The main role of central banks should be:
1. Create a low inflationary environment
2. Create financial stability
3. Prevent Mild downturns turning into full blown recessions.
Therefore, there are many arguments against cutting interest rates at the first sign of panic. If necessary Central Banks should allow a moderate recession. These are some of the benefits of not cutting interest rates aggressively.
Benefits of Recessions.
1. Moral Hazard.
The argument is that people have been borrowing recklessly. This explains alot of the problems with the US sub prime mortgage market. As a consequence of reckless borrowing banks are suffering defaults, writing off debts and this is a contributing factor in the recent downturn in the stock market. However, if the central bank aggressively cuts interest rates, this merely encourages people to keep borrowing recklessly. If interest rates are kept high, people will think twice before undertaking imprudent borrowing.
Basically, the concern is that if interest rates are cut at the first sign of trouble, people will think it is fine to borrow beyond their means, - because the Central Bank will always help out debtors by cutting interest rates.
2. Financial Boom and Bust.
we can see two examples of Central Banks cutting interest rates too aggressively.
1987 saw a stock market crash of 25% in one week. Many felt this heralded a recession (like the great depression, following the wall street crash of 1929). As a consequence Central banks cut interest rates so that real interest rates were very low. This had the effect of pumping money in to the economy. In the UK particularly, this led to an economic boom and inflation. The result of this Lawson boom (high inflationary growth) was the need to raise interest rates aggressively to 15% in 1992. This caused a severe recession in the UK. Arguably the Central Banks should not have panicked because of the stock market crash. It was a mistake to make monetary conditions so loose.
A similar event occured in 2001 after the dot com bubble burst, and in response to the events of 9/11. The years following 2001 led to an era of very cheap credit. This underpined much of the boom in borrowing and the later problems of the sub prime market. If interest rates had been kept higher in 2001, it would have caused a little more pain then. But, it would have avoided many of US's current financial ills.
3. Deal with Fundamental Imbalances.
A downturn in the economy is usually the consequence of fundamental imbalances in the economy. For example, the US is experiencing a large current account deficit; which in turn is contributing towards a devaluing dollar. This deficit is mainly as a consequence of cheap credit and high consumer spending. Much of this spending goes on imports, especially from China. A period of high real interest rates would help reduce this imbalance in spending and saving.
Higher levels of spending would help in the long term lead to more investment and sustainable economic growth.
4. Creative destruction.
The economist J. Schumpeter, argued that recessions had many benefits for the long term success of the economy. In particular, recessions were an opportunity to weed out the inefficient firms and encourage firms to be more efficient. Although this may be painful in the short term it does have long term benefits.
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