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Cambridge Journal of Economics 2009, 33, 581608 doi:10.
1093/cje/bep026
The limits of central bank policy: economic crisis and the challenge of effective solutions
Jamie Morgan*
Downloaded from http://cje.oxfordjournals.org/ by guest on December 13, 2013
The paper examines the development of central bank policy prior to and during the recent nancial crisis. The argument is made that it contained multiple failures that not only generated constraints on adequately identifying and addressing the crisis but also contributed to that crisis. Those failures derived from a combination of theory and institutional practice. Specically the use of forms of inationary targeting based on broad adherence to the Taylor rule framework and the use of versions of a Conventional Theoretical Macro Model (CTMM) were both problematic. This was particularly so in the way policy was focused through issues of the primacy of price stability. The institutional arrangements of the central banks were also problematic. The division of labour between the central banks and other regulatory bodies and the limited information available within a liberalised nance system hampered efforts to fully appreciate the gravity of the situation. Partly due to the constraints imposed by the thinking and strategies that had been developed the central banks never got to grips with the fundamental problems of the crisis. Interest rate policy and liquidity provision were undertaken in ways that steadily radicalised the approaches of the banks but always in a way that was event led and always in ways that could not resolve those fundamental problems. The nature of the crisis highlights the importance of transforming the approach and institutional framework of the central banks. Relatedly, it highlights the need for a more Keynesian and heterodox approach to economics within decision making bodies at central banks. Key words: Central bank policy, Taylor rule framework, Fed, Bank of England, Keynes, Interest rates, Liquidity JEL classications: G0, B4, P1
1. Introduction
As many of the papers collected here argue, and as many academics and policy makers around the world now acknowledge, the current economic crisis is both quantitatively and qualitatively different than any in recent memory. Though beginning as a nancial crisis restricted to particular states and regions it has become a pan-systemic and essentially global economic crisis (Thompson, 2009). The nature of that crisis has revealed basic vulnerabilities within states and around the world. Those vulnerabilities were based on
Manuscript received 31 March 2009; nal version received 10 May 2009. Address for correspondence: The Centre of Excellence in Global Governance Research, PO BOX 4 (Yliopistonkatu 3) 00014, University of Helsinki, Finland; email: zen34405@zen.co.uk * University of Helsinki.
The Author 2009. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved.
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a combination of debt and leverage, intra-nancial multiplication and securitisation, pathological structural developments in individual economies, and unsustainable asymmetries in global capital accumulation, creating imbalances in trade, investment and consumption dynamics (Morgan, 2008, 2009; Wade, 2008). Initially, the crisis was slowburning, involving progressive reappraisals of the nancial outlook by major institutions and punctuated by a series of critical events. Each event was followed by a period of calm and an attempt by states, markets and many in the media to promulgate the view that recovery was imminent and that real economy effects would be shallow and short-lived. This remained the case from the freezing of credit markets and the decoupling of Libor and market interest rates from central bank short term interest rates in August 2007, through the crash of equity markets in January 2008, and the collapse of Bear Stearns in March 2008, all the way through to the stagation debates of that summer. The rhetorical shift was, however, progressively towards the negative: nancial deleveraging / correction / slowdown / downturn. Yet it was only after the bailout of AIG and the collapse of Lehman in September 2008 that it no longer became tenable to pursue a rhetorical line of limitation. There are at least two reasons why a rhetorical line of limitation was pursued. One is that key actors in the system were aware of the potential negative behavioural effects of stating either how bad things were or what worse case scenarios might entail. In a liberalised and increasingly interconnected and interdependent system words and actions have great condence effects. These are no less signicant than the individual substantive aspects of the system to which they refer. The two are, in many respects, linked. A second reason for a rhetorical line of limitation was simply that the scale and extent of the emerging crisis was under-estimated. That it was under-estimated is in turn indicative of the predominance of the ideas that gave birth to the dysfunctional system from which the crisis then manifested. These two reasonsawareness and under-estimationmight appear to be contradictory. They are, however, more appropriately thought of as in tension. Key actors were sufciently aware to know that problems were emerging but they were also committed to policy positions and institutional arrangements that constrained the way problems were perceived and how they could be managed. In this paper I focus on one example of this constraint: the role of central banks. More specically, given their nodal roles in the initial nancial crisis, I focus on the Bank of England and the Federal Reserve Bank (Fed), but also with some comment on the European Central Bank (ECB). My main point is that although it would be an over-statement to suggest that theoretical models absolutely dominate and determine central bank perspective and policy one can still plausibly argue that they provide a signicant resource for how data is viewed and how thinking on issues regarding economic management are framed. Since the 1990s the Bank of England and Fed in particular have made use of a Taylor rule framework approach that is, in turn, rooted in a Conventional Theoretical Macro Model (CTMM). The Taylor rule focuses on the manipulation of short term interest rates to maintain stable ination and economic growth. The Taylor rule framework and the CTMM are problematic in a number of specic and general ways, which I set out in Sections 2 and 3. Specically, the combined approach pays little or no attention to broad money, is based in rational expectations and has, in its Bank of England guise, used an extrapolation procedure that has a strong presumption of long term stability. More generally, and from a Keynesian point of view, the modelling procedure creates problems of certainty that fail to account for qualitative changes in a system. In terms of the crisis the problems meant that within a monetarist perspective of inationary targeting there was no pressure deriving from the approach for the central banks to act to forestall potential problems inhering in the broader tendencies and capacities of the economy. Rather the opposite held true, the apparent success of inationary targeting in
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creating relative price stability as part of the great moderation provided central banks with a degree of condence that economic management was effective. Furthermore, the very condence instilled by the great moderation provided the grounds for deviations from the Taylor rule so long as relative price stability was maintained. One could argue that in the context of the underlying deationary effects of global outsourcing to least-cost sites such as China, weakened domestic trade unions ability to secure higher pay claims, and in the context of the use of ination measures that strip out bubble markets like housing, the central banks used discretion to maintain interest rates below what a strict adherence to a Taylor rule would otherwise require. As such, the existence of price stability and the economic management ethos of the central banks helped to feed nancial instability by contributing to a debt-related economic growth culture that helped feed further pathological developments, for example, in securitisation and intra-nancial multiplication. Maintaining nancial stability is the other main remit of central banks. Clearly central banks were constrained in their view of the potentials for problems to become genuine nancial crisis. Here the institutional arrangements in which central banks are placed come into question and I explore this in Section 4. A key issue is that if price instability is not providing a signal of nancial instability then the central bank must look to other sources of information and impetus to identify any incipient instability. What the crisis reveals is that the division of labour regarding nancial oversight and the simple fact of the opacity and complexity of liberalised nance worked against any individual institution having a broad view of the pan-systemic potential for crisis. The degree of discretion and the potential for dissent and discussion inherent in a committee-based decision making process at the central banks did not ameliorate this. Problems were either not recognised as profound or were not acted upon effectively until it was too late. Thereafter, as I set out in Section 5, central banks found themselves consistently unable to get to grips with the emerging crisis. Although the central banks have steadily radicalised their approaches to the crisis they have done so in a way that has been event-led. In any case their primary policy tools: short term interest rates and liquidity management, are simply not set up to deal with a pan-systemic and structural crisis. My nal point is that the very fact that such a crisis has been possible indicates the need for a fundamental change in the ethos of the nancial system. Part of that change must also be a change in the approach to banking, including the institutional arrangement of central banks, the theoretical models used, and the broader role of the economist within the central banks. I briey address these points in the conclusion.
2. The Taylor rule framework, CTMM and monetarism

There are, for various historical reasons, differences between all central banks.1 However, there are also commonalities.2 The Fed, Bank of England and, to a lesser degree, the ECB, have pursued a form of policy informed by a common brand of applied monetarism that emerged in the 1990s. Each sets a short term interest rate whose purpose is to feed through and inuence short term market interest rates and, less directly, long term commercial rates. Each is mandated specically to control ination as part of its primary function. As such
1 For a useful source of information on central bank structures see the Bank for International Settlements (BIS) homepage at www.bis.org. For background on the Fed see Hetzel (2008). On the Bank of England see Bean (2001). 2 According to Eugenio Solans, member of the ECB governing council: I think that there is an excessive and useless gap between academic discussions and central banking practice concerning monetary policy strategy. When reading academic literature, one draws the conclusion that many different and even opposite approaches exist, whereasin practicethe ways in which central banks take monetary policy decisions are not so different (Solans, 2000).
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each has some form of ination target. The Bank of England has a specic target ination rate imposed by the Chancellor and currently set at 2% based on the consumer price index (CPI). The allowed parameter of deviation is 1%. The ECB has more generally articulated an aim of price stability, also at 2%, rather than a specic institutional arrangement. The ECB has operated with greater latitude in terms of its target because it has had to work across multiple economies that have not converged on the basis of monetary union in the ways initially predicted (Surrico, 2003). The Fed is slightly different again. Under Alan Greenspan, it operated according to a preferred ination rate creating an implicit target (Mishkin, 2007). As of 2009, however, supported by both Ben Bernanke and new governor Frederic Mishkin, the Fed has moved towards making this target a more explicit condition. Whether implicit or explicit, the main point is that some form of targeting has been linked to the basic tenet that low and stable ination is a key constituent in economic growth and that the manipulation of short term interest rates affects both market rates and broader inationary expectations. When not in a time of crisis, everything else is viewed through the primary importance of price stability, controlling ination and the role of interest rates in doing so. The theoretical basis of the role of interest rates has been provided since the mid1990s by the Taylor rule framework (e.g. Taylor, 1998).1 The framework can be expressed in various ways. Asso et al. (2007) at the Federal Reserve Bank of Kansas express it as: . . r 5 p 1 1 2y 1 1 2p 2 2 1 2 The framework provides a simple relation between the short term interest rate and the goals of monetary policy. The interest rate, r, is set to moderate ination and push gross domestic product (GDP) to its trend level. The deviation of GDP from trend is represented by y, and p is the rate of ination over the last four quarters. A target ination rate is one at which GDP is on trend (in this case, 2%). Knowing the current ination rate and output gap then allows one to set a corresponding interest rate to moderate ination and minimise business cycle uctuations by balancing the equation (again 2% at equilibrium). The effect of current interest rates on ination is assumed to be time-lagged over several quarters. The approach is quasi-historical, since Taylor tested the framework by assessing its t to actual Fed interest rate policy in the late 1980s. It is also conveniently empirical in the sense of application. It produces a simple formula for setting interest rates, as well as a justication for focusing primarily on short term interest rates as opposed to complicated measures of monetary aggregates. It was, as such, appealing to central banks like the Fed, which, since the late 1980s, had been steadily moving away from a reliance on such complicated aggregates. From 1995, the Board of Governors of the Fed and the Fed Open Market Committee (FOMC) who set interest rates began to discuss and apply the Taylor rule framework in various modied forms. It was also taken up by the Bank of England monetary policy committee (MPC) in 1997 and became a constituent in interest rate decisions made by the ECB governing council (Surrico, 2003).2
1 For academic reference to the consensus among practitioners see the American Economic Review conference papers and proceedings 2001. Of particular note are Woodfords defense (2001), and Alvarez et al.s (2001) critique. For the broader context regarding the dividing lines of Monetarism see Taylor (1993, 2007) and Leeson (2000). 2 It is, for example, set out as equation 3 in Angeriz and Arestiss (2007, p. 866) synthesis of the Bank of England model, discussed hereafter. Note that Angeriz and Arestis set out the model using six equations whilst Smith (2007) reduces it to three. The essential features, however, remain the same. Note also that targeting has a longer history at the Bank of England than adoption of a Taylor rule framework. It was initially introduced in 1992 following withdrawal from the exchange rate mechanism (ERM). However, its context and signicance were substantively changed by the independence of the Bank as of 1997 and the creation of the MPC.
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The Taylor rule is itself one constituent in the CTMM. Versions of the CTMM are used by the Bank of England, the Fed and a wide variety of central banks as a primary modelling tool (Smith, 2007). The model is also used in turn by many capital market actors in order to assess central bank behaviour. The CTMM is a three equation model. The rst equation is used to determine the output gap (an IS curve). The second equation is a Philips curve used to determine ination. The latter two feed into the Taylor equation. For tractability purposes the CTMM assumes a closed economy, broadly rational expectations (a discounted future) and excludes broad money or credit. The Taylor rule framework constituent of the CTMM had a particular appeal in that it was a rule based approach that could easily be reconciled with a central banks relevant decision making bodys use of discretion in setting interest rates. If targeting is institutionalised and explicit then the existence of parameters creates a licence for degrees of variation from strict adherence to the rule. If targeting is looser the same applies in an informal way. The focus on price stability related to the rule also creates scope for discretion. In principle, interest rate policy is usually held to be neutral in the sense that it should not in itself be used as an additional source of economic growth.1 If it were then it would tend to be inationary in its effects. However, if relative price stability is maintained then it becomes possible for interest rates to deviate from a rigid application of a Taylor rule framework precisely because of relative price stability. The assumption remains that the Taylor rule holds good but that broader factors within the economy are affecting prices in ways that allow interest rates to be higher or lower than might otherwise be expected. Further latitude is also provided by the Taylor Principle. The Taylor Principle states that the nominal interest rate should increase by more than a ratio of 1:1 with ination in order that the real interest rate is increased. The issue here becomes which measures of ination and GDP are used and what degrees of expected feed-through from underlying forces are allowed for that are perhaps not visible in current data. All central banks consider a wide variety of ination measures but will place greater emphasis on one or the other in making decisions. The Bank of England is required to use the CPI. Even here there is still a great deal of scope for debate regarding current economic conditions and the future effects of those conditions. There is, therefore, the potential for a great deal of discretion that might see interest rates become expansionary. For example, arguably US interest rates were expansionary during the run up to the end of the dotcom boom of March 2000. Greenspan repeatedly justied the rate based on underlying productivity effects. Thereafter, the market collapse and the events of 9/11 were used to justify even lower interest rates, based on issues of exogenous shocks and on anticipated underlying deationary forces as China entered the World Trade Organisation. Relative price stability, particularly as measured using methods that strip out volatile aspects of the economy (housing, energy, food and clothing), provided an overall context for this. A Taylor-based approach, then, had the appeal of technical elegance, a focus on a simple primary policy tool and a degree of exibility in its application. As such, it provided a useful theoretical resource in resolving the perennial conict in central bank practice between rigid rules-based approaches and intuitive discretionary approaches. In particular, it tted with a new consensus that spread from the Fed that combined a more exible rule-based approach with discretion and did so based on a new interest rate setting strategy (Blinder and Reis, 2005). From the mid-1990s to the current crisis central bank interest rates in the UK and US were historically low, at least when compared with the preceding period of the
1
An orthodox monetarist position would argue that interest rates cannot be a source of growth in the long
run.
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1980s. More importantly their movement lacked a volatility that could itself be problematic for economic stability. Changes were small, typically 0.25% or 0.5%, incremental and signalled. A policy of gradualism limited the destabilising effects of sudden large changes. A policy of incrementalism created a trend or tendency that it was assumed would form an expectation management system that various economic actors could internalise as a behavioural pathway. The pathway followed a narrative of how and why central bank policy was evolving. Here the very existence of a relatively simple rule-based approach that the central bank could be seen to be broadly adhering to provided a useful underpinning to the strategy. In the case of the Bank of England, the 1997 institutional changes were also intended to add credibility to central bank behaviour by depoliticising interest rate decisions. The overall intention was that economic actors would factor in the trend and accommodate to it, affecting employment, wages, consumption and capital markets. From June 1989 to August 2006 there were 74 interest rate changes by the FOMC of which 57 were 0.25% and 16 were 0.5%. From the beginning of 1998 to the end of 2007 there were 33 changes in the base rate by the MPC, 32 of which were 0.25% and one of which was 0.5%. Rates varied from 7.5% to 3.5% and, prior to the crisis, averaged around 5%. Until the end of 2003 the general trend had been downwards. The overall approach to interest rates is one described by Bernanke as constrained discretion (Bernanke and Mishkin, 1997).1 Its communicative aspect has been one variously articulated as partial transparency, the creation of a direction bias and the communication of balance of risk. Communication is understood to work at different levels. For example, at the Bank of England one has the quarterly reports: the ination report and the nancial risk report. These provide hard empirical evidence based on data sets and forecasting. These are based primarily on the Bank of England Quarterly Model (BEQM), strongly inuenced in its design by CTMM (Harrison et al., 2005; Smith, 2007). The contents provide material for market actors, analysts and the media. The media simplify and humanise the material to suit their particular medium and audience. Other avenues of communication include representations to the Treasury Select Committee, speeches to specic functions by the Governor and deputy governors, the (delayed) published excerpts from monthly MPC meetings (indicating voting splits, hawks and doves etc.), as well as the letters the Governor must write to the Chancellor if and when the parameters of the ination target are breached. The underlying tenet is that central banks can play a nodal role in shaping behaviour through communication that in turn can feed through to achieve the goals incorporated in the theoretical model. Both articulate a kind of stability. The theoretical model claims to moderate the business cycle, whereas the strategy of interest rate changes and their communication, broadly in accordance with (but not slavishly beholden to) the model, allows for adjustment to be gradual and manageable. For central banks there seemed to be a broad t between theory, policy and fact. Despite the, pace Shiller (2005) and Greenspan, irrational exuberance culminating in the dot.com crash March 2000 to October 2002, the period from the mid-1990s to the credit crunch of August 2007 was one of low ination, general economic growth and relatively stable high
1 The balance within the strategy between formal rules and discretion has been variable: Greenspan tended more towards discretion and Bernanke, at least formally, has articulated a more rules-based approach (stricter adherence to the models described as a more empirical-scientic approach). The difference, however, is a matter of degree. The clearest statement of the narrowness of the difference was provided on 14 November 2007 when the Fed announced a new communication strategy with a greater emphasis on showing the role of a rules based and data approach but one that also highlights the need for greater transparency. Fed economic forecasts would be published each quarter rather than biannually and would be for three rather than two years and published excerpts from FOMC meetings would include greater information on any dissenting positions.
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employment. Central bankers, and Treasury ofcials who worked in conjunction with them, took to referring to this period as the great moderation or, in Mervyn Kings phrasing, the NICE economy (non-inationary consistently expansionary).
3. The multiple points of failure of applied monetarism as central bank policy

Central bank policy during the period of the great moderation was deeply problematic in a number of ways. Ultimately those problems were part of the reason why the moderation was misunderstood. A useful way to begin is with the primary focus of applied monetarism in accordance with the Taylor rule framework: short term interest rates as a means to create low and stable ination on the understanding that these are main constituents in economic growth. If we consider this as a problem of theory the model has deep methodological problems that then create practical problems of policy. Taylors approach is rooted in modied rational expectations as is the CTMM more broadly. The equilibriums constructed from trend rates ultimately assume normal distributions that underpin the notion of statistical convergence around measures of GDP and ination. Put another way, reality has a series of fundamentals that provide an enduring rational calculative basis for actors within the system allowing it to return to equilibrium. When this is conjoined with forecasting based on collected data this shifting idealised point becomes not just the goal but also the real point of the system at any one time. It is an as if that becomes the real that should be. From a Keynesian point of view one would argue that one cannot simply assume that equilibrium will be restored through rational response. The very notion of equilibrium is dubious in the way it is understood through the assumptions of CTMM. Here, seeking to realise that equilibrium reveals a basic problem. Tacitly averaging out and terming that stability, which is then understood as a moderation of variation in some deep underlying cycle of relations between the variables in an equation, de-emphasises that the variation is itself real and not reducible to the variables in the equation but to their multiple causes. The stability implied by the targets is, in one sense, ctitiousan imagined goal, conjured from the equation. But it is ction with a function. It takes the relative instability of a period and shows how the equation would have moderated it or it takes the relative stability of a period and iterates it without demanding a broader picture of what it is that is creating the relative stability. It does not formally exclude that broader picture of causes. It simply does not require it to be part of the decision making process in setting interest rates once the model has been run. Nor does it mean that manipulating interest rates cannot be correlated in a statistically signicant way with ination and growth over a given period (which is what the great moderation was). Policy can be effective in this sense. And, of course, one might argue that the data or empirical information fed into the model to derive ination and GDP levels (output gaps etc.) capture causes. One might respond that they are capturing Lucasian stylised facts. Even if this were valid, again, interpretation and understanding of those causes remains vital because it is in those causes that the very basis of any specic conjuncture of stability or pattern that has occurred resides. This raises a further Keynesian point regarding liquidity preference and the marginal efciency of capital, both of which are inherent to policy interventions in relation to output gaps and ination. Interest rates are ultimately set against a psychological unknown whose only anchor is that actors are, and are being assumed to be, continuing to act on the basis of what they have already done because they deem this a reasonable way to proceed (Keynes, 1936: chs 11 & 12). Seismic shifts in patterns of behaviour are not common but nor are they uncommon. Shifts in behaviour based on widespread changes in attitude or belief may be a cause of
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other radical changes in a system. Conversely, other substantive aspects of the system may change in ways that affect behaviour. In either case, the complex of causal relations may themselves be unstable or fragile in their current relative stability. This was clearly the case in the run up to the dotcom collapse and is clearly, as Minsky (1982, 1986), Kindleberger and Aliber (2005) and others have argued, a common characteristic in all kinds of gradually accumulating bubbles. As Minsky also pointed out the capacity for this to occur is not some randomised exogenous shock to an otherwise stable system, it is intrinsic to the dynamics of a system. An important aspect of this is that in so far as a distribution or pattern holds good for a time it is based on rationales not a single rationality. It is, therefore, a basic error to identify the causes of stability as correlative with stability per se. Paradoxically any approach to the empirical aspects of theoretical modelling must also be counter-factual in thinking about the future implications of what has gone before. The trouble with the Taylor rule framework is that it pushes all of these considerations to the side. This is important because there is no pressure deriving from the model for the central bank to act to forestall potential problems inherent in the broader tendencies and capacities of the economy. Rather the opposite holds true, if short term interest rates are the primary tool of monetarist policy and interest rates are set relating to inationary targets, so long as target parameters remain unbreached there is no pressure on the central banks to forestall problems through direct intervention via interest rates. Of course, the models are also forecasting and the (dis)inationary effects of interest rates are held also to be time-lagged, so one might assume that an effective interest rate policy was in any case always one managing and constructing the future. This is precisely what the Taylor rule claims to offer. However, there is a painful tautology built into the forecasting. The forecasting assumes that the Taylor rule holds good and that given interest rate changes can maintain GDP on or around trend and achieve target ination rates. Modelling involves margins of error, stress testing etc. and thus simulations are run in which there are deviations. But the basis of the modelling still remains that the underlying relations hold good. As such, the complexity of the models disguises the fact that the future is held to be like the past.1 The modellers would argue that they are linking the future to the past (a patterned dependency). However, qualitative change as a cause of crisis is ultimately excluded. This insight is not one restricted to classical Keynesians and, most notably, Shackle (1990). It implies the confusion between probability and uncertainty but it is also a broader problem of complexity as Marshall acknowledged a century ago:
But while a mathematical illustration of the mode of action of a denite set of causes may be complete in itself, and strictly accurate within its clearly dened limits, it is otherwise with any attempt to grasp the whole of a complex problem of real life, or even any considerable part of it, in a series of equations. For many important considerations, especially those connected with manifold inuences of the element of time, do not lend themselves easily to mathematical expression; they must either be omitted altogether, or clipped and pruned till they resemble the conventional birds and animals of decorative art. And hence arises a tendency towards assigning wrong proportions to economic forces; those elements being most emphasised which lend themselves most easily to analytical methods. (Marshall, 1890/1930: 850)
That the CTMM is based on a closed economy is in this sense deeply problematic for its broad realism. Equally concerning is its lack of specic attention to credit-money (such as M4). In terms of the realism of the model one might also note that the BEQM is a two part model. As Smith notes (2007: 14):
1 It is not as simple as to suggest that imperfect knowledge and uncertainty are ignored by modellers, but rather that they are distorted in what they signify; see, for example, Orphanides and Williams (2005).
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The BEQM is built in two distinct parts: a theoretical core model with imposed calibrated coefcients and a set of non-core equations that include additional variables and dynamics not formally modelled in the model core. This is analogous at the level of the whole model to the classic co-integration approach, in which the steady state is estimated in stage one and the dynamics in stage two. The stabiliser terms in the BEQM are dened as the difference between the lagged dependent variable and the prediction from the core model. This means that the whole model snaps back very quickly onto its imposed core.
Modelling of this kind is one reason why central bank and global institution forecasts have consistently run behind the severity of real world events over the last couple of years. It is a main reason why those forecasts have been progressively updated. Forecasts have never been as inaccurate in the modern period as they have been since 2007. Qualitative changes in the system have rendered the models essentially redundant. The design of the models has failed to adequately represent change. The existence of the models, one might further argue, created an impediment to fully grasping that such change was occurring and what it might mean.
4. Institutional failure, price stability and nancial stability

It would be too simple to state that central bank policy is made mechanistically. It has a strong technical aspect and this has surely been found wanting. At the same time policy decisions are made by committee. The very fact of the crisis tends to indicate that the committees were also found wanting. The committees comprise a balance of experts of different kinds. The 12 members of the FOMC include the seven Governors, the president of the New York Fed and, on a rotating basis, four of the 11 remaining reserve bank presidents. Governors tend to be longstanding research active members of the Fed, prominent academic economists and individuals with extensive experience in the upper echelons of commercial banking. The nine members of the MPC include the Governor and two deputy governors, the executive director and chief economist of the Bank and four external members appointed by the Chancellor. The external members tend to be prominent academic economists. Ostensibly, then, the decision-making bodies comprise individuals with a range of expertise and positions that might be described as insiders and outsiders. The published edited minutes of meetings indicate that discussions are wide-ranging, covering all aspects of economy before decisions are made.1 Several cautionary points are relevant, however. The insideroutsider distinction is more relative than real. Members tend to share a background of training and/or research in orthodox economics: precisely the kind from which the Taylor rule framework and the CTMM have derived. The notion of a distinction between doves and hawks is also more relative than real. Members do not have a published or practical track record for unorthodox thinking on economic systems. Published minutes indicate that there can be disagreement but that strong dissent is diminishingly rare. This is also reected in voting patterns, which are rarely evenly split and tend towards unanimity. Within the MPC Professor David Blanchower is currently the nearest to a genuinely independent gure. He is, however, a labour economist not a nance economist or an expert in economic systems at the broadest level. As such it is likely that his point of view carries little authority in discussion.2 A background in economic systems and economic crisis is rare. Ben Bernanke has such a background. His works on the non-nancial causes of the Great
One should also note that the central banks also refer to opinion polls, condence indexes, etc. He was, for example, prominently slapped down by Mervyn King at a Treasury Select Committee hearing in the summer of 2008. Though Blanchower has published little on ination and monetary policy his views can be found in a speech to the Royal Society in Edinburgh, 29 April (Blanchower, 2008).
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Depression and on the nancial accelerator mark him out as a genuine expert on crisis and qualitative change. He is not, however, a Keynesian or a dissenting gure like Minsky. He is a former editor of the American Economic Review and, in many respects, an orthodox economic modeller. One might also note that by the time he became chairman of the Fed in 2006 the underlying causes of the crisis were already in place. Moreover, the institutional arrangements of the Fed produced two additional problems. First, the liberalisation of nance markets had increased the complexity, opacity and rapidity of nancial systems changeand most of that was beyond the immediate oversight of the Fed. Second, based on those issues that were already manifestingsuch as the housing market bubble Bernankes options were highly limited in terms of the constrained discretion policy that had been developed. Any major deviation in rhetorical line from the Fed or any sudden shift in interest rate setting policy would likely be destabilising in themselves. Indeed, as I note in the following sections, as the central banks radicalised in response to the crisis from 2007 this additional destabilising proved to be the case. Arguably, then, both the FOMC and MPC had become prisoners of discourse, unfolding events and their own institutional arrangements. In any case, these key decision making committees focus on interest rates. In ordinary circumstances the broader issues that central banks also address are relevant only in so far as they relate to interest rates. As such, the ability of the key dialogical and democratic decision making bodies (as opposed to the chairman of the Fed and governor and deputy governors of the Bank of England who are members) within the central banks to raise and address broader issues are highly constrained. The notion of becoming a prisoner of discourse, events and institutional arrangements is also important when considering those broader issues. The other main function of central banks in addition to controlling ination is the maintenance of nancial stability. A key question is how does one account for the failure of the central banks to effectively address nancial stability prior to the actual manifestation of the crisis? One can consider this in terms of two contextualising issues. First, the problem of institutional division of labour and a related limitation on information within a liberalised nance system. Second, the problems that emerged from a primary focus on price stability in a context of underlying deationary forces. Since its independence in 1997, formalised in the Bank of England Act 1998, the Bank of England has been mandated to maintain nancial stability through operations to affect liquidity and is also empowered to act as lender of last resort. It is further mandated to ensure that the UK nancial system is benecial to the rest of the economy. However, though the Bank had responsibility for the system as a whole, the newly created Financial Services Authority (FSA) was given responsibility for oversight of individual nancial organisations business models. The Treasury was given responsibility for setting target ination levels, managing the national debt and broadly overseeing the operations of the other two institutions. This was the now maligned tripartite system. This tripartism created an apparently clear division of labour but an actual problem of blurring due to issues of adequate information ows between the institutions, as well as issues over actual responsibility, and chains of command and hierarchy regarding nancial stability. Have instabilities arisen, is it likely instabilities will arise, who is informed, what is to be done, who makes the ultimate decisions, should one institution pressure another to take rmer action? In the US similar issues of a division of labour arose between the Fed, the Treasury and the Securities and Exchange Commission (SEC), as well as a host of other oversight committees to which state and federal nance organisations reported. This division of labour problem, with its ambiguities, was exacerbated by a further information problem. In both the UK and USA many nancial institutions operated
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without direct supervision. These included hedge funds, private equity limited liability partnerships (LLPs) and special purpose vehicles.1 Other important organisations were under-scrutinised in their operations. These included the treasury arms of nancial conglomerates and investment banks. The repeal of Glass Steagall in the USA, and the light-touch oversight approach of the FSA contributed to this under-scrutinisation, as did the development of cross-border and shadow banking and the increasing use of off-balance sheet strategies. The key areas of intra-nancial multiplication in which securitisation, debt and leverage grew were precisely the areas in which the main oversight bodies had the least information and the least direct inuence. In an era of nancialisation (Froud et al., 2006; Palley, 2007) this was a glaring regulatory aw. One important point of context regarding the failure to adequately address nancial stability was that the overall system was everybodys problem but nobodys specic responsibility. Fully grasping its complexity of inter-connections was hampered both by the lack of an overall picture, the lack of effective communication between different regulatory institutions and, just as importantly, the fact that regulators accepted the basic story of the underlying robustness of the nance system. One sees this latter point, for example, reected in the blithe approach of the FSA towards those it regulated. One sees it in central bank and global institutions common strand of reference prior to mid 2007 to a new age of risk spreading and nancial organisation efciencies based on ever more complex mathematical and computerised modelling. Here, it was not that problems went unidentied, but that they were identied as problems within the system not of the system. Critics were marginalised, worse-case scenarios rejected. And yet many vulnerabilities were manifest from 20042006 in the UK and USA in ways that clearly showed inter-connections (Gills, 2008; Pettifor, 2006). Absolute levels of debt were rising and leverage levels were rising making debt servicing more interest rate sensitive. House prices were rising faster than incomes. The expansionary business models of some banks were increasingly dependent on the renewal of short term debt in wholesale markets. Investment banks and treasury arms of commercial banks were increasingly engaging in proprietary trading. Their role as prime brokers was expanding intra-nancial multiplication and fuelling further securitisation and the creation of structured credit products. Speculative investment through other derivatives that were originally intended as insurance (credit default swaps, blended foreign exchange futures etc.) was creating a highly unstable asset class. These were all issues that made tenable the notion that the ongoing dynamics of the nancial system were leading to collective qualitative changes. It was, however, 2007 before major institutions began to transform their assessment of these trends. Prior to 2007 the dominant position was that issues, although potentially problematic, could, and likely would, be resolved through market corrections, perhaps with small nudges from the state. By 2008 it had become more common to refer to issues as actual systemic problems based on multiple connections. For example, the April 2007 Global Financial Stability Review from the International Monetary Fund (IMF) was tentatively just ahead of the curve in stating that debt and leverage were creating vulnerabilities should a highly unlikely constellation of risks occur. That the IMF and the main central banks and state Treasuries had underestimated the problem was acknowledged in the April 2008 Review, which refers to a collective failure to appreciate the extent of the leverage taken on by a wide range of institutions and the associated risks of
1 The legal structure of LLPs provide numerous advantages including the maintenance of condentiality or secrecy (see Morgan, 2009).
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a disorderly winddown.1 The use of appreciate here is signicant in terms of what it connotes. The very basis of a liberalised market system is one where individual economic actors are assumed to behave on the basis of individual self-interests. The IMF statement that a disorderly wind-down was unexpected only makes sense if one has a single unied rational expectations approach to market behaviour based on a transformation from individual self-interest to stabilising collective outcomes (returning to a dynamic equilibrium based on fundamentals). The indication seems to be that the very narrative of a robust system was one rooted in an orthodox theory perspective. From the point of view of Keynes or Minsky, a disorderly wind-down is precisely what you would expect. In terms of nancial stability, the issue then is not so much the lack of a general awareness of some rising individual balance of risk issues but the translation of that to an early understanding of the potential for genuine crisis to which policy measures could be applied. Central banks did not rapidly raise interest rates in order to affect market rates and sharply curtail bubble effects. Their targeting systems and focus on price stability worked against this. In fact, the Fed in particular, but also the Bank of England to a lesser degree, had done something less over the decade. Since the market crash of 200002, each had maintained short term interest rates at slightly lower than the Taylor rule might require. One reason for this was the existence of powerful underlying deationary forces arising from a combination of globalisation and lower bargaining power amongst labour (Coutts et al., 2007; Hatch and Clinton, 2000; Turner, 2008). Allowing interest rates to be expansionary offset these deationary forces. Price stability and the great moderation seemed to make this approach reasonable. In the case of the Bank of England, the use of the CPI as an ination measure that strips out housing effects further meant that low and expansionary interest rates would not affect its targeting effectiveness. Since the Taylor rule framework meant that the central banks placed less emphasis on complex measures of monetary aggregates and the CTMM excludes broad money, the main modelling resources of the central bank would not be agging this as problematic.2 Even as interest rates started to rise in 2003 and 2004, the new system for introducing rises meant that they would not rise sharply. Commenting on the situation, in a Bank of International Settlements paper, William White notes that price stability is not a necessary correlate of nancial stability (2006). Too great an emphasis on it can either reduce attentiveness to instability or lead to destabilising effects. Arguably, low interest rates and a clear understanding that the movement of interest rates would be gradual, incremental and signalled fed the continued growth of the nance system. As such it fed the associated and ultimately pathological changes in economic structure that were occurring, particularly in the USA and the UK. Those changes included rising consumption and rising proportions of GDP reliant on expanding nancial services, retail, leisure and housing markets. One might note here that ination and deation are never just monetary phenomena. It requires an atomistic approach for Friedmans famous dictum to hold. Ination and deation are underpinned by the structural dynamics of economies. Approaches to ination
1 The January World Economic Forum also focused on the problem, publishing Global Risks in which it was stated: Many would argue that the overall resilience of the global nance system will only become evident under conditions of severe stress over the next year. The complexity and near-innite feedback loops of the modern nancial system have exposed it to a small risk of very large systemic shocks. The context, however, remained one in which the system was seen as robust enough to deal with any arising problemsrather than that the system itself was problematic. 2 Note that concern and focus is the issue here, since the Bank of England was aware of changes in the money supply and its sources. The Bank of England Ination Report does contain data on the money supply and M4 (which includes bank deposits as credit creation). Tim Congdon, former member of the Treasury Panel of Independent Forecasters puts M4 expansion between 2004 and 2007 at over 12% per annum.
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and deation do not just have monetary effectsthey help to shape the further dynamics of those economies. In the real world there are structural effects in a way that monetarist theory tends to abstract from. Those effects themselves can progressively constrain central bank policy. In terms of the current crisis, as growth became increasingly reliant on areas of the economy that used or produced debt and leverage the central banks ability to sharply curtail nancial activity was reduced. The line between creating a break on the system and tipping the economy into recession was always going to be thin. If growth areas are also leverage areas then they are amongst the most interest rate sensitive. They would, therefore, ultimately be disproportionately affected by larger interest rate movements. Furthermore, if they involved bubbles the sensitivity was more than simply one of the absolute costs of debt it was also one of the potentials for sudden changes in sentiment. The potential for recession through the use of interest rate policy was signicant irrespective of any further collapse into nancial crisis of the kind that the central banks simply did not place any credence in. The fundamental problem was, therefore, that economies had been allowed to develop such a basic vulnerability that combined the potential for nancial and real economy instability. The very existence of the vulnerability arose in the context of a primary focus on interest rate policy and then served to constrain any effective use of interest rate policy. Overall, then, the central banks did not pursue a strong restraining approach to interest rates prior to the crisis, despite that interest rates were increasing. Furthermore, in the context of the institutional problems that existed, discretion did not mean that central banks made the leap from the overall stability of the nance system to the individual activity of nancial organisations. They did not press them to change their business models nor pressurise other oversight bodies, such as the FSA, to do so. Nobody pushed strongly for legislation to empower the central banks to address aspects of nancial innovation or to question the appropriateness of a hazy division of labour between regulators with all of its impediments. On the contrary, policy makers in the UK and USA championed their nance centres as beacons of the new economy. Accordingly, one might argue that the central banks did not only fail to respond adequately and early to the potential for nancial crisisthey contributed to it. This can also be seen in the failure of the communicative aspect of strategy. Clearly, the communicative aspect, in conjunction with the slow gradual increase in interest rates, failed to shape behaviour. The strategy assumes that problems could be managed: actors would respond to warnings and higher borrowing costs.1 Housing markets would cool, leverage levels would fall, intranancial multiplication would reduce etc. This, however, was not the case because actors did not read the signals as anticipatedtheir rationales responded differently.2 Small incremental interest rate rises and subdued warnings of rising balance of risk left actors seemingly feeling that rising debt servicing costs could be managed rather than reduced. Home owners still felt wealthy, consumption continued to grow. Banks operating an
1 The response is referred to by the Bank as re-pricing risk. It is discussed in the Quarterly Inationary Report as a time-lag effect where equity and housing markets slowly respond to the previous rises in interest rates and the current change in credit spreads and supply of credit. The third quarter report for 2007 is notable in that it acknowledges the failure so far to undergo rapid re-pricing. 2 A complexity of rationale is always a feature of market behaviour. There is a general tendency towards a mass psychology of markets (anticipating what average opinion expects the average opinion to be Keynes, 1936, p. 156), but also a differentiation of signicant asset investments (equities in particular) when new information is provided (prots warnings, analysts notes, quarterly accounts, etc.). For example, during 20068, banking stocks tended to rise just after quarterly reports despite historically poor performance and large writedowns, because the news was often better than expected. Other blue chip stocks, such as Apple, by comparison, might be treated in an opposite way. In January 2008, Apple reported prots of $9.61 billion for 2007, a 57% increase, and also stated a projected sales expansion for 2008 of 29% for the next quarter. The expansion, however, was less than expected and its equity fell 17% to 23 January.
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originate-and-distribute model felt no need to be overly concerned. Those buying securities could be comforted by the AAA rating they carried. Some could be seduced by the way defaults of all kinds remained low in rising markets, creating a statistically selfconrming trend of growth even as absolute debt levels were rising in vulnerable ways. In essence, the psychological unknowns of an uncertain future initially responded to the past by proceeding as though the past remained a good guide to the future despite changing conditions (see Keynes, 1936, pp. 1523). In the end it only required some immediate trigger for the underlying accumulation of problems to manifest and for the whole context of behaviour to switch. In the meantime, the very notion of a great moderation (job security, low ination, easy credit, continuing growth) gave a degree of condence to institutions like the central banks, to individual consumers/employees etc. and to capital market actors that subverted the very intention of applied monetarism to be the one doing the managing. It is in many ways curious that the central banks were not more aware of this possibility. Ironically, whatever credibility the great moderation had, and the role the central banks had in constructing and perpetuating it, was undone by its own credibility. In the end, this left the central banks with nowhere to go: the vulnerabilities of the nance system had already accumulated (securities had been issued and used as collateral, highly leveraged large levels of debt created etc.). Thereafter, the additional policy tools available to the banks were all ones designed to deal with manifest problems not forestalling problems: additional liquidity provision, lender of last resort options, etc.
5. The central banks respond: the radicalisation of orthodoxy

As the crisis has developed the main central banks have radicalised within their own orthodoxy. That radicalisation, however, has not been proactive but rather event led. Events have forced the banks to adopt measures at odds with applied monetarism and more broadly at odds with market liberalism. The rates and degrees of radicalisation have varied depending on the policy area. The Bank of England, for example, was notably more reluctant than the Fed or ECB to adopt loosened liquidity policies for commercial banks. Of greater signicance, however, was that at all points all the central banks have been unable to get ahead of the emerging problems. This again, indicates that there continued to be a lack of overall perspective. If there had been then the banks should have pursued some of the policies earlier and, in other cases, had them in place before they became imperative.
5.1 Interest rates

Initially, when the nancial crisis began to manifest in August 2007, the interest rate responses of the main central banks followed the existing strategy of small incremental changes. The immediate problem, as of 9 August, was that supplies of credit within the system dried up sharply and inter-bank lending rates (Libor, Euribor etc.) began to deviate sharply from central bank rates, both as overnight rates and three-month rates.1 This was a supply problem creating a liquidity problem creating a pricing problem. This meant that reducing both the central bank rate and the additional discount rates (the higher rate at which banks borrow directly from central banks) would, on their own, have limited effect on inter-bank lending. The central banks were also tied into their targeting focus on ination and continued to see the economic problems that were arising through the medium of their
1 The inter-bank short term lending average rates are always slightly higher than central bank ratesfractions of percentages. However, from 9 August they began to deviate sharply. For example, on 10 August, three-month Libor was 6.5%, Euribor was 4.75% and the US inter-bank rate was 5.75%.
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models, remit and institutional division of labour. As such, there was a certain rationale to not responding with immediate large interest rate cuts. However, in the context of the wider impact of the spread of fear and the real effect this had on behaviour and thus market sentiment, there was a steadily growing pressure to continue to make cuts and to make larger cuts, creating the impression that the central banks were committed to addressing the scale of the problem. This impression was intended to limit further capital market downturns and ultimately address the economic crisis that followed the initial nancial crisis. It was, however, always event-led and thus never got ahead of the emerging problems. The Bank of England base rate at the beginning of the nancial crisis was 5.75%. Its discount rate was 1% higher. The Fed funds rate was 5.25% and its discount rate was 0.5% higher.1 The ECB rate was 4%, with a more variable discount usually up to 1% higher. The Fed took a more aggressive approach to cutting interest rates in 2007. It cut twice at regular FOMC meetings on 18 September and 11 December. Both cuts were at the upper end of normal at 0.5%, reducing the rate to 4.25% and with a commensurate change in the discount rate. The Bank of England resisted cuts until 5 December when the rate was reduced by just 0.25% to 5.5%. The ECB left its already lower rate unchanged. The sudden domino collapse in world equity markets on 21 January 2008 began a more rapid unravelling of the established interest rate policy of the main central banks. This began with the Fed. By January the equity prices of commercial and investment banks were on a long downward trend and highly volatile. Since banking stock had become prominent on main indexes any large trading volumes and price falls in these stocks would have large effects on the index. This effect was being exacerbated in three ways. First, it was exacerbated through the need of some nancial organisations to sell off all kinds of equity assets at short notice to cover margin calls emanating from the banks who acted as their prime brokers and who were triggering margin calls based on value falls in securities as collateral (itself exacerbated by leverage).2 Second, it was exacerbated by some of the same nancial organisations, mainly hedge funds, shorting the banks in order to try to recoup some of their losses. Third, it was exacerbated by the growing climate of suspicion and fear as traders realised that the future had become increasingly uncertain and that a great deal hinged on the health of the US economy. These effects were rapidly transmitted from one equity market to another through the inter-connections of the global trading system.3
1 Interest rate changes are reported by the press ofces of the main central banks. See for example, http:// www.bankofengland.co.uk/publications and navigate from news releases. 2 A margin is the per cent rate of the value of the amount lent by prime brokers/bankers that the collateral of the borrower must maintain. For example, a fund invests $1 million in a portfolio of securitiesthe fund wants to borrow money in order to make this investment, and the banks set a margin of 15%, which means that the fund equity or collateral assets stood against the loan must retain a value of 15% or more of the value of the investment (initially $1 million). In this case $850,000 is lent on a $1 million investment with a 15% margin. If the invested assets fall in value then the margin is breached (a larger proportion of the value of the invested asset is now the original loan sum) triggering a margin callthe fund must restore the margin by repaying capital to the lender. The standard way to do this is to sell assets. 3 On 21 January all major equity markets in the world fell signicantly in a domino effect as they opened and closed around the globe. The range of the fall was between 3% and 7.5%. There were two immediate triggers for this. The rst trigger was a report that Chinas banks had large exposure to US securities investments. The second trigger was the growing realisation that if defaults in issued securities rose in ways feared then the main monoline insurers might be unable to meet their obligations. Another catastrophic fall in equity values around the globe occurred on 22 January, ranging between 2.5% and 6%. By this point, equity values had fallen more than 17% and close to 20% in most major markets from the peaks of mid-2007. It was subsequently revealed, on 24 January, that SocGen had been selling (2023 January) into a falling market to dispose of an unauthorised V50 billion of bets by Jerome Kerviel. These were derivative trades on European equity indexes like Dax. SocGens total capitalisation was then only V36 billion. The selling almost certainly contributed to the collapse in markets.
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The collapse of the 21 January drew the Fed to respond with an emergency 0.75% overnight cut to 3.5% to forestall further effects on the next days trading. At the scheduled FOMC meeting of 2829 January, the rate was cut a further 0.5% to 3%. However, the Bank of England and ECB rates remained unchanged. On 18 March, in the wake of the collapse of Bear Stearns, the Fed cut by 0.75% to 2.25% and then another 0.25% to 2% on 29 March.1 It was April before the Bank of England responded with a cut to 5% and the ECB rate again remained at 4%. Thereafter, as world oil and food prices soared through the summer, further rate cuts remained on hold despite steadily worsening data on all aspects of economy (output, consumption, employment, etc.). It took the events of late September and the nal acknowledgement that there was in fact a broader economic crisis to reverse the hesitancy of the summer. In October, the Fed cut its rate to 1.25%, the Bank of England, at an unscheduled meeting, to 4.5% and the ECB to 3.75% (having actually increased rates to 4.25% on 3 July). On 6 November the Bank of England cut the base rate to 3% and the ECB cut to 3.25%. The Fed and the Bank of England then started moving towards effective zero rates in December, the former cutting to 0.5% on 16 December and the latter cutting to 2% on 4 December (and then down to 1.5% on 8 January, 1% on 5 February and 0.5% on 5 March). The ECB began to follow the same track also cutting, on 5 March, to 1.5%.
1 The collapse of Bear was triggered by the collapse of two large hedge fund groups, Peleton and Carlyle Capital Corp (CCC), at the beginning of March. Each was a classic example of a margin call spiral exacerbated by leverage (termed haircut contagion). Each represented an actual loss to particular investment banks but also a market signal that investment banks face continued and escalating exposure problems. This in turn created further liquidity problems for investment banks as funding was withdrawn and market capitalisation reduced. On 3 March the CCC mortgage bond fund reported liquidity problems. CCC, set up in 2006 solicited funds on the basis of a claim of 15% annual returns. The fund was listed in Amsterdam. Its initial $600 million equity was leveraged 32 times to create a fund size with assets of $21 billion, mainly invested in mortgage backed securities, many issued by Fannie Mae and Freddie Mac. The fall in the value of assets caused escalating margin callsaccruing to $400 million during the week. CCC failed to meet these calls resulting in default notices from the lenders (owed a total of $20.5 billion). CCC shares were suspended on 7 March. By 10 March, $5 billion in assets had been liquidated. By 13 March CCC had still failed to meet its margin calls and another $97 million had accrued on the remaining $16 billion of assets not yet seized. On 13 March the 14 main lenders refused additional funding and/or new terms and conditions and CCC effectively became insolvent. The banks seized the remaining assets. That same day Bear Stearns CEO issued a statement denying the bank was illiquid. Bear had lent $1.6 billion to CCC. In 2007 it had reported $46 billion in collateralised debt obligations (CDOs) and mortgage backed security holdings, from a total of $176 billion in securities assets. In the fourth quarter of 2007 it announced its rst overall loss at $854 million and by March 2008 its total writedowns were over $2 billion. Other investment banks had larger scale exposures and writedowns but Bear had a greater reliance on income from securities (74% of tangible equity) and a greater proportion of exposure to such securities (424% of tangible equity compared with an average of 309%). Rather like Northern Rock it had a particularly vulnerable business model in its industry sector. In March Bear started to experience precisely the same kinds of reactions and spirals that the funds it lent to had. Asset values started to fall, brokers and traders became reluctant to trade with an organisation that they feared might collapse, terms and conditions become more adverse, its own liquidity cushion started to seep away as counterparties reduced funding and its market capitalisation started to reduce further. Since investment banks are effectively transmission points, creating and moving on forms of investment (for clients and for themselves through proprietary trading), a reticence to trade and nance trade with them is fatal, particularly when market conditions are already difcult for all investment banks. An investment bank that cannot nd other backers for its underwriting and cannot nd buyers for the securities it issues on behalf of clients cannot function. It becomes institutionally illiquid and quickly experiences a cashow problem that threatens its solvency. At the beginning of March Bear Stearns had a capital pool of cash and liquid assets of $21 billion, by 10 March this had slowly declined to $18.1 billion and fell that day to $11.5 billion on the back of the rumours about exposure. Thereafter counter-party withdrawals and credit refusals began to escalate and as of 13 March its available liquidity had fallen to $2 billion. On Friday 14 March Bear announced it had a solvency problem and was seeking credit support and a possible buyer. The best source to track emerging market stories of this kind is www.enancialnews.com which provides a daily press release and market update service that makes extensive use of sources like Thomson nancial.
The limits of central bank policy 5.2 Problems of interest policy as theory and practice
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The key problem with interest rates as the primary policy tool of central banks has been that it was not a tool designed to deal with the kind of crisis that emerged. This was not just because the initial manifest problem was supply of credit in the system rather than cost per se. Such a position simply meant that a central bank would have to balance reducing short term interest rates intended to affect inter-bank rates with also offering greater supplies of short term funds to banks to create liquidity. Direct borrowing from the central bank could also be encouraged by reducing and even waiving the discount rate, both of which the central banks then did at various times. Rather, the problem was also that the primary policy tool remained constrained by the focus on targeting and management, which were based on a modelling system and institutional division of labour that could not cope with a pan-systemic and qualitative problem. The Bank of England and ECB in particular became mired in a focus on the short term inationary potential created by rising oil and food prices in 2008 rather than the underlying problem that a recession would contract growth and almost certainly depress prices based on the characteristics of the emerging crisis.1 However, discretion in interest rates clearly played an increasing role compared with approximate adherence to the Taylor rule framework. Cuts became larger, more frequent and could be unscheduled. Yet as acts of discretion they were, in 20078, always in the wake of some major event whose immediate effects had to be forestalled. Given the context of the interest rate strategy the central banks had developed prior to the crisis this aspect of radicalisation, at least prior to the shift to near zero rates, might be thought of as a communicative act designed to foster condence. To a degree this seems to accord with a Keynesian insight (1936, p. 317):
It is the return of condence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a purely monetary remedy have underestimated.
The point, however, is that the central banks were already working in the context of trying to return condence, rather than preventing its erosion in the rst place. The commitment to do so still remained one beholden to the central banks focus on price stability and short term targeting broadly in accordance with its rule focus and institutional remit. These remained a drag on more radical thinking. What radicalisation there was occurred behind events. The stagation fears of the summer of 2008 highlight the problems this created in terms of the Taylor rule and a monetarist focus on interest rates as the primary policy tool for economic management. A combination of slowing growth and rising prices is one that interest rates simply cannot tackle. The very existence of the combination produces a perverse context for a theoretical position that assumes interest rate variations can maintain ination and GDP on trend. The net effect is to produce a kind of cognitive dissonance that results in either policy paralysisa wait and see approachor a coin toss choice concerning which of the two one wants to tackle most (slowed growth or rising
1 The debate over inationary forces began even earlier. For example, the published minutes of the MPC meeting of January 2008 reveal that a cut was vetoed because of concerns over inationary pressures. Only one member, David Blanchower, voted for a cut. Blanchower was also later the lone voice in the MPC concerned about deation. Within the MPCs discursive context the rise in ination reported in the quarterly Ination Report on 13 May seemed to vindicate this caution. The indicator used for interest rate targeting, the CPI, increased from 2.5% to 3% (just at the top end of the Treasury-set parameter), the retail price index (including housing costs) increased to 4.2%, whereas core ination (excluding food and energy costs) was more stable at 1.4%.
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inationa monetarist will always fear ination more).1 Arguably, the central banks lost valuable time in getting ahead of events by doing nothing on interest rates during the summer of 2008. One can also consider this in a broader context. Even as events unfolded in 2008 in a slow-burning crisis there was a basic refusal to accept that the nancial crisis would be more than merely a drag on the real economy. There was a basic refusal to see it as a genuine emerging economic crisis of larger proportions and longer term signicance. If there had been such a vision then forestalling a pan-systemic set of negative feedback loops would have been high on the agenda. One aspect of this would have been to cut interest rates aggressively towards 0% (in the context of other measures), ideally from August 2007 but at least from January 2008. This policy would have been to prevent conditions that an earlier brand of monetarist such as Fisher, with a greater interest in broad money supply such as credit, would recognise as debt-deation and Keynes would recognise as liquidity trap.2 Clearly, all the points made in Sections 24 provide reasons why this did not occur. At the same time, it is not unrealistic to expect the central banks to have been capable of this approach. In order for them to do so short term ination targeting and price stability would have had to be lower on the agenda. There would also have had to have been a broader cross-section of economic opinion within the decision making bodies. That breadth would have had to include more heterodox economic analysis and genuine expertise in the ramications of the inherent instabilities of economic systems. In practical terms the bodies could have looked more closely at the Japanese economic experience. Japan provides the template for the current crisis, starting from the leverage in the banks and a housing market bubble. It also illustrates the potential problems of waiting too long to start to cut interest rates because of fears over ination (Turner, 2008).3 For the Bank of England, Fed and ECB to have followed this tack in 2007 or 2008, rather than early to mid-2009, would have required them to step outside the whole theory and practice in which they had operated.4 Instead they opted for an expansion of the terms and conditions of liquidity creation.
5.3 The expanding remit of liquidity creation

The immediate response of the Fed and ECB to the slowing of credit markets on 9 August 2007 was to provide increased liquidity. Liquidity is typically provided through the offer of
The paralysis over interest rate direction was seen as an impediment to the effective management of expectations as early as January 2008. Donald Kohn, vice chairman of the Board of Governors of the Fed, speaking at the American Economic Association conference in January 2008 commented that cutting interest rates during a period of inationary pressure (oil price had just hit $100 per barrel) was creating mutually irreconcilable narratives. 2 Fisher argues that as a debt-related-asset sell-off is triggered the broad money supply contracts because repaid loans are not recycled (either the banks become cautious or the appetite for borrowing falls off) creating the conditions for falling prices that in turn creates new distressed sellers creating further falls in prices and so on. 3 As Turner rightly points out, the limited impact of scal stimulus through public works in Japan was not a failure of Keynesian principles per se but rather a failure of Japan to rst solve the liquidity trap problem in order to place a stabilising oor under scal expenditure. In this context higher public spending simply crowded out private investment at the same time as contributing to growing savings levels as the population feared job insecurity, bank fragility and equity market collapse. Interestingly, Chancellor Darling was specically asked at a G7 Finance Ministers meeting in Tokyo, in February 2008, if the UK could learn anything from Japans experience. The reporter notes that Darling refused to answer but looked disdainful. 4 One might also note that Ben Bernanke specically agged his concerns over deation when he took up his post at the Fed, which may explain why the Fed was ahead of the Bank of England and ECB in its policy measuresthough it does not explain why the Fed remained event-led.
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additional short term funds at xed rates (discount or otherwise) or through term auctions (where the rate is set by the bidding). The funds were available to commercial banks registered as eligible in the relevant jurisdiction. Prior to the crisis the Fed typically offered funds for liquidity on a daily basis, whilst the ECB has engaged in periodic ne-tuning intervention. Prior to the crisis total sums were typically single gure billions. As the crisis unfolded, all the central banks engaged in larger scale and/or more frequent liquidity interventions. Again, this was event led. On 10 August, 2007, the Fed provided $24 billion and the ECB V98.4 billion in funds. This was followed on 6 September by two more unusually large interventions of $31.25 billion and V42.2 billion, respectively. The Bank of England initially did nothing. Mervyn King had, since early August, articulated a strong moral hazard position, arguing that the problem was not condence in the central bank or the nance system as a whole, but rather individual banks poor practices, which would simply be reinforced by any attempt to ease the problems indicated by increased Libor. He placed this also in terms of his initial reluctance to use interest rates in a more discretionary way. For example:
Interest rates are not a policy instrument for protecting unwise lenders from the consequences of their past decisions. We are certainly not going to protect people from unwise decisions that they have made before . . . We dont know whether these tremors in nancial markets signal a more disruptive movement to come, or constitute a gradual release of pressure on spreads that have built up over some time. So its impossible at this stage to judge how large and how persistent this tightening of credit conditions is likely to be. [But] I do not think there is much sign of major damage to loan performance in other markets. So far what we have seen is not a threat to the nancial system, either in the United States or Germany, let alone in the United Kindgom. It is not an international nancial crisis. To the extent that these spreads are starting to widen, I think that it is a welcome development as a more realistic appraisal of risks is being seen. (Duncan, 2007)
However, from early September the Bank of England was forced to act. An additional liquidity auction sum of 4.4 billion as overnight funds was announced on 4 September to be available for each of the following three weeks. The daily settlement margin of error of the commercial banks accounts with the Bank of England was also widened from 1% to 3.75%. Still, three-month Libor continued to rise and on 19 September the Bank also moved to offer 10 billion of additional three-month funds in each of the next four weeks and agreed to accept mortgage securities as collateral. Initially there was a reluctance to use the facility, just as there was also some reluctance to access Fed funds available at the higher discount rate. In both cases it was not just because of the rate but also because accessing the funds was not wholly anonymous and might provide a market signal that the banks applying for the funds were facing signicant problems. This in turn could affect their market capitalisation in a time of equity market fear. For this reason, the Fed encouraged the more prominent US banks to access discount rate funds to remove the market stigma. The Bank of England did nothing and many cross-border banks simply applied for short term funds through the ECB. The Bank of England initial offerings remained undersubscribed despite a persistently high Libor that indicated a shortage of short term funds. For example, on 25 September there were no takers for the Bank of England 10 billion auction but an ECB auction of V50 billion was over-subscribed with 159 applicants (from the 2,141 eligible institutions). Even anonymity did not prevent problems emerging. On 27 September the ECB provided V3.9 billion in overnight funds to an unnamed bank at a punitive discount rate of 5%. The unscheduled, singular, and large nature of the provision created generalised uncertainty, as did the fact that the institution accessing the
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funds could be from one of many geographical locations. Inter-bank lending rates increased sharply. As the cycle of liquidity offerings expanded, however, the general problem of stigma became less of a concern for the applying banks. It was, to a degree, overtaken by eventsemergency action became normalised. The more immediate problem was that the scale of liquidity provision was always less than the overall scale of the problem being addressed. The key problem for the banks and other nancial institutions was that wholesale markets, and commercial paper markets in particular, had reduced or frozen. This left them with a short term funding problem in two ways. It left the banks with an ongoing problem of recurring funding shortfalls to balance short term transaction asymmetries between themselves. It also left the banks with funding shortfalls related to their ongoing exposures to other nancial organisations that in turn were in dire need of capital for liquidity. These included investment banks, hedge funds and leveraged structured investment vehicles. These funding shortfalls were created by a combination of broken transformation models (renewing short term borrowing to maintain long term investments), falling values of assets (all kinds of securities that were now also illiquid) and margin calls (that are not met). The overall problem of scale was an escalating one. Intra-nancial multiplication and increasing reliance on wholesale markets had created trillions of dollars of exposures. Reductions in the liquidity of assets and in the willingness of organisations to lend among themselves (collateralised by such assets) were creating a spiral of losses of value. This was steadily manifesting solvency problems from liquidity problems, which in turn created new needs for new liquidity via the injection of funds from the central banks. This escalation was actually occurring faster than any increase in defaults in the underlying security assets that rst triggered the problem. As in the case of interest rates the provision of liquidity by the central banks did not seem fundamentally set up to deal with the problem. This was exacerbated by the way the central banks took an event-led approach on liquidity as they did with interest rates. Moreover, the scale of provision may have increased but it did so in ts and starts. For example, the next large unscheduled change in liquidity provision was the $41 billion provided by the Fed on 1 November 2007 following its cut to the Fed Funds Rate and undertaken in the context of the analyst Meredith Whitneys note that Citigroup was undercapitalised by $30 billion in terms of its Tier 1 Capital ratio as a measure of nancial stability. This came on the back of the rst phase of huge writedowns in securities and private equity investments reported by the US banks in their third quarter accounts. Whitneys note caused a fall in Citis share price of 7% and an overall fall in value of the Dow totalling $369 billion. A further $47.25 billion of unscheduled funds was provided by the Fed on 15 November in the wake of Bank of Americas third quarter accounts. The Fed, as with the other central banks, increasingly met each event with large-scale liquidity injections. However, these injections remained small in proportion to the scale of the exposures and could not address the basic problem that what was at stake was the capitalisation of the banks because of their exposures. It could not restore value to the assets that the banks held or guaranteed or were linked to through their use as collateral by borrowing organisations. Liquidity provision was, therefore, always highly constrained as a way to restore inter-bank lending and also wholesale markets more broadly. Liquidity provision, as with interest rate policy, was in many ways little more than a condence statement, one equally hampered by the problem of returning condence to a system that was now unwinding in a disorderly way. This remained so despite the move to coordinated liquidity provision between the main central banks. At a G10 meeting in mid-November 2007 it had been agreed that greater
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coordination was needed. This manifested in a joint announcement, on 12 December, of new funds for auction: two Fed auctions totalling $20 billion each of one-month funds, two Bank of England auctions each of 11.25 billion in three-month funds and two ECB auctions to talling V20 billion (plus other auctions by other central banks). Most of the funds were not subject to discount rates. The Fed auction was through the newly created Term Auction Facility (TAF): a xed sum offering of longer term funds (28 day, 35 day funds etc.) in a swap for collateral where the rate is set by the bidding process (the minimum is the expected federal funds rate and the maximum is behaviourally moderated to less than the discount rate).1 The Fed auction of 19 December, 2007, was at less than the discount rate of 4.75% and received applications to the sum of $61 billion (i.e. was more than three times oversubscribed). The oversubscription indicated the degree of demand in the market. The outcome also illustrates the underlying problem. Inter-bank rates remained signicantly above base rates, commercial lending did not ease, the market capitalisation of banks continued to slide (resulting at this point in a rush to access sovereign wealth fund capital) and other nancial organisations continued to become insolvent. The TAF, as with coordinated provision by the other main central banks, though beginning as a short term measure, became a persistent feature of the nance system. Its scale of single offerings varied but tended to slowly increase. It increased to $30 billion in January 2008 and $50 billion in early March.2 March was another pivotal month. As rumour began to spread that Bear Stearns faced insolvency the central banks responded with another round of coordinated large scale injections. The Fed added another $200 billion of unscheduled funds to the $200 billion already committed through the TAF and other avenues for the month.3 Bear, as an investment bank rather than a depository institution could not access TAF funds and, as it slid into insolvency, on 14 March the Fed sought to manage the problem by facilitating a takeover by JP Morgan and also creating a Primary Dealer Credit Facility under provision 10b5 of the Federal Reserve Act. This extended TAF-type funding to non-deposit institutions. Again, the response was event led and was unable to prevent the continuation of underlying problemsLehman Brothers was almost immediately singled out as the next most vulnerable of the investment banksthough that story did not reach its conclusion until September. The provision of a credit line to JP Morgan by the Fed, guaranteeing $30 billion of Bear securities (with JP Morgan agreeing to accept the rst $1 billion of any losses), generalised the core aspect of what had occurred at Northern Rock. It reinitiated a process of directly socialising any costs of the ongoing crisis. It signalled a shift from simply providing short term liquidity in swaps and loans of up to three months to accepting the longer term risk inherent in the accumulation of speculative investment assets that was at the heart of the problems being experienced by the banks. This process, however, was politically fraught.
5.4 Problems of liquidity policy

Liquidity policy in tandem with interest rate policy was never able to manage the emerging crisis. The specic problem in terms of liquidity policy was that it only became necessary because of vulnerabilities inherent in the way the nancial system had developed. The
1 See http://www.federalreserve.gov/newsevents/press/monetary/20071212a.htm for the basis of the TAF and http://www.federalreserve.gov/monetarypolicy/taf.htm for summary statistics. 2 Combined with a new $100 billion open market operation of 28 day swaps for repurchase of offered securities (Treasury, federally backed mortgage securities via Freddie Mac, etc.). 3 The unscheduled Fed intervention raised average bank market equity by 7.5% but Bears by just 1%.
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problems had to exist in order for the central banks to shift from ordinary low level and limited liquidity management operations to larger scale interventions. In terms of the scale of the problem the interventions were never going to be large enough. Only long term liquidity offerings on a huge scale could break the cycle. More specically, only guaranteeing the capitalisation of the banks, and the underlying value of the assets they and other nancial institutions held, would have had any possibility of stabilising interbank lending and freeing credit markets as a long term outcome that would have avoided the perpetual manifestation of new problems in the nance system through illiquidity. This would be more than the lender of last resort and nal intervention policies that central banks use to draw a too big to fail line under the main banks when problems reach their culmination. It would be a pre-emptive multi-trillion dollar exercisenotional though most of it would have been in terms of actual defaults if the system could have been genuinely stabilised. Again, given the points in Sections 24, this was not likely. It would have required several differences. First, an overall context in which nancial stability was decoupled from a focus on price stability. More importantly, where orienting on nancial stability took precedence over and framed any commitment to price stability. Second, the rst point would in turn (as in the case of interest rate policy) have required that decision making bodies contain a greater range of heterodox thinkers with an expertise in economic systems as systems with inherent instabilities. Third, it would have required an operational institutional structure that did not inhibit information ows regarding possible instabilities and did not create impediments to imposing policies designed to generate stabilities. These three, however, as avenues through which liquidity based problems might be resolved still presuppose the system that creates the problems. In the end they imply the need for vigilance in chasing a runaway liberalised system. The existence of the system based on particular tendencies to overcome regulation and work round interventions is the more fundamental problem. This is one of regulative ethos. Should the system be based on the ethos of what is not prevented is allowed, or should it be based on the ethos of what has not been allowed is prevented? The point may seem abstract but it can easily be rooted in law through contract enforcement within national boundaries. The potential for important changes here now exists. However, in the context of liquidity provision during the crisis, the very notion of a political consensus and mandate for radical policy intervention was problematic. Such intervention prior to the manifestation of the problems on a large scale would require not only establishing the likelihood of those problems but also persuasively setting out why they should be collectively tackled. As the crisis has illustrated, consensus and mandate have remained divisive issues even as the problems have manifested. The US Treasury and Fed could not even coordinate a small group of larger US banks in October 2007 to create the Master Liquidity Enhancement Conduit as a $100 billion special purpose vehicle to buy up and isolate already problematic sub-prime-related securities, despite the fact that the banks were better placed than anyone else to know the ramications of a failure to do so. Creating a broader popular mandate when the basis of the narrative of the recent period was one of private risk and great gains, and where the institutions continued to state that the overall real economy effects would be muted was unlikely to say the least. The problems experienced in passing the subsequent US Treasury open-ended usage $700 billion banking bailout plan simply underscore the nature of the difculty. To be genuinely effective early on all kinds of areas might have needed to be covered in one way or another in order to facilitate the ow of credit and close down problems of downward
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spirals from fears over collateral sources. These areas (issued securities, nodal nancial organisations from which margin calls might emanate and escalate etc.) were all areas based on nancialisation, multiplication and private sources of prot: quintessentially areas of market liberalism much of it belonging in no single country. One might also note that the growing demands by market actors during 20079 indicate the tension in a neoliberal ideology: limited intervention is in everyones interest but when we fail we demand aid/support etc. It indicates that market liberalism is not free market, but rather more exploitatively oligopolistic (limited numbers of key actors extracting disproportionate gains). Liquidity management cannot x this basic problem because the problem is structural. Liquidity management presupposes the problems it is ultimately required to try to x. But it cannot x them if it leaves in place the underlying tendency to expand nance in vulnerable ways. When such vulnerability develops it can merely continue to fail until such time as costs are socialised. That is what a pan-systemic crisis signals. This is another basic Keynesian point that There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most protable (Keynes, 1936, p. 157) It is the basis on which Robinson afrms that economics is a socio-political realm that demands genuine discussion of what kind of economy is socially benecial:
Keynes brought back the moral problem that laissez-faire theory had abolished . . . By making it impossible to believe any longer in an automatic reconciliation of conicting interests into a harmonious whole, the General Theory brought out into the open the problem of choice and judgement that the neo-classicals had managed to smother. The ideology to end ideologies broke down. Economics once more became political economy. (Robinson, 1962, pp. 723)
This is a point also made by those inuenced by Aristotle, such as Maki (2001, p. 39), that the very idea of wealth as money rather than as a useful thing distorts the fundamental measures and perspectives of economics, as well as (as MacIntyre, 2000, argues) its practices in society.
5.5 Illustrating the contradictions of the shift to socialised costs

After the events of March 2008 in the USA, and in the context of the growing number of rights issues being prepared for new capital raisings by the British banks (particularly Royal Bank of Scotland), the Bank of England introduced the Special Liquidity Scheme (SLS).1 The SLS offered Treasury gilts over the following six months specially issued by the Treasurys Debt Management Ofce in swaps for commercial banks currently illiquid but AAA-rated mortgage securities and credit card or unsecuritised mortgage assets. The Treasury gilts, as more liquid assets, could then provide better collateral for the banks. The swap was for one year, extendable to three, providing a longer term source of funds to the banks than typical central bank liquidity operations. However, the terms of the offer illustrate a tension inherent in the political process of socialising costs. The central bank, under Treasury direction and also subject to Kings own preference for moral hazard argument, wanted to limit the costs to the taxpayer of any losses deriving from the banks assets. At the same time the Bank of England was under pressure to do something substantive. Specically, to ease the problem created by illiquidity and value losses in the banks that had now become a main issue for the individual banks lending function and for the stability of the nance system as a whole. The Bank of Englands approach was to
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http://www.bankofengland.co.uk/publications/news/2008/029.htm
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weight the scheme on the side of protecting the taxpayer against losses. Only AAA securities issued before 2008 would be accepted. If the securities ratings fell after they had been accepted they were to be replaced. The securities accepted would be taken at a percentage discount rising with the duration to maturity of the security. For example, if under three years to maturity then the assets would be taken at a 12% discount. If 35 years then the discount would be 14% and so forth. The discount was to offset any possible defaults in the underlying income streams of the securities. The participating banks would also be charged a fee minimum of 0.2% of the transaction. The scheme itself was openended in terms of the sums of securities involved but it was initially estimated that demand would be around 50 billion. Not only was the scheme relatively small (the total stock of mortgage securities in the UK was 1.2 trillion at the time and the ongoing wholesale funding of the banks stood at 550 billion), but it had also been set up in terms of a contradiction. According to Mervyn King the aim was to improve the liquidity position of the banking system and raise condence in nancial markets while ensuring that the risk of losses on the loans they have made remains with the banks. Since the core issue was one of problem assets rather than all assets then accepting only the highest quality assets and in relatively small amounts was essentially meaningless in terms of longer term effects. It did, however, expose the taxpayer to the possibility of losses in high rated mortgage securities. But this would only occur if the banks (and building societies) were unable to accept back their better assets i.e. they had become insolvent and/or been nationalised. Since the poorer, less liquid, assets remained on the books of the banks the core of the problem of condence in the banks would remain. There would be, therefore, a continuation of writedowns as defaults and valuations fell and a continuation of suspicion of bank equity (and the adequacy of tier 1 capital measures and so forth). As such, the SLS would do nothing to trigger new lending, improve liquidity or put a oor under the problems of the banks. This being so it represented a politically and economically acceptable (rather than genuinely rational) policy move that did nothing to prevent the eventual need to partially nationalise some UK banks. In policy terms it could be described as a failure to prevent the future socialising of costs. This was so even though the scale of the scheme was larger than initially anticipated. By its close on 30 January 2009 the SLS had been used by 32 banks and building societies creating a total of 185 billion in new Treasury securities against swaps of 287 billion in bank securities. Over the duration of the SLS the nance system continued to decline. The Bank of England continued to introduce more piecemeal and limited policy solutions. It introduced a Discount Window Facility in October 2008, which accepted a broader range of securities as collateral. These ranged from AAA securities to illiquid debt securities. In January 2009 it extended the period of lending from 30 days to one year.1 This was still not sufcient to prevent the partial nationalisation of Royal Bank of Scotland and HBOS/ Lloyds. It was not sufcient to prevent the need for the Treasury to develop the Asset Protection Scheme in 2009, which introduced a whole new raft of public exposure to potential losses generated in the private sector. It was not sufcient to prevent the accumulating effects of the economic crisis in 2009 resulting in a huge rise in public spending in the UK, as it did in other countries around the world (precisely as public revenues fell). It was not sufcient to prevent the need to add quantitative easing as the nal logic of ineffectually cutting interest rates. One can make the same points regarding
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http://www.bankofengland.co.uk/markets/marketnotice090319dwf.pdf
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the Fed and the ECB. In short, central bank policy was not enough to either stabilise the nance system or to contribute effectively to managing the broader economic problems that ultimately became the current economic crisis. As such central bank policy failed the basic test of central banking identied by its rst prominent theorist Walter Bagehot. In doing so that policy has exposed that in exact proportion to the power of this system is its delicacy I should hardly say too much if I said its danger (Bagehot, 1873/2007, p. 8).
6. By way of conclusion: ethos and practice

The failure of central bank policy has been a theoretical and a practical failure. It indicates the need for a rethink of the institutional arrangements and division of labour of the central banks. It suggests that a focus on short term interest rates and targeting as a primary policy tool is potentially dangerous. It indicates that the theoretical basis of central bank modelling should be reassessed. This latter point might seem to imply simply adjusting the modelling process: allowing for broad money, eliminating rational expectations and removing the stability bias in the BEQM. However, doing so would raise profound problems for the tractability of modelling as a forecasting and management tool. It would bring into question the very method and purpose built into modelling. For a modeller it would raise the issue of how to reconcile any reconstruction of modelling with reliability, understood as producing determinant outcomes (answers).1 For a critic it raises the issue that the very notion of reliability creates a false condence: one that might only manifest when qualitative change undermines a period of relative stability. This in turn raises the broader point of the role of the economist and the very nature of economy. As such, the problem of theory links back into the problem of practice and of institutional arrangements. The economist as critic and economics as a broad based set of approaches is something that the theory and practice of economics, including within central bank policy, has tended to suppress. There has always been a counter-discourse objecting to this, even within the work of those claimed as founding fathers of modern economics. Jevons, for example, states:
In matters of philosophy and science authority has ever been the great opponent of truth. A despotic calm is usually the triumph of error. In the republic of the sciences sedition and even anarchy are benecial . . . Show us the undoubted infallible criterion of absolute truth, and we will hold it as a sacred inviolable thing. But in the absence of that infallible criterion, we have all an equal right to grope about in our search of it, and nobody and no school nor clique must be allowed to set up a standard of orthodoxy that shall bar the freedom of inquiry. (Jevons, 1871/ 1970, pp. 2601)
Leontieff was amongst the rst to recognise this in the modern development of economics:
Uncritical enthusiasm for mathematical formulation tends to conceal the ephemeral substantive content of the argument behind the formidable front of algebraic signs . . . [but] it is precisely the empirical validity of the assumptions on which the usefulness of the entire exercise depends. What is really needed, in most cases, is a very difcult and seldom very neat assessment and verication of these assumptions in terms of observed facts. (Leontieff, 1971, pp. 12)
But perhaps verication is the wrong term since the main relevant role of the economist is as seer: taking what has and is happening and seeing where it might lead. This requires a degree of iconoclasm and non-conformity that must be mirrored in both theory and
1 There are, however, compromises in the form of post-Keynesian approaches to banking analysis (Alves et al., 2008) and central bank policy (Palley, 2006).
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practice. It also requires a more pluralistic forum for debate regarding how the whole economy is structured in a way that modern macroeconomics does not capture. One of the main outcomes of the current crisis is the acknowledgement by policy makers that new thinking is required, that regulation must change the nature of the nance system and its relation to the economy. Part of the problem, however, is that the people advising on this are drawn from the same pool that created the current problems. It would be wrong to simply denigrate key actors in economics and policy as technocrats in some primitive sense. However, Mervyn King, Paul Volker, Larry Summers, Tim Geithner, Ben Bernanke and a long list of others are all, in various ways, products of economics training and an institutional socialisation that is an impediment rather than an aid to new thinking. New regulation could, from the current point, run in various directions. It could involve greater degrees of oversight, and coordination and communication between oversight bodies in a still liberalised system where the oversight bodies have more rapid response measures to call on in intervening to sterilise and isolate problems.1 This, however, presupposes a balance of regulation based on an underlying continuation of the ethos of the system as isthe ethos where whatever is not formally prevented is allowed. This ethos, based in a debased form of Berlins (1969) concept of negative liberty where the notion of Smiths (1759/2000) moral gravitation in the form of sentiment has been excised, simply endorses the continuing arms race between regulator and the system. An alternative would be to rethink the very basis of banking and nance. As many have begun to note, nancial innovation has also been social innovation and social transformation (Engelen et al., 2008). It has gone hand in hand with a more general capture of areas of political policy that should be subject to broader checks, balances and debate, by narrowed specialised knowledge discourses because they are technical areas subject to expertise and particular interests (Moran, 2007). More broadly, heterodox thinking in more democratic forums is required (Patomaki, 2009). In this context the question, what is the social welfare benet of banking and nance, should be one that is directly addressed in thinking about the structure of the system that then needs to be regulated. This may result in a quite different context in which a central bank would operate. Robinson, writing in 1970 of the coming crises of that decade, provides an important reminder here:
It is easy enough to make models on stated assumptions. The difculty is to nd the assumptions that are relevant to reality . . . Even if the crises that are looming up are overcome and a new run of prosperity lies ahead, deeper problems will still remain. Modern capitalism has no purpose except to keep the show going . . . It should be the duty of economists to do their best to enlighten the public about the economic aspects of these menacing problems. They are impeded by
1 This, for example, seems to be the basis of many of the current favoured reform approaches. It forms the basis of the US Treasury Blueprint for Regulatory Reform, published on 31 March 2008. Its main points were: (i) give the Fed greater oversight of non-depository nancial institutions, including the ability to conduct onsite examinations; (ii) make the Fed primarily responsible for nancial market stability; (iii) establish a Mortgage Origination Commission (MOC) to regulate home loans on a national basis. All three essentially add another layer of regulation to already existing national and state institutions designed to produce coherency through top stage oversight and strategic direction. They also add some hands-on aspects to Fed powersincluding greater direct scrutiny of investment banks and private placement markets for securities. The general way of thinking also forms the basis of new SEC regulations designed to bring hedge funds under its remit. It provides the basis of much of the discussion by the Financial Stability Forum through the IMF to provide a more effective global early warning system (2008), which is essentially based on improving transparency, accounting and reporting in ways that reduce under-estimation of risk. It is the basis of Shillers (2008) approach to solving the problems of nancial innovation by adding more and better innovation (reducing information asymmetries). It is the basis of the Centre for Economic Policy Report (CEPR) approach to standardising securities trading through central clearing houses (Brunnermeier et al., 2009).
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a theoretical scheme which (with whatever reservations and exceptions) represents the capitalist world as a kibbutz operated in a perfectly enlightened manner to maximise the welfare of its members. (Robinson, 1971, pp. 1424)
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Cambridge Journal of Economics 2009, 33, 581608 doi:10.

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The limits of central bank policy

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2. The Taylor rule framework, CTMM and monetarism

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The limits of central bank policy

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The limits of central bank policy

3. The multiple points of failure of applied monetarism as central bank policy

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The limits of central bank policy

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4. Institutional failure, price stability and nancial stability

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The limits of central bank policy

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The limits of central bank policy

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5. The central banks respond: the radicalisation of orthodoxy

5.1 Interest rates

The limits of central bank policy

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5.3 The expanding remit of liquidity creation

The limits of central bank policy

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The limits of central bank policy

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5.4 Problems of liquidity policy

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The limits of central bank policy

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5.5 Illustrating the contradictions of the shift to socialised costs

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The limits of central bank policy

6. By way of conclusion: ethos and practice

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The limits of central bank policy

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