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What Role for Central Banks in View of the Current Crisis?

Listed author(s):
  • Philip Arestis
  • Elias Karakitsos

Central banks have an aversion to bailing out speculators when asset bubbles burst, but ultimately, as custodians of the financial system, they have to do exactly that. Their actions are justified by the goal of protecting the economy from the bursting of bubbles; while their intention may be different, the result is the same: speculators, careless investors, and banks are bailed out. The authors of this new Policy Note say that a far better approach is for central banks to widen their scope and target the net wealth of the personal sector. Using interest rates in both the upswing and the downswing of a (business) cycle would avoid moral hazard. A net wealth target would not impede the free functioning of the financial system, as it deals with the economic consequences of the rise and fall of asset prices rather than with asset prices (equities or houses) per se. It would also help to control liquidity and avoid future crises. The current crisis has its roots in the excessive liquidity that, beginning in the mid 1990s, financed a series of asset bubbles. This liquidity was the outcome of “bad” financial engineering that spilled over to other banks and to the personal sector through securitization, in conjunction with overly accommodating monetary policy. Hence, targeting net wealth would also help control liquidity, the authors say, without interfering with the financial engineering of banks.

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File URL: http://www.levyinstitute.org/pubs/pn_09_02.pdf
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Paper provided by Levy Economics Institute in its series Economics Policy Note Archive with number 09-2.

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Date of creation: Mar 2009
Handle: RePEc:lev:levypn:09-2
Contact details of provider: Web page: http://www.levyinstitute.org

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  1. Edward E. Leamer, 2007. "Housing is the business cycle," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 149-233.
  2. Claudio Borio, 2008. "The financial turmoil of 2007-?: a preliminary assessment and some policy considerations," BIS Working Papers 251, Bank for International Settlements.
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