The role of central banks in the financial crisis: lessons for the future

In summer 2007 a relatively minor financial development –an increase in non-performing loans in the high-risk mortgage segment in the United States– triggered a financial crisis which, as it subsequently gathered speed as a result of the bankruptcy of the US investment bank Lehman Brothers, reached unprecedented proportions and geographical extension. True to the behaviour pattern identified by Carmen Reinhart and Kenneth Rogoff (see Reinhart and Rogoff, 2009), this financial crisis eventually led to a crisis in the real sector whose effects became apparent in late 2008 and were particularly severe in the following year, when the world economy underwent the sharpest contraction seen since the end of the Second World War. At the time of writing of this article, this situation is far from having returned to normal, particularly in Europe, where the sovereign debt markets continue to be subject to strong tensions and three euro area countries (Greece, Ireland and Portugal) are under financial support programmes of the European Union and the International Monetary Fund. Despite this, the world economy has taken a path of progressive, although bumpy, recovery which is being clearly led by the emerging economies, and the general conditions in the international financial markets seem to be tending towards a gradual return to normality, within a climate of enormous uncertainty associated with the serious sovereign debt crisis afflicting the euro area and with the risk of falling back into recession which, although unlikely, has not been sufficiently ruled out. All in all, the most likely scenarios for the coming years suggest that the world economy has managed to circumvent the serious danger of repeating an episode similar to the Great Depression of the 1930s. The path of the world economy would unquestionably have been very different if economic policy had not responded rapidly and forcefully to apply the lessons in macroeconomic thinking learnt from the mistakes committed in the 1930s. The recourse to expansionary demand policies and to the activation of financial rescue mechanisms managed to detain the process of feedback between tensions in the real and financial sectors usually seen in crises of this size and which began to feature dangerously in the world economy from the closing months of 2008. More specifically, governments widely adopted discretionary measures to stimulate spending and quickly designed and put into practice plans to support their respective financial systems and restore investor confidence. These actions, moreover, were carried out following common basic principles decided at world level in the G20. It is important to realise that, like the crisis itself, the attempt at widescale international coordination of economic policy responses was historically unprecedented. It thus comes as no surprise that its undeniable virtues were tempered by shortcomings and hesitancy. The action of governments was accompanied by a no less timely and forceful reaction from central banks, which led to a relaxation of the general monetary policy stance in the main economic areas and to changes in scope in their respective operational frameworks. In fact, given the greater flexibility with which monetary policy can act, it was the reaction of central banks that took the leadership in operations and was instrumental in dealing with the risk of widespread liquidity crises, which, had it materialised, would have triggered a dangerous contractionary vicious circle which other branches of economic policy could have done little or nothing to combat. This article seeks precisely to analyse in detail this reaction of the monetary authorities, comprehend their contribution to overcoming the tensions and draw the appropriate lessons from this experience. More specifically, our work focuses above all on the actions of the European Central Bank (ECB) and the US Federal Reserve (Fed). The singular geographical pattern of this crisis, centred on this occasion on the advanced economies, and the importance of the United States and the euro area in this context justify this selective approach which, moreover, allows a comparison of the European and US experiences. As will be seen below, this comparison will allow us to extract some important teachings on the design of monetary policy strategy and operational framework. This does not imply that experiences of great interest are not to be found in the specific reaction of other central banks or that all the cases fit one of these two patterns, although it is true that debate has polarised around these two models. For this purpose, after this introduction we review the measures adopted by the ECB and the Fed from the outbreak of the crisis (Section II), consider the main challenges and possible lessons to be learned (Section III) and close with a brief set of conclusions (Section IV).