Academic journal article The Cato Journal

Learning the Right Lessons from the Financial Crisis

Academic journal article The Cato Journal

Learning the Right Lessons from the Financial Crisis

Article excerpt

More than eight years after the onset of the global financial crisis, there is one thing that ought to be clear to everyone: unconventional monetary policies are not working. We have had three rounds of quantitative easing (QE) and the Fed's balance sheet has increased nearly fivefold from $825 million in August 2007 to just over $4 trillion today; the federal funds rate fell from 5.25 percent to almost zero by December 2008 and has remained there until the 25 basis point increase in December 2015; federal debt has more than doubled to just over $18 trillion, rising from 61 percent to 101 percent of GDP; vast amounts of public money have been thrown at the banks to keep them afloat; and there has been a huge expansion in financial regulation. To say that the results have been disappointing would be an understatement: output has been sluggish, unemployment has been persistent, bank lending has flatlined, productivity has risen at an unprecedentedly slow rate since 2011, and poverty and inequality have greatly increased. (1) For their part, the banks are still much weaker than they should be, and major banking problems--especially, "too big to fail"--are still unresolved and continue to pose major threats to future financial stability. Seven years of extreme Keynesian policies have failed to produce their intended results. We see similar results in Europe and in Japan. In the latter, this comes after 25 years of such policies.

It is curious that in every discipline except Keynesian macroeconomics, practitioners first consider what caused a problem and then seek a treatment that addressed the cause. If the cause of a medical condition is excess, then the remedy would be moderation or abstinence. However, in Keynesian economics, if the cause is excess spending, then the standard treatment is even more spending. Keynesians then wonder why their treatments don't work. To give one example, former U.S. Treasury secretary Larry Summers (2014: 67) recently observed: "It is fair to say that critiques of [recent] macroeconomic policy ..., almost without exception, suggest that prudential policy was insufficiently prudent, that fiscal policy was excessively expansive, and that monetary policy was excessively loose." Summers is correct, but he fails to note the irony: that the majority of policymakers still advocate insufficiently prudent prudential policy, excessively expansionary fiscal policy, and excessively loose monetary policy. One can only wonder what these policymakers expect to achieve, other than the same result those policies produced last time, on a grander scale.

It is therefore important that we return to first principles and rethink monetary and banking policy. Instead of mindlessly throwing more money and stimulus around, we should consider what caused our current problems and then address those root causes. We would suggest that the causes of our malaise are activist monetary policies on the one hand, and a plethora of government-created incentives for bank risk taking on the other. Both causes are themselves the product of earlier state interventions.

This diagnosis suggests the following reform program: (1) recommoditize the dollar, (2) recapitalize banks, (3) restore strong governance in banking, and (4) roll back government interventions in banking. The first two reforms directly address the causes just mentioned--monetary meddling and government-subsidized risk taking--and are intended to get the financial system functioning normally again. The two remaining reforms serve to eradicate the root causes and strengthen the system long term by protecting it against future state intervention.

Recommoditizing the Dollar

The key to monetary reform at the most fundamental level is to establish a robust monetary constitution that would have no place for institutions with the power to undermine the currency; thus, there would be no central bank. However, before we can end the Fed, we must first put the U. …

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