Effectiveness of the Transmission of Monetary Policies and Lessons Learned in 2007 and 2008 Global Financial Crisis - Essay Example

?Effectiveness of the Transmission of Monetary Policies and Lessons Learned in 2007 and 2008 Global Financial Crisis By Instructor’s name Institution City and State of the institution Date of submission Introduction The global financial crisis that occurred between 2007 and 2008 has resulted in various heated discussions among financial analysts regarding the role of monetary policy amidst various central banks in the world (Krugman, 2009). It has also resulted in a number of debates as regards the effectiveness of the transmission mechanism of monetary policies. In the past, monetary policy has been associated with a financial stability of an economy. The problem that a majority of countries face is concerned with the effectual transmission mechanism of an effective monetary-policy. A number of lessons can be learned regarding the effectiveness of the transmission mechanism of monetary policy by central banks in the year 2007 and 2008. The lessons would be based on interest rate, inflation, exchange rates, balance sheet, expectations, as well as moral hazards that characterized the market prior, during and after the 2008 global economic-crisis. A Brief State of the 2007 Financial Crisis and Failure of the Monetary Policy Transmission Mechanism Although financial crisis is not a unique occurrence, the financial crisis of 2007 was more global than other economic crises experienced in the past (Mankoff, 2010). It is also regarded as the most impactful relative to other proceeding financial crises. Due to its high level of degree in terms of impact and globalization, a large number of monetary policymakers were compelled to utilize both conventional and unconventional financial policies. A majority of economic analysts as well as financial institutions in the world were surprised by the fast pace at which the subprime crisis in the US led to a world financial crisis (Cecchetti, 2009, p. 53). The global financial crisis led speedily to a world economic crisis. This fast pace left a considerable number of individuals in the business and financial circles with unanswered questions regarding the effectiveness of the transmission mechanism of monetary policy. In particular, the 2007 and 2008 financial crisis questioned the effectiveness of various institutional frameworks (Mankoff, 2010). It also questioned the national and internal monetary instruments in ensuring financial stability at the global level. In relation to Shiller’s (2008) argument, attention has been paid to the role and operation of financial markets, as well as financial institutions. Specifically, questions regarding the effectiveness of financial institutions and markets to price and administer risk have been raised. Analysts observe that there have been inability of private sector to manage risk effectively, and failure of public sector’s supervision of the financial markets (Mankoff, 2010). Interest rate While the financial world changed in the year 2007, the monetary instruments were not updated to handle the change (Swagel, 2009, p.43). The instruments were not transmitted effectively to realize positive impact. Initially, interest rates were traditionally treated as the main financial instrument that would protect an economy against financial difficulties, as well as enhance economic growth. A large number of emerging economies, including India, lowered their interest rates in an anticipation that both prices and output would respond effectively. However, both output and prices did not respond in respect to the anticipation. An interest rate is majorly used in managing the supply of money in an economy. Interest rate has been observed by many individuals as a key monetary instrument in controlling lending and borrowing between financial institutions and consumers. The borrowing and lending is also executed amongst financial institutions. In the event that there is a high supply of money in an economy, a central bank would opt to raise the level of an interest rate. In this regard, credit availability is likely to be lessened. However, if a central bank perceives that there is lesser money supply than expected, interest rate would be lowered. This action would stimulate high level of borrowing among consumers. As a result, economy is boosted via increase in consumer spending on various products and services. The motive of controlling interest rates by central banks is related to managing inflation, and spurring economic growth. As a general rule, high level of money supply is likely to cause demand-pull inflation. Eventually, inflation may lead to a financial crisis. According to economists, the financial crisis that began in the year 2007 was majorly caused by unprecedented spreads in interest rates (Mankoff, 2010). A majority of economists agree that the low interest executed by Federal Reserve in the aftermath of the 2001 attack was the root cause of the 2008 global financial crisis (Hemerijck, Knapen and Doorne, 2009, p.36). At the end of the year 2007, the US Fund interest rate, as authorized by Federal Reserve, experienced a significant increase (Freedman, 2010, p.27). In this period, commercial banks and other financial institutions were unwilling to lend each other. As a result, the Federal Reserve was restrained to lower the interest rate. This activity was carried out in an attempt to restore confidence following the fear that was being experienced in the financial market. Later, the Federal Reserve cut the interest rate to 4.75% (Cecchetti, 2009, pp. 53-58). Further research by Cecchetti (2009, p.63) shows that the initial cut was followed by an additional cutting which saw the interest rate decrease to 3% in January 2008. According to Conaghan (2012, p.13), the Bank of England reduced the interest rate to 3% from that of more than 4.4%. O?zkan and Unsal (2012) provide that the same scenario was witnessed among the EU members when the European Central Bank reduced interest rate from 3.75% to less than 3.3%. Despite the efforts made by Federal Reserve with respect to lowering the interest rate, the confidence was not yet restored in the financial markets. This was manifested by a considerable decrease in the credit flow. This led to the failure of a number of financial firms, among them, Lehman Brothers. Others were bailed out such as AIG. At the end of 2008, the interest rate was lowered to 1% (Paulson, 2010). Paulson (2010) further indicates that in the first financial quarter of the year 2009, the interest rate was reduced to less than 0.25%. Notably, in the wake of the 2008 financial crisis, a number of emerging economies such as India were attempting to manipulate interest rates in an effort to control the spill-over effect. Despite the Bank of Jamaica lowering the interest rate, the commercial banks maintained a high level of interest rate. This led to wide spreads between the central bank rate and that of other commercial institutions. The Jamaican occurrence, which witnessed an interest rate spread of more than 11%, raises a major question- the ineffectiveness of the transmission of monetary policy (Krugman, 2009). As Eichengreen and Flandreau (2010, p. 33) discuss, the failure of the Federal Reserve and Bank of England to have impact on the economy by manipulating the interest rates also raises a question as to whether the transmission mechanism of monetary policy as far as central banks’ interests rates are concerned are effectual in effecting the economy positively in the face of a potential economic crisis. Although it is a matter of opinion, it is evident that transmission mechanism as far as interest rate is concerned is not effective in the absence of other monetary tools. Inflation Interest rate and inflation are more interrelated than other economical aspects. Governments normally attempt to influence the level of inflation by controlling the interest rate. In the event that a country is experiencing a high level of money supply than required, a demand-pull inflation is likely to occur. This is due to the fact that there would be high level of currency in the economy which would be chasing few resources. Due to high demand (as a result of high supply of currency), products and services are bound to experience prices increase. If products and services end up being expensive, there is a likelihood that employees would request for a salary increase in order to afford an expensive life. In this scenario, employers would be compelled to raise the prices of products and services to pay the scaling wages. This leads to cost-push inflation, a factor that would enhance additional level of inflation in an economy. Generally, the rise in the prices of commodities is associated with devaluation of assets. Monaco (2009, p. 318) accentuates that the Great inflation, which was experienced in 1970s, was a result of various factors. Among them are cost-push inflation emanating from the rise of oil prices and lack of credible and effective monetary policy. Indexed contracts are also blamed for preventing a decline in wages. A majority of economists state that to experience price stability there should be a credible monetary policy that would aim future anticipations in relation to inflation. The genesis of the 2008 financial crisis was set by disproportionate risk taking in the real estate sector. This was ignited by more-than-usually expansionary fiscal policies. The expansionary monetary policies coupled with diverse mortgage securitization led to housing inflation. The housing inflation occurred in the face of less transparency in the financial markets. This further resulted in the market inefficiency. In this case, it was believed that stringent monetary policies, which would control the undue lending by banks, would have been effective. Unlike the past inflations, the 2008 inflation shocked a number of economists given that inflation-targeting approaches assumed by various central banks were adopted from experts and academics. In line with Nazar’s (2010, p. 538) argument, the approaches from the practitioners and other experts were perceived to be unsurpassed strategies for long-lasting price stability. Analysis indicates wages pressure is not among the cause of inflation in the recent past. It is indicated that due to fear arising from competition among employees from emerging economies, the costs of the global labour have been kept at low levels. The increase of energy prices was also insignificant to fuel the 2008 economic crisis. As a result, one would judge that only liquidity might have played a major role during the economic meltdown (Blinder, 2013). The targeting inflation-anticipations at the medium and short-terms were not effective in preventing the undue-expansionary policies from causing high level of demand. In this case, it can be argued that a rise in the level of inflation is a long-term effect of an expansionary monetary-policy. This also raises question regarding the effectiveness of the transmission mechanism of both short and long-term expansionary fiscal policies as far as targeting inflation is concerned. The above scenario shows a failure in the transmission of both short and long-term expansionary policies in controlling inflation. Foreign Exchange The effect of the foreign exchange market was not realized at an early stage. As early as 2007, it is evident that fixed income instruments and markets were experiencing a significant stress (Takagi and Shi, 2011, p.15). A considerable effect began in August 2007 when a large number of foreign investors experienced big losses. In this period, the waves of financial crisis were realized when spill-over effects of stock and fixed income instruments’ losses were spread to held currency positions. This period was characterized by capital flight which saw the US government securities devaluated. Melvin and Taylor (2009, p.13) state that a large number of investors were liquidating most of their portfolios, including investments in foreign exchange. Fear was ignited again after the circulation of rumours regarding the insolvency of Bear Sterns. Confidence was later restored after it was bought by JP Morgan Chase (Melvin and Taylor, 2009). However, as Shiller (2008) states, the confidence was eroded following the collapse Lehman Brothers which was deemed too big to fail. There was lack of effective monetary transmissions, such as placing a cap on leverage to reduce the level of risk. The Balance Sheet Balance Sheet of the Federal Reserve as at July 2007 (US$ Billions) Assets Liabilities Securities Held Outright The Repurchase Agreements Loans Principal lending The Foreign Exchange Reserves Gold Held Other Assets Total Value of Assets 790.6 30.3 0.19 20.8 11 27.5 880.4 Capital Notes of the Federal Reserve Reserve Balances of Commercial Bank The US Treasury Deposits and Liabilities of Foreign Officials Other Liabilities Total Liabilities 34.1 781.4 16.8 42.4 5.7 846.3 Source: www.federalreserve.gov/releases/h41/ The second entry on the liability part is reserve balances of commercial banks, which are held for various purposes. Firstly, it is a mandatory to hold them. Secondly, central banks hold them for purposes of meeting consumers’ demand in regards to withdrawing, as well as making payments to commercial banks. Thirdly, it can act as an emergency fund, for instance, during financial catastrophe or other natural disasters. The reserve balances being at less than $17 billion is small in relation to the US’ counterparts in the Euro zone (Federal Reserve Statistical Release, 2007). It was about 10% of the total reserve balances held by banks among national banks of the European Union (Berlatsky, 2010). Assets The Federal Reserve holds repurchase agreements and outright securities. Newell, Papps and Sanchirico (2007, p. 263) state that securities that are held by the Federal Reserve are in the form of bonds, Treasury bills and notes. A law exists which provides that the Federal Reserve cannot purchase additional securities from the US treasury directly. In this case, the Fed can only purchase additional holdings via the secondary market (Coval, Jakub, & Erik Stafford, 2007). The repurchase agreements which exceed US$30 are vital as far as adjusting the level of reserves in the banking system is concerned (Federal Reserve Statistical Release, 2007). Such types of activities are executed on a daily basis by various central banks in emerging and advanced economies. Repurchase agreements are perceived by many individuals as an overnight mortgage- they are short-term loan that fully collateralized. According to McLean and Nocera (2010, p.14), various financial firms normally pledges a bond to the Federal Reserve in an objective to receive finances. However, financial institutions have been unwilling to utilize the primary lending. Before the beginning of the crisis, the borrowing amounted to less than US$200 million every day (Federal Reserve Statistical Release, 2007). Regarding the effectiveness of the transmission mechanism as far as balance sheet is concerned, it can be noted that central bank have the ability of purchasing a security by crediting the deposits of commercial banks. If policy makers are not careful, overnight interest rates may decline to zero. This may pose danger to an economy. Central banks should ensure effective transmission of policies regarding purchasing of securities to ensure interest rates are maintained at reasonable levels. Moral Hazard during the 2007 and 2008 Financial Crisis The failure of Lehman Brothers and bailing out of Fannie Mae resulted in many analysts questioning the moral hazard of rescuing banks and large financial institutions (Berlatsky, 2010). According to Berlatsky (2010), the bailing out to companies such as AIG by utilizing taxpayers’ money is perceived as immoral by a large number of financial consumers in the world. Instead of funding productive projects, the money is spent on financial firms that undertook huge risk. Arguably, it is painful that boards of directors have been awarding themselves huge bonuses while they understand that investors and shareholders’ investments should be protected. It is also discouraging that most financial products were highly leveraged, a factor that increased risk of loss. This is as well perceived as an immoral practice (Berlatsky, 2010). More importantly, the malpractices associated with accounting that was executed by Lehman Brothers and other companies such as WorldCom are against the financial moral practices. For instance, the accounting gimmick executed by Lehman Brothers during the foreseen crisis in an attempt to enhance their positive financial-perception to new and existing shareholders is immoral (O?zkan & Unsal, 2012). Although countries such as the US relied heavily on bailing out large companies in the past by using taxpayers’ funds, the US president saw it prudent to protect the economy and innocent financial-consumers from future financial crisis. The president claimed that the failure of the financial system is as a result of the responsibility of owners and directors of various financial firms both at Wall Street and Main Street. However, more emphasis is placed on the Wall Street firms (Paulson, 2010). This led to the president and other democrats advocating for Wall Street reforms that would see consumers’ investments, as well as taxes are protected. As a result, managers, owners and directors of local and international financial institutions are bound to become responsible about their actions. In the future, in the event that a financial firm is facing a crisis, other financial firms would be required to bail out the deemed insolvent firm. Conclusion In regards to the effectiveness of the transmission mechanism of monetary policies as far as transparency and credibility is concerned, central banks are partially failing. Lessons should be drawn from the recent past financial-crisis. For instance, in the US, financial institutions were offering complicated financial derivative instruments which tended to confuse consumers. This also made it difficult for the Federal Reserve to oversee and scrutinize the financial market in an attempt to protect consumers, and ensure credibility. Prior to the 2007 financial crisis, most financial markets in the world were associated with over-expansionary policies which had an objective of spurring economic growth. However, lack of stringent policies and effective transmission mechanism saw a large number of financial firms over-leverage their products- this increased the level of risk to unsustainable levels. A large number of financial systems in the world were embracing liberal markets, yet they suffered huge risks due to greed and other irresponsible actions. Conclusively, central banks and governments should ensure a multifaceted monetary-policy framework is formulated to ensure a successive transmission of fiscal policies. This would see many economies avoid experiencing a near zero-lower bound and financial crisis in the future. List of References Berlatsky, N., 2010. The global financial crisis. Detroit: Cengage Learning. Blinder, A., 2013. After the music stopped: the financial crisis, the response, and the work ahead. New York: Penguin Press. Cecchetti, S., 2009. Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis. Journal of Economic Perspectives, 23(1), pp.51-75. Conaghan, D., 2012. The bank: inside the Bank of England. London: Biteback. Coval, D., Jakub B. and Erik, S., 2007. Economic Catastrophe Bonds. 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