; the undisputable aura of the NMC has indeed been further tarnished by the cascade

of unprecedented events that have occurred since the outbreak of the GFC. Our aim in this

paper was to show that, following a chaotic inflationary decade in the 1970s and a set of very

inconclusive monetarist experiments in the 1980s, the seemingly prevailing NMC that gained

prominence in the 1990s, has undoubtedly been shattered by the GFC. We have characterized

the limitations of monetary policy during the years 2007-2010 and identified some of the

lessons that have ensued for the relevance of the NMC. Finally, a set of unanswered issues

were addressed so as to renew the reflection on monetary policy in a post-crisis scenario.

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