How Economic Policy Will Be Different After the Crisis:New Targets for Monetary Policy.
Before the credit crunch, the primary objective of monetary policy was low Inflation. The argument was that if inflation was low, economies would avoid boom and bust cycles and therefore we could avoid recessions. In the mid 2000s, there was even talk of an end to 'boom and bust' - the end of the trade cycle. However, this recession has made such predictions look rather hopefully. The New Targets for Monetary Policy will include:
Credit Cycle. This credit crunch could be seen as a boom and bust in credit lending (especially for mortgages). Monetary authorities will need to ensure banks don't get carried away with lending beyond their capacity. Banks will need to be forced to keep a certain ratio between assets and liabilities. One principal reason for the collapse of Northern Rock was that 75% of its loans were not backed by savings. - In other words they were borrowing to lend mortgages.
Housing Markets. When UK house prices were rising 25% a year, the MPC said that house price inflation was not their target. If they had increased interest rates to reduce house price inflation, they would have been criticised for going beyond their remit and reducing growth unnecessarily. The thing is nobody felt that house price inflation was their responsibility. But, the impact of house prices on the economy can not be underestimated - they really do have a big impact, therefore reducing house price volatility will be important.
New Instruments of Monetary Policy.
- Quantitative Easing. If deflation becomes widespread, we will see more Central Banks consider quantitative easing (printing money is a loose explanation for QE) However, we hope this will be just a short term measure. There is always a risk associated with increasing the monetary base (especially with large government borrowing) see: Quantitative easing
- Credit Control. It is not possible for Central banks to control inflation, economic growth, house prices, credit,exchange rates just through using interest rates. Monetary authorities will need to develop tools which limit a credit boom and ensure sustainable lending practises. It is exactly the kind of regulation banks would previously have scoffed at. But, with banks on their knees grovelling for bailouts they are no longer in a position to dictate terms.
- Micro Regulation of Finance and Banking. In addition to regulating growth of credit, governments will need to adopt better regulation for certain banking practises.
- Policies to Reduce Volatility of House prices. The UK has now seen two spectacular boom and busts in the housing market in the past two decades. We cannot rely on interest rates to control house prices, but more needs to be done to regulate borrowing. However, with limited supply (in the UK) this is easier said than done.