Axel Leijonhufvud has written an excellent policy paper for CEPR. Some highlights after the jump.
On the determination of the price level and monetary policy:
In the days of metallic standard, the price level was ultimately
determined by the demand and supply of monetary metal. The system could be imitated on a fiat standard. Not so long ago monetarists still explained the equilibrium of the price level in terms of the demand and supply of money. Reserve requirements imposed on the banks and the public’s slowly changing habits with regard to the use of paper currency together with the central bank’s control of the monetary base determined the supply. Today, the reserve requirements are essentially gone, substitutes for the use of currency have proliferated and the monetary base adjusts to the demand for it. What this means is that the price level has lost any quantitative anchor. It is no longer determined
by market forces.
Although the price level no longer has a market determined equilibrium, the central bank can use the interest rate to govern the direction in which it is changing. Set the rate below a certain value and prices should rise; above it, and they should fall. Find just the right rate and the price level should stay constant. This is what the policy strategy of inflation targeting was supposed to achieve.
However, the inflation targeting policy doctrine failed in the US. The Federal Reserve’s policy of keeping the federal funds rate extremely low helped engineer the recovery from the collapse of the dot-com boom. In the ensuing years, US consumer prices stayed within the Fed’s inflation target range. This seemed to indicate that they had found the right level for the interest rate. But the stability of consumer prices was misleading. Inflation was in fact kept in check by the policies of a number of countries intent on keeping their currencies undervalued vis-à-vis the dollar so as to maintain their exports of consumer goods to the American market. American prices were kept from rising by competition from these imports.
Hence, the Fed was misled into keeping interest rates far too low for far too long. It was running what was in effect an extremely expansionary monetary policy
although it did not produce CPI inflation. What it did bring about was asset price inflation, most notably in housing and real estate, coupled with a very serious deterioration in the quality of credit in the system.
Some simple arithmetic helps illustrate what is going on. Consider, as an example, a bank which uses $1 billion of capital and $24 billions of borrowed money to invest in $25 billions worth of assets. Its leverage ratio (debt/equity) is 24. That is high but not extraordinary in recent years. All five of the big American investment banks3 had higher leverage ratios than this at the end of 2007. Many big European banks exceeded this ratio and hedge funds often operate with still higher leverage.
Even if the rate on its assets exceeds that on its debt by only 0.5%, the bank would earn a rate of return on equity somewhat in excess of 12%. When competition from other financial institutions compresses this margin between the rates on assets and on liabilities, the bank has two strategies available by which it can maintain the rate of return on equity that its investors may have come to expect. Both give rise to self-reinforcing, positive feedback processes which serve to grow a bubble. One is simply to increase leverage further. The other is to shift part of its portfolio into riskier asset classes promising higher margins. Of course, these margins too will come under competitive pressure. Thus the recent boom ended with leverage ratios at historic highs and risk premia at historic lows.
But the riskiness of high leverage is as obvious as its profitability. Suppose 20% of the bank’s assets were in mortgages or mortgage-backed securities and that it
incurred a 20% loss on them. A decline of just 4% in the market value of its asset portfolio would render the firm insolvent and would cause it to go bankrupt if it was forced to use mark-to-market (MTM) accounting which would reveal its condition for all to see.
The early stirrings of political debate on reforms have been unthinkingly ideological. Proponents of free markets argue that none of our present problems would have happened except for government interference in housing and mortgage markets. Others regard markets in general as unreliable and would like to see virtually all financial markets tightly regulated and all financial institutions closely supervised. One side needs to recognise that system-wide leverage is not stabilised by market forces and that fluctuations in it are destabilising to the real economy. The other side needs to recognise that properly structured financial markets will generally work well and that governments are unlikely to find competent supervisory talent that could improve their functioning.