The folly of the central banks of Europe

John Muellbauer 27 October 2008



When future economic historians look back to trace the triggers for the October 2008 financial panic and the unnecessarily severe recession of 2009, they will likely put their fingers on two.

  • The failure to keep Lehman Bros functioning as a going concern.
  • The failure of the ECB and the Bank of England to use their interest rate setting firepower to organise a substantial globally co-ordinated interest rate cut (the 8 October 2008 cut was too timid).

Economics ministries, not central banks, demonstrated decisiveness

A convincing argument for independent central banks adopting an inflation targeting framework is that, where central banks are forward looking and responsive, they should be able to avoid deflationary slumps. The markets then should expect the central banks to assess clearly the global economic situation and the downside risks, and take decisive action. Instead, it was the European finance ministries, via the bank refinancing packages announced between October 8th and 14th, that demonstrated their far greater understanding of the risks involved. They acted in a timely and potentially effective internationally co-ordinated manner. It was less effective because the central banks failed to follow up their initial too small interest rate cut. They were persuaded into a co-ordinated half point interest rate cut on October 8th. The central banks then sat on their hands, despite a daily barrage of deflationary news.

Emerging markets and the deflationary firestorm

By October 16th, the impact on emerging markets of the deflationary firestorm, in consequence of the collapse in global growth and in commodity prices, had become all too apparent. History shows that the resulting combination of financial and currency crises leaves long-lasting damage in lost output, bankruptcies and bad debts that handicap future recoveries. There is little chance of a significant commodity price recovery from recent levels in the next six months. The reason is that instead of stabilising the global economy, emerging market demand, such as China’s, is falling, and thus amplifying the shock. As I pointed out at the Bank of England’s Monetary Policy Roundtable (Sept 30th), a straightforward piece of economics underlies this idea. While consumer spending is closely linked with the level of income, investment is more driven by growth. It is the huge share of investment in national output in emerging economies that makes them, and their commodity demands, highly sensitive to the global slowdown.

The dual effect of the depreciation of emerging markets’ currencies and the massive falls in commodity prices will induce the largest negative shock to the price level in developed economies since WWII. Moreover, collapsing export demand and rapidly rising unemployment will add domestic deflationary pressure. The deflation will in part be offset by the improvement in the terms of trade for the developed countries, and eventually also by fiscal measures undertaken to boost demand. However, with the rise in food and energy prices accounting for approximately 80% of the rise in inflation in 2007-2008 in most European countries, the coming collapse of inflation in 2009 should have been obvious to every central banker.

What could have been?

As late as October 21st, the central banks of Europe still had an opportunity for credible and confidence boosting action on interest rates. A short-term rise in global stock markets gave a window for action which would not have been seen as a ‘too little, too late’ fire-fighting reaction to market panic. An accompanying statement could have noted the dramatic shift in the inflation outlook. It could have acknowledged that, in effect, monetary policy had involuntarily tightened with falling inflation expectations raising real interest rates. Policy had already been tightened through raised market interest rates paid by households and firms, due to widened spreads under the credit crunch.

Would a co-ordinated 1% cut, accompanied by the promise of decisive and timely further action in the light of rapidly evolving news, have worked to halt the panic? Sceptics, perhaps including some in the central banks, were doubtful, but quite wrong.

The most obvious impact of a cut would have been to raise the profit outlook of private sector banks in every country. This would have boosted the flow of investors’ funds to the sector and raised banks’ share prices, thereby enhancing their ability to lend and replenishing trust of depositors and in the interbank market. The result would have greatly amplified the benefits of the earlier refinancing operation of the ministries of finance, and lowered money market and credit spreads.

Some of the cut in policy rates would have lowered borrowing rates faced by hard-pressed households and firms, though more gradually for some types of debt. Where floating rate debt dominates (e.g. the UK), cash flow effects on consumer spending are large. In research (with Janine Aron and Anthony Murphy) summarised in my Jackson Hole paper of 2007, this effect was estimated for UK consumption. With credit now so restricted and debt levels so high, the size of the impact on spending of a cut in borrowing rates is larger than ever. Thus, had the policy rate fallen, the UK might well have experienced a less severe recession than Germany, which is far more exposed to the slump in exports of capital goods.

Currency crises in emerging markets

Another benefit would have been to ameliorate currency crises in emerging markets and smaller countries such as Denmark. Their exchange rates depend in part on interest rate spreads with the major currencies. A co-ordinated global interest rate cut would have widened spreads without these countries having to raise rates to support their currencies in the face of severe recessions. Moreover, as late as October 21st, many other central banks would have felt able to join a co-ordinated cut without exposing their currencies.

More generally, the reduction in policy rates, and the prospect of more to follow, would have reduced returns on safe assets, such as government bonds, and induced investors at the margin to rebalance towards riskier assets, such as equity and corporate debt. The rise in such asset prices would eventually have helped to restore collateral values, slowing the spiral of rising bankruptcies.

Following the panic beginning on October 22nd, the task of restoring confidence is far harder. With asset prices so much lower, the bad loan position of the banking system looks worse, and with it, the potential burden on tax payers. The damage for the UK looks particularly severe, with its debt and housing market vulnerability - reflected in the sudden decline in Sterling and in Treasury gilt prices.

Conclusion: Scrap the models and agree on a big, coordinated rate cut.

Why Europe’s key central banks made this potentially catastrophic error is a long story. One reason, however, rests in their econometric models, based on fashionable but outdated economic theory.

It is deeply ironic that central bankers who rightly have made much of the moral hazard of bailing out private bankers, have adopted central bank models excluding channels for real world moral hazard and credit crunches. These models are overdue for the scrap heap. Central banks making policy without functioning models are like aeroplanes flying without radar, and the consequences are now obvious.

They now have a last chance to undo the damage of last week. They need to put aside short-term currency wobbles, focus on the big picture and surprise the markets with a much larger cut, probably of 2 percentage points. If international co-ordination is now harder to achieve, then leadership by the ECB and the Bank of England will have to suffice.


John Muellbauer “Housing, credit and consumer expenditure.” in Housing Finance, and Monetary Policy: a Symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30-September 1, 2007, Federal Reserve Bank of Kansas City, 2007, p. 267-334.



Topics:  Financial markets

Tags:  ECB, subprime crisis, financial crisis, UK, rescue package, currency crisis

John Muellbauer

Senior Research Fellow, Nuffield College; Professor of Economics, Oxford University; and Senior Fellow, Institute for New Economic Thinking, Oxford Martin School

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