Michael D. Bordo1
A Historical Perspective on the Crisis
The recent global financial crisis/recession/slow recovery in many advanced countries leads to the important question for central banks. Do they need to change the plot? Before jumping to that question we need to put the recent crisis experience in an historical context. How does the recent global financial crisis compare to earlier ones? The recent financial crisis was global in the sense that it affected many countries in several geographical regions. My re-search with John Landon Lane (2010) shows that the world has had five global financial crises since 1880 (1890-91, 1907-08, 1913-14, 1930-33 and 2007-2008). See Figure 1.
These conclusions come from cluster analysis of several banking crises chro-nologies. We defined a global banking crisis as involving two or more regions.
We measured both crisis incidence and real output losses in the recessions associated with the crises. Crisis incidence was weighted by real GDP relative to the U.S. Our results show that the recent crisis is definitely not the worst in the past century. In terms of both global incidence and lost output it was fourth in ranking comparable to the crisis of 1907-08. Compared to the Great Depres-sion it was only a shadow of that event.
One of the hallmarks of the analysis of global financial crises is that in every case the U.S. was involved. This is important. It reflects two facts: the U.S. is big and interconnected with the rest of the world; the U.S. has always had a crisis prone banking/financial system going back to the early nineteenth cen-tury.
1Michael D. Bordo is Professor of Economics and Director of the Center for Monetary and Financial History at Rutgers University, New Brunswick, New Jersey.
Figure 1: Weighted 2-period Moving Sum of Banking Crisis Frequencies:
1880-2009
In sum the historical perspective tells us that the crisis was bad but could have been worse. Reasons why it was not so bad include: 1) monetary authorities around the world learned to act as lenders of last resort; 2) we left the gold standard; 3) the presence of automatic stabilizers and social safety nets.
Where should we go from here?
Given the historical background the question is where should central banking be going in the future? Based on the history of central banking which is a story of learning how to provide a credible nominal anchor and to act as an LLR, described in my paper delivered earlier in the conference (Bordo 2010), my recommendation for central banks is to stick to the tried and true—to provide a credible nominal anchor to the monetary system by following rules for price stability. Also central banks should stay independent of the fiscal authorities.
The recent crisis has weakened central bank independence and returning to the pre-crisis regime as soon as possible would be desirable.
If the central bank is successful in maintaining a stable and credible nominal anchor then real macro stability should obtain. But in the face of real shocks central banks also need to follow short-run stabilization policies consistent with long-run price stability. The flexible inflation targeting approach
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lowed by the Norges Bank seems to be a good model that other central banks should follow. Moreover if all countries follow similar credible inflation tar-gets (or better still price level tartar-gets) then international monetary stability would be maintained. The benefits of the classical gold standard could be adopted without going back to the gold standard has been advocated recently.
A central bank should also serve as a lender of last resort to the money market.
Lender of last resort policy involves temporarily expanding liquidity and then returning to the price path consistent with price stability. The central bank should preferably do this by open market operations rather than by discount window lending to individual banks, to let market forces choose the recipients of funds rather than relying on discretion. But if the discount window is to be used, loans should be made only to solvent institutions. Bailouts should be avoided.
The history of central banking also suggests that the central bank should pro-tect the payments mechanism and be ready to provide liquidity assistance only to institutions which provide means of payment. The role of a central bank is not to protect non-bank financial institutions which do not provide means of payment. The supervision and regulation of these institutions should be han-dled by other authorities.
The historical examples of the Wall Street crash of 1929 and the bursting of the Japanese bubble in 1990 suggests that the tools of monetary policy should not be used to head off asset price booms. Following stable monetary policy should avoid creating bubbles. In the event of a bubble however, whose burst-ing would greatly impact the real economy, nonmonetary tools should be used to deflate it. Using the tools of monetary policy to achieve financial stability (other than LLR) weakens the effectiveness of monetary policies for its pri-mary role to maintain price stability.
Thus a strong case can be made for separating monetary policy from financial stability policy. The two should be separate authorities. However if the institu-tional structure doesn’t allow this separation and requires FSA to be housed inside the central bank then it should use tools other than the tools of monetary
policy (the policy rate) to deal with financial stability concerns. The experi-ence of countries like Canada, Australia and New Zealand which largely avoided the recent crisis, shows that some countries got the mix between monetary and financial stability policy right. It also shows that universal banks can work and do need to be broken up as some have argued.
Finally a lesson from the recent crisis is that financial regulation (preferably by agencies other than the central bank) should be based on providing incen-tives for private financial agents to take prudent actions (“to have skin in the game”). History suggests that holding sufficient capital was important for fi-nancial stability. In the era before World War I in the U.S. commercial banks held much higher capital ratios than subsequently. It was a private sector at-tempt to provide financial stability.
References
Michael D. Bordo (2010), “Long-Term Perspectives on Central Banking” pa-per prepared for the Norges Bank Symposium “What is a Useful Central bank?” Norges Bank, Oslo November 18
Michael D. Bordo and John Landon Lane (2010), “The Global Financial Cri-ses: Is it Unprecedented?” Paper prepared for the 2010 EWC-KDI Conference on “The Global Economic Crisis; Impacts, Transmission and Recovery”
Honolulu, Hawaii August 19-20