NCPA - National Center for Policy Analysis

Financial Crises: Prevention, Correction and Monetary Policy

November 14, 2011

The financial crisis that surfaced in 2007 has stressed the need to identify the ultimate sources of the incentives that were behind the preceding credit and housing bubbles.  To lower the likelihood of future financial collapses, prudent economic policies as well as an adequate regulatory and supervisory framework for financial institutions are required.  Monetary policy, in turn, should be directed toward price stability, says Manuel Sánchez, a Member of the Governing Board of the Bank of Mexico.

There were two cyclical causes of the banking crisis.  The first was the atypically low interest rates that characterized American financial markets for years before the housing bubble burst.

  • These rates were suboptimal and contributed to excessive risk taking and lending, as capital appeared to be free flowing.
  • Whether they were due to expansive monetary policy or large inflows of funds from developing countries is not the correct focus: what matters is recognizing the role that low interest rates played in the housing bubble.
  • Additionally, government policies that rewarded non-market lending, and gave rise to subprime mortgage rates, distorted market incentives and encouraged the leveraging of positions.

The crisis was also partially causes by structural issues.

  • Specifically, banks were held back by little regulation with low capitalization requirements and few demands for the maintenance of minimal liquidity.
  • Oversight must be expanded and regulation must be introduced in order to rein in negative externalities caused by bank actions in response to these circumstances.

It is on this final cause that the Federal Reserve should focus its monetary policies.  The best central bank is that which encourages price stability and acts passively in the market to prevent crises.

Source: Manuel Sánchez, "Financial Crises: Prevention, Correction, and Monetary Policy," Cato Journal, Fall 2011.

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